Thoughts from the Frontline Weekly Newsletter

The Endgame

by John Mauldin
January 17, 2009

In this issue:
The Endgame
Employment Numbers Are Worse Than Posted
Aye, Captain, I'm Giving Her All I've Got!
Problem #1: Deflation
Problem #2: Pushing on a String
The Muddle Through Middle
Conversations With John

Deflation? Stimulus? Deleveraging? Recession? A soft depression? A return to a bull market? With all that is going on, how does it all end up? When we get to where we are going, where will we be? In chess, the endgame refers to the stage of the game when there are few pieces left on the board. The line between middlegame and endgame is often not clear, and may occur gradually or with the quick exchange of a few pairs of pieces. The endgame, however, tends to have different characteristics from the middlegame, and the players have correspondingly different strategic concerns. And in the current economic endgame, your strategy needs to consist of more than hope for a renewed bull market.

Rather than looking at just one year, in this week's letter we take the really long view and ask what the end result or endgame will look like. There are three possible scenarios (and multiple combinations) that I can think of, we will explore each. Any of them could happen, so we will need to look at some signposts to get an idea of what is actually going to occur. I can make the following prediction that will be absolutely correct: Whatever scenario I lay out here, events and time will change what actually happens. But this will give you an insight into my longer-term biases, and that should be useful. As I tell my kids, put on your thinking caps.

There are a few housekeeping topics I need to cover, but I will do it at the end of the letter. I just did two interviews with Aaron Task and Henry Blodget at Yahoo Tech Ticker, and will provide the links. I also want to talk about the upcoming Strategic Investment Conference, April 2-4 in La Jolla, which is going to sell out. And make sure you get around to subscribing to my new information service, called Conversations with John Mauldin. I will be posting the first conversation very soon, and you don't want to miss it! So, stay with me and let's jump right into this week's letter.

Employment Numbers Are Worse Than Posted

First, I have to address some more government data that can be misleading. We were told Thursday that initial unemployment claims were "only" 524,000. The talking heads immediately said that was proof the economy is simply bad, not falling off a cliff. Again, like last week, that seasonally adjusted number masks the real number, which was 952,151. That is not a typo. There were almost 1 million newly unemployed last week! That is up over 400,000 from the same week in 2008, while the seasonally adjusted number was up only 200,000. Last week the real number was 726,000, so this is a material rise of over 225,000, yet the seasonally adjusted number suggests a rise of only 57,000 from last week.

The continuing claims data leaped over 500,000 to (again, not a typo!) 5,832,746. The length of time people are staying unemployed is also rising rapidly. We are up almost 1.5 million new continuing claims in just the last five weeks. That is a stunning rise of over 30% in unemployment claims in just over a month. The data is truly ugly, but it is what it is.

When you are in periods where there are deep outliers to the data because of very real turning points in the economy (such as we are going through now), the seasonally adjusted numbers can mask the real underlying trends, both up and down.

Aye, Captain, I'm Giving Her All I've Got!

Let me repeat a point I made last week, which is important and necessary for us to grasp if we are to understand where we are headed.

We are in completely uncharted territory in terms of the economic landscape. Like the USS Enterprise in Star Trek, we are boldly going where no man has gone before. But the captains of our fleet are Keynesians to their core (and they don't have any Vulcan advisors). They don't have any historical maps to guide us back to a functioning economy; they only have theory. The North Star they are guiding us by, for good or ill, is John Maynard Keynes, with a slight nod to Milton Friedman.

It is not a question of whether or not there will be massive stimulus. The question is simply how much and for how long. And my wager, as outlined below, is that it will be far larger than anyone would want to admit today. Think of Scotty, aboard the Enterprise, when Captain Kirk demands more power, "But Captain, I'm giving her all she can take. She's ready to explode!" (But he always finds a little bit more.)

Let's set the scene for where we are today. The US likely just experienced a 4th quarter with GDP down over 4%. Some estimates suggest 5%. For all of 2009 we are likely going to be down at least 1-2%, which will make this the longest recession since the Great Depression. Unemployment is headed to at least 9%. Consumer spending will be off by at least 3% this year and again in 2010, as consumers start to find virtue in savings, which should rise in the US to 6% within a few years. Housing prices are going to drop another 10-15%, taking homes back to a level where they may be more affordable.

Corporate earnings are going to be dismal for at least the first two quarters, with forward estimates being lowered again and again. (For a thorough analysis of earnings, look at the January 2, 2009 issue in the archives.) Global trade is falling rapidly, and it is likely that we will see a global recession this year, which will result in further negative feedback on US, European, and Japanese exports.

On a more positive note, oil is below $40, which is more of a stimulus to consumers than anything anticipated by the incoming Obama administration (at least as far as consumers go). With short-term rates at zero, adjustable-rate mortgages are actually not the problem anticipated a year ago, and many homeowners are rushing to refinance their homes at lower rates. Large banks have indicated a willingness to actually cut the principle and interest on troubled mortgages, which might lower the number of defaults.

Conversely, the number of defaults is high and rising -- throughout the developed world. It is likely to be 2011 before the housing market finds a real bottom and housing construction can begin to rise.

The credit markets are still in disarray. While there are some signs that the frozen markets are thawing, the Fed and the US Treasury are having to provide more bailout capital to large US banks. Citigroup is breaking up. Bank of America needs massive amounts of capital to digest Merrill. The hole that is AIG just keeps getting deeper. It is going to take several years for the credit markets to function at anything close to normal, as we simply vaporized a whole credit industry worldwide. To think it will take anything less is simply naive. And in the meantime, the various central banks of the world, along with their governments, are going to step in to fill the need for credit.

Obama has signaled that he needs the remaining $350 billion of Troubled Asset Relief Program money as soon as possible, although his delegated Treasury Secretary, who will run the program, may be in some trouble, as he failed to pay taxes on his income from his stint at the IMF.

(This is not an "Oops, I forgot!" The IMF does not withhold income taxes from its employees. However, he was given a memo about the taxes he owed. And he did pay them for two years when he was audited and caught. He clearly knew the nature of the taxes due the two prior years, yet did not come clean on those years. Dumb move for someone on a fast-track career and who clearly has an impressive intellect. He has got to be kicking himself. Since the Treasury Secretary is in charge of the IRS, this is not good for Obama. Someone on his team should have vetted this more thoroughly. I do think Geithner is otherwise as qualified as anyone else on the short list, but this is a very large cloud hanging over him.)

The auto industry is reeling. Without a lot more government funds, it is unlikely that GM or Chrysler will survive without going through bankruptcy. The industry needs to shed about 20% of capacity. No amount of government funding will change that reality. Beyond autos, industry after industry is on the ropes.

I could go on and on, but you get the picture that is facing the Obama administration and the entire rest of the developed world.

So, how do we get out of this mess? As noted above, the captains of our collective ships are Keynesians. They are going to provide as much stimulus as needed.

Problem #1: Deflation

We got the Consumer Price Index numbers today, and they tell a tale of deflation. On an annualized basis, the CPI for the last three months was a negative -12.7%! Even core CPI, which is without food and energy, was a minus 0.3%. The CPI for 2008 was just 0.1% for the whole year. This was the smallest calendar-year increase since 1954, and it's down from 4.1% for 2007. (To see the whole release and data, you can go to www.bls.gov.)

I outlined the problem of deflation last week in my 2009 Forecast so I will not go into detail, except to note that central bankers are going to fight tooth and nail any tendency for deflation to catch hold in the economic mind of the country. It is simply part of their DNA.

Obama wants an extra $825 billion in his stimulus package, in addition to the $350 billion in TARP monies. The Fed has started to buy mortgage assets, and that could be $500 billion or more. That is in addition to some $300 billion plus and growing in commercial paper, in addition to bank assets, etc.

Let me predict right here that this is merely the first installment. The problems described above are very large. It is one thing to make credit cheap and yet another to make consumers either want to borrow more, or be able to convince a lender that borrowers can repay their debts. On the one hand, the government is providing capital to banks and hoping they will lend it, and on the other hand the regulators are telling them to reduce lending and increase their capital. Their commercial mortgages on a mark-to-market basis are imploding. Consumer credit risk is high and rising. What's a bank to do?

Let's add it up. In the US, we have seen massive wealth destruction on personal balance sheets. At the end of the third quarter the losses totalled $5.6 trillion, between housing and stocks. They could be over $10 trillion at the end of the fourth quarter. (Source: Hoisington) The losses will almost certainly top $12 trillion by the middle of the year as housing continues to deteriorate. Pick any country in the developed world or much of the developing world, and it's the same picture: wealth destruction.

We have seen at least a trillion dollars of capital on financial companies' balance sheets disappear; and given the recent spate of bailouts, it is likely to get worse.

As I have been pounding the table about, a credit crisis and imploding balance sheets, a housing crisis, and a massive earnings shortfall that yields a relentless stock market drop are all independently deflationary. The combined forces are massively so. To think that a mere trillion or so dollars in stimulus will be enough to reflate the US and the world economies is simply not realistic.

Let me offer a simplistic definition of what I mean by reflation: it's when the velocity of money stops falling for at least two quarters and the economy emerges from outright recession.

And much of the proposed stimulus is not really stimulus. Temporary tax cuts, as much as I like them, that are not targeted at getting small businesses recharged (which is where the real growth in jobs will come from) will likely be saved, much in the way that the last stimulus package did little real good for the economy, and simply put us another $177 billion in debt that our kids will have to pay. Helping keep people in their homes when they are already over their heads in debt is not really stimulus, however noble it sounds. Over 50% of mortgages that are reduced and rewritten are delinquent again within 6 months. That does not bode well for future efforts. Better to let the home go at some price to someone who can afford it. Tough love, but realistic.

Giving money to states to allow them to continue to spend beyond their budgets is not stimulus. And why should Texas pay for a profligate California? We have our own problems. The Robin Hood approach to stimulus programs is nonproductive and only encourages bad budgeting habits.

What will work? Infrastructure development, although that takes time, and some real thought should be given as to which projects are undertaken, rather than allocating according to which Senator has the most seniority. Spending on defense equipment, which must all have US content (which will be distasteful to the left), is real stimulus. Upgrading technology in a number of areas qualifies, although past experience suggests governments are not good at spending new tech money wisely.

Spending on green technologies? Creating a million new jobs in clean tech? Get real. How do we go from less than a 100,000 real clean-tech jobs to 1,000,000 in five years, let alone one? And three million new jobs? Really? From where? What government program could do this? In what universe? It makes for nice feel-good talk, but has no bearing on reality.

Don't get me wrong. In the midst of the late 1970s malaise, when the gloom was as thick as it is today, the correct answer to the question, "Where will all the new jobs come from?" was "I don't know, but they will." And it is still the correct answer. The US free market system is still the most dynamic economy in the world, and I truly believe that we will see new industries spring up, which will be a jobs dynamo. But that will take time. It is not a short-term solution, and by short-term I mean 1-2 years.

My bet is that in the third quarter, when earnings reports come out and are terrible, unemployment is over 8% and pushing 9%, and there is no evidence of a recovery, that we will see more stimulus from both the Fed and Congress. Count on it.

The Fed and the Keynesian captains of our economic ship are "all in." If the current plans do not reflate the economy, they are not going to say, "Well, that is too bad. We did what we could. Now we just have to go ahead and let the US economy catch Japanese disease." Not a chance. They will up the ante.

And they will keep trying to "jump start" the economy until it works. Obama told us to expect trillion-dollar deficits for years to come. Give him this: he is being candid and honest.

The Fed, and I think other central banks, are going to step in and be the buyers of last resort for a whole host of debts, both corporate and consumer. There are those who worry about creating inflation, because they actually do have to print money to buy these debts. While I would prefer a world where a central bank does not intervene in the markets, the time to fix the problem of excess leverage was a decade ago. Allowing banks to go to 30:1 leverage based on "value at risk" models and other financial wizardry that clearly neither the banks nor the regulators understood, was simply bad policy, and we are paying for it. As Woody Brock so wisely notes, 30:1 leverage is not three times more risky than 10:1 leverage, it is 25 times more risky. (Trust me, or at least Woody, on the math.) As an aside, many European banks were even more highly leveraged.

The End Game

The US (and indeed soon the whole world) is in a deep recession. The US is going to try and combat that recession with stimulus on a scale never before tried. It is a grand experiment. On the one hand is the theory that you can allocate stimulus and keep the velocity of money from falling. On the other hand is the theory that once the deleveraging process starts, there is not much you can do about it: it is going to work its way through the economy. We are about to find out which theory is correct.

So, let's look at three possible outcomes, with the best outcome first. The basic optimistic assumption is that, while this recession is deep and the worst in the post-WWII era, it is still just a recession. Free-market economies eventually recover. Recessions do their work of reducing excess capacity, and the businesses which survive enjoy increased market share and potential for profits to rise. And corporations do indeed have on balance stronger than usual balance sheets going into this recession, except for most financial corporations. Another exception is businesses that were bought by private equity firms with large leverage. Many of those will have to be restructured. And those that have too much leverage or were too aggressive with expansion programs? They will go the way of all overleveraged flesh.

Besides, the optimistic scenario holds, the massive amount of stimulus being applied to the US economy is on a scale never seen. It will work, just as an easy monetary policy has always worked. (Except in the '70s, but we won't make that mistake again! We learned our lesson, yes we did! Volker can stay in retirement.)

This scenario assumes that the psyche of US consumers has not actually been seared all that much, and that they will return to their spending habits as soon as they are able. It also assumes this is a normal business-cycle recession. There really is no endgame. It is business as usual. There has been no fundamental altering of the US dynamic. Banks will start lending again, businesses and consumers will start borrowing, and things get back to normal. Deflation is just some bugaboo that a weird coterie of economists and investment writers harp on to scare the children into behaving more rationally. It can't really happen here. And besides, the Fed can print enough money to make deflation go away. The real worry will be if they overshoot and inflation comes roaring back.

Problem # 2: Pushing on a String

The economy clearly let leverage run to an irrational level. You've seen the graphs. US debt to GDP is now over 300% and has risen precipitously in the last ten and especially the last five years. Leverage and debt fueled the growth of the economy, but debt growth hit a wall and now the deleveraging process is the painful result. This brings us to the worst-case scenario: that all the efforts of the Fed will go for naught and that we are in a liquidity trap.

A liquidity trap is a situation in monetary economics in which a country's nominal interest rate has been lowered nearly or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy. In these situations, borrowers prefer to keep assets in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation. (Wikipedia)

And there is no question, at least in my mind, that the economy, if left to its own devices, would fall into a soft deflationary depression, which would take years to climb out of. The contention of those who believe that we are headed for such a state of affairs is that no matter what the Fed does, excesses on the part of consumers and unrestrained government deficit spending is going to create a Perfect Storm. First of deflation and then, because the Fed is going to try to re-inflate the economy by printing money, we will see a resurgence in inflation and a collapse or, at the very least, a serious drop in the value of the dollar. Further, to expect foreign governments to continue to buy depreciating dollars and allow the dollar to continue to be the world's reserve currency is not realistic. And of course, there are those who think we will eventually see hyperinflation as the Fed is forced to monetize the national deficits, with gold going to $3,000 (or higher!). And Obama, with his talk of trillion-dollar deficits for an extended period, certainly adds fuel to that fire.

If, and it is a big but possible if, the Fed is indeed pushing on a string, then we are likely to see 15% unemployment, yet another lost decade for the stock market, and a real calamity in the pension, endowment, and insurance worlds, which are planning on 8% long-term portfolio returns to meet their obligations. And while I think it is a possibility we must be mindful of, it is not the most likely scenario.

The Muddle Through Middle

Now, we come to the third scenario and -- no surprise to long-time readers -- the one I think is most likely. I think that after we climb out of recession, we Muddle Through for an extended period of time. Follow my reasoning, and remember that I am often wrong but seldom in doubt! And please allow me some room to speculate. I can guarantee that I have some (or most) of the particulars wrong. But I think I have the general direction we are heading in.

We are in a serious recession. We have to allow time for both the housing market and the credit markets to heal. This will take at least two years. I think we have permanently seared the psyche of the American consumer. Consumer spending is likely to drop at least 6-7% over the next two years, and maybe more. The combination of all three bubbles (consumer spending, credit, and housing), which were made possible by increasing leverage and poor lending standards, is by definition deflationary. (I know, I keep repeating, but most readers do not really get the rather disturbing implications.)

The US government in general and the Fed in particular will react to the problem. Most of the government stimulus, other than that used to reliquefy the banking system, build useful infrastructure, and encourage small business to expand, will be wasted or have little short-term effect. The Fed (and central banks around the world), on the other hand, do have the potential to succeed with a "shock and awe" type of stimulus program.

The problem is the Velocity of Money. (You can see this explained in my December 5, 2008 letter.) There is just no way of knowing when the Fed programs will really create some traction. Anyone who shows you a model that says such and such an amount of stimulus is needed is from the government, trying to tell you that this time we really do know what we're doing. Any such models are based on assumptions about things we have no way of knowing.

The Fed (and the US government) are going to continue to run deficits and print money until the economy begins to reflate. That is one thing I truly believe. Will it be a total of $2 trillion? Three? Four? More? I don't know. How large will the Fed balance sheet be in a few years? I don't know. And neither does anyone else. There are just too many damn variables.

But I do believe that at some point there will be some inflationary traction. And combined with an economy resetting itself at some new level of consumer spending, and with a basically resilient US free-market system, a recovery will begin.

But here's the problem. Let's assume, and we can, that we find this new set point for the US economy (see the "Economic Blue Screen of Death"). And that the economy begins to grow, but the Fed has injected a lot of liquidity. Now some of that liquidity is "self-liquidating." By that I mean, commercial paper is typically 90 days. The Fed simply has to begin to wind down its commercial paper investments, and it takes away some of the liquidity it created. Those mortgages they bought? Each month, as payments are made, a little liquidity is taken back from the economy.

And if inflation is an issue, they can begin to withdraw that liquidity or raise rates. Of course, that will serve to slow the economy down, but better a slower Muddle Through Economy than a return to the high stagflation of the '70s.

That gets us to 2011-12. The economy is growing, albeit slower than anyone would like, but government deficits are still in the trillion-dollar range, as Obama and the Democratic Congress have increased the entitlement programs, locking in big deficits for a long time. High deficits put the dollar under pressure. The demand from voters is to get the deficit under control. However, the Social Security surpluses are beginning to dwindle. And just like in the early '80s, we have a Social Security crisis. Some combination of higher taxes, reduced benefits for wealthier Americans, later retirement ages, and a different methodology of indexing for inflation will be the order of the day.

But Social Security is the relatively easy problem. Medicare benefits will be at nose-bleed levels and will swamp the ability of the government to fund it and other government programs. Democrats will never allow the programs to be cut back. And getting the 60-plus Republican senators needed for such cuts is just not likely to happen by 2012-2014.

The problem will be dealt with by cuts in some government programs, but mostly by tax hikes on the "rich" and increased contributions by participants. Since many of the rich are the very small business people who we need to create jobs, this is going to be very anti-growth, extending the Muddle Through Economy for yet another few years. And if taxes are raised too much in 2010 when the Bush tax cuts go away, then we could see a relapse back into a recession.

Such an environment of higher taxes and slow growth is not good for corporate earnings. Earnings in the recent years have been at all-time high levels as a percentage of GDP. Earnings as such are mean reverting, and thus are unlikely to rise back to previous levels in terms of percentage of GDP. (Of course, in nominal terms they should rise.) This is going to put a constraint on stock market growth.

Pension plans, endowments, insurance companies, and individual investors who are counting on 8% long-term compound returns from their stock portfolios are as likely to be disappointed in the next five years as they were in the last ten. The environment I am describing is one of compressing price to earnings ratios, much like the period from 1974 to 1982.

This environment is going to force the creation of new investment programs and products based on income generation. And that is one of the forces that will bring about a real recovery in the middle of the next decade. Investment capital will be made available to businesses that can generate low double-digit or high single-digit returns, as well as new technologies with the promise to deliver new paths to profits.

The second major force will be the arrival of new waves of technological change. We will see a biotech revolution beyond our current comprehension. It has the real potential for solving a great deal of the Medicare entitlement program problems. For instance, it is likely we will have a real cure for Alzheimer's within five years. Since that is as much as 7% of US medical costs, that can create a real cost reduction. The same for heart disease, obesity, cancer, and a host of other medical conditions that will start to be dealt with by a new generation of therapies. That is going to create a new, very real bull market in biotech.

I expect to see a new generation of wireless broadband that powers whole new industries. And it will not just be green tech, but entirely new forms of energy generation that drive the cost of energy down and, combined with other new technologies, make electric cars practical. And along about the end of the decade, the nanotech world begins to really get into gear.

And just as the tightly wound, low P/E ratios of the early '80s gave way to a spring-loaded major bull market as new technologies became the driver for a whole new set of public companies, we could (and should!) see a repeat of that performance. There is a new bull market in our future.

The problem is getting from where we are today to that next dawn. The definition of insanity is to keep repeating what you have done in the past and expect a different result. We are in a long-term secular bear market. P/E ratios are going to decline over time to low double digits. Hoping that stocks somehow rebound to new highs and that the economy is going to go back to what we saw in 1982-1999 or 2003-2006 is not a strategy. You need to be proactive and take charge of your portfolio, looking for absolute-return types of investments for the next 4-5 years. Simply using a traditional 60-40 split of stocks and bonds is not going to get you to retirement nirvana. It will lead to retirement hell.

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