Goldilocks and Just One Bear
The markets have closed up for five straight days. So much for my concern that either the economy might be slowing down or that if the economy does not slow down inflation will be a problem forcing the Fed to take action later this fall. Clearly, the majority of investors think we are in a Goldilocks scenario. In fact, Ed Yardeni uses that term in an interview with Mark Gongloff at the Wall Street Journal Online. Mark then contrasts my views with Ed's in an excellent piece called "Soft Landing: Many See a Goldilocks Market, While Others See Stagflation Light."
That interview will be the basis for this week's letter, as it serves to contrast the tension between those who see the markets rising to new heights and those like myself who see problems. I am in the smaller group, at least for now.
But first, there is an interesting pattern developing in the markets, called a "W" formation. While I normally do not talk about technical charts and patterns in this letter, I think this bears (pardon the pun) looking at. This is from good friend Bill King in his daily King Report:
"We want to revisit our warning about 'W' patterns, especially when they occur after long, pronounced rallies. The following charts compare the current rally and ensuing 'W' formation with what occurred in 1987. We are NOT suggesting that a 1987-like crash is imminent; but we are warning that 'W' formations can lead to dramatic market reversals.
[Look at the two charts below.]
"Please note that the 'W' formation (black rectangle, top chart) that materialized in April-May 1987 produced a decline (May 1987) that did NOT breach the base points of the 'W', so a rally developed. The current 'W' pattern has formed over three months. The 1987 'W' formed over one month, September.
"The current stock market is in a weaker technical position that it was in 1987 as evinced by its position to its quarterly and yearly moving averages. In 1987 interest rates were much higher, but the economy was stronger and the US trade deficit problem was in its embryonic stage.
"The moral of the story is stocks need to rally sharply from here to negate the 'W' pattern, or on any decline stocks must NOT breach the base of the 'W' pattern. If a stock decline violates the base of the 'W' pattern, Big Mo, as in 'Momentum Players' will be unleashed by traders and investors and he will be hurling red tickets."
Goldilocks and Just One Bear
So, will we see the market move on up as it did in May of 1987 or roll over as it did later? Ed Yardeni, chief investment strategist at Oak Associates, is one who believes the market is ready to move on up and out, as the economy is going to continue growing strongly and inflation will not be a problem. Let me quote a portion of his interview and I will intersperse my comments in brackets. I recognize it is a little unfair to Ed to not give him a chance to counter back; but I think it will be instructive, and that is the purpose of this letter. (You can read the whole piece at The Wall Street Journal Online.)
The Wall Street Journal Online: So has the Fed engineered a soft landing?
Ed Yardeni: I'm not sure it's a landing at all. The economy is growing along its trend line, at roughly 3% to 3.5%. And since much of that growth is coming from productivity, it's not inflationary. That really means this is the best-of-all-worlds scenario, allowing the Fed not only to pause, but maybe to leave rates unchanged for a while. I think a federal funds rate of 5.25% [its current level] or 5.5% is neutral, and at neutral you can have sustainable trend growth with low inflation. It looks as though the Fed is getting its forecast: It wanted to see some slowing with inflation moderating, and the latest data are showing that.
[But the economy is not growing at trend. It is slowing, or at least it was in the last quarter. Look at these notes from Richard Berner of Morgan Stanley:
["Business conditions deteriorated sharply in early August, more than reversing July's improvement, with the Morgan Stanley Business Conditions Index (MSBCI) plunging 9 points to 40%. The August slide marked the 3rd consecutive sub-50% reading, thus pulling the three-month moving average down by 7 points to 44% and yielding the first sub-50% reading since mid-2003. The weakness in the MSBCI over the past three months is palpable, and caps a series of challenges to our call that business conditions will firm in the second half of 2006.
["Details of the August canvass also paint a bleak picture: The advance bookings index plummeted 14 points to 46%, the lowest reading since January 2005, and our newer expectations index also fell 14 points to 39%, the first sub-50% reading in the short, 6-month history of the index. This month, hiring plans weakened further although plans to increase capital spending improved somewhat. Importantly, more analysts who had previously reported unchanged conditions downgraded their assessment of business conditions this month. The percentage of analysts noting deteriorating conditions increased to 41% from 24%."
[That does not sound like an economy that is going to rebound to 3.5%, especially given the slowdown in the housing markets.]
WSJ.com: The Fed doesn't have a reputation for managing soft landings; it is usually accused of going too far in its tightening campaigns.
Yardeni: It did accomplish one in the 1990s. The Fed raised interest rates a lot in 1994 and then more or less left rates alone. Bond yields stabilized, inflation remained low and the economy did just fine.
WSJ.com: This sounds suspiciously like the fabled Goldilocks scenario.
Yardeni: I recently pointed out that many economists have been waiting for Godot -- a mid-cycle slowdown or a soft landing or even a recession. But Godot is a no-show, while Goldilocks is doing quite well. There are still bears out to get her: People are still out there fretting about the trade deficit, the federal budget deficit, a super-spike in oil, geopolitical jitters and more. But the economy has weathered all of these storms awfully well, and all in all we do have a Goldilocks scenario unfolding.
WSJ.com: How long could such a thing go on?
Yardeni: I think it could certainly continue through the end of the year and into next year -- then ask me again.
I really believe the unleashing of globalization through the increase of free trade and the interdependence of financial markets is creating global prosperity, and what we're learning is that it's not a zero-sum game: If Asians are doing well, Americans can do well. We're at full employment. When you look at consumer measures, some economists interpret big increases in compensation as inflationary. But that just proves consumers have the purchasing power to keep spending.
WSJ.com: But housing is clearly slowing down.
Yardeni: That's not a surprise -- we started to see signs of it last fall when surveys were showing people saying they couldn't afford to buy homes. Prices got too high. Housing is in a cyclical downturn.
WSJ.com: Isn't that bad news for the economy?
Yardeni: It's an important industry, but it's still pretty tiny compared to the overall economy. And while residential construction is slowing down, what people have mostly missed is that there is a huge boom in non-residential construction. The data show we are building hotels, offices, commercial properties, manufacturing facilities and warehouses.
[Housing construction doesn't have to stop to contribute to a slowdown. It just has to moderate. As Dallas Fed chief Richard Fisher told us this week "The annualized rate of housing starts fell 3% to 1.795 million in July. Starts have plummeted 21% since peaking in January and are at their lowest level since November 2004. Building permits plunged 7% in July to their lowest level in four years. 'Builders are responding as one would expect,' Fisher said. 'They are cutting staff, renegotiating prices and getting concessions from subcontractors, and either walking away from or renegotiating planned land purchases and other contracts. This is disinflationary activity that impacts economic growth.'" (The Daily Reckoning)]
WSJ.com: But several economists have noted that housing contributes fairly significantly to economic growth in other ways, including employment.
Yardeni: That's true, but a slowdown doesn't imply that we are therefore going to lose a lot of jobs. We have a 4.2% adult unemployment rate [which doesn't include teenagers]. Lots of industries need to hire. I think what the bears are missing is that this is a very dynamic economy, thanks to globalization. We are creating lots of jobs in the railroad industry, in trucking, warehousing and importing all the stuff that has to be processed and moved. We need people who can sell the goods that foreigners want and who can manage the financing of these transactions.
[It's not a slowdown if the unemployment rate does not go up. For unemployment to rise, you simply have to see the growth of jobs slow down, like we are seeing today. Remember, we need to see 150-200,000 new jobs a month to maintain current levels of employment, simply due to growth and turnover.]
WSJ.com: So what does this mean for investors? For months we've heard people talking about getting defensive. Is risk aversion the wrong idea now?
Yardeni: We're starting to see the mood swing away from risk aversion. You may remember back in May when we saw emerging markets sell off. They've already regained half of what they lost. I think we'll see investors coming back to cyclicals and industrials -- all the stocks that were weakest in May, June and July should do better.
And here's is my portion of the article:
John Mauldin: Mr. Mauldin believes the economy is likely to slow more sharply than markets realize, even as inflation remains a concern -- a bad combination for stocks.
WSJ.com: You have long been concerned about rising inflation and a potential slowdown in the economy. Recent data seem to have Wall Street feeling better about both. Are you heartened by the same data, or still concerned?
Mauldin: I'm still concerned about a slowdown. What did we see this week? We saw inflation coming in relatively high again and housing coming down. One of our best forward-looking indicators, the yield curve, is inverted. Everybody always says, "This time it's different," but so far it has never been different. I get nervous when you fly in the face of an indicator that is consistently right -- and that is confirmed by other indicators.
The Conference Board's index of leading economic indicators [has fallen at a 1.4% annualized pace in the past six months]. Every time it has turned down in a six-month stretch in the past, we have had a serious slowdown or recession. Another very good leading indicator is the ratio of concurrent to lagging indicators. That has been going down, and that trend has always been followed by a serious slowdown or recession.
WSJ.com: That doesn't seem to be what the market is expecting.
Mauldin: The market is betting the economy is only going to slow down to 2% growth or so. But a significant chunk of this economy is powered by housing. If housing slows down, it is going to take one or two percentage points off GDP. And if people can no longer use their homes as piggy banks, then that will take another half point to one percentage point from GDP.
WSJ.com: What about corporate profits?
Mauldin: Corporate profits are at record all-time highs in terms of their percentage of GDP -- meaning you can't get much better than this. And that's a mean-reverting statistic. It always reverts to the mean.
WSJ.com: What does that mean for stocks?
Mauldin: When everything is priced for perfection -- and we are pretty perfect, I think - that's a difficult situation in which to be bullish on the stock market.
WSJ.com: Are we really priced for perfection? P/E ratios seem to be at reasonable levels.
Mauldin: John Hussman [manager of the Hussman Funds] has said that if you normalized earnings, meaning if you took earnings back [from a record-high percentage of GDP] to where they would normally be, the P/E for the S&P would be closer to 24 or 25. If you revert earnings to the mean, you're looking at real room to fall. I think there are better opportunities, with less downside risk, where you can put money to work.
WSJ.com: What are they?
Mauldin: Bonds. I think a laddered portfolio of bonds [which spreads an investor's money across bonds of different maturities] is one place where you want to be. You should be in absolute-return funds [which try to avoid exposure to the broader market]. PIMCO has a couple run by Rob Arnott. If you have access, I like commodity funds and hedge funds. For the average guy it's tough -- he doesn't have as many opportunities.
WSJ.com: How long could this situation last?
Mauldin: I think we will see another bull market in the 2010s that will be every bit as big as what we had in the 1980s or '90s. I think it will be driven by another round of telecom, tech, biotech, nanotech and globalized platform companies. I think it will be a really powerful rally -- but not from here. We have just got to hit the reset button on some imbalances.
WSJ.com: Some people point to the fact that the Fed has managed a soft landing before, in 1994. How does this period compare?
Mauldin: I don't think it's a fair analogy. The consumer wasn't nearly as tapped-out then. Corporate profits weren't as strong, so there was plenty of room to improve. It was a much rougher period of time, and P/E ratios were much lower. And remember, back then we had inflation and interest rates coming down. We're not watching inflation coming down now, and if it does, it will be because the economy is slowing.
WSJ.com: What about this week's weaker inflation numbers?
Mauldin: What people didn't notice in the PPI is that finished consumer goods were up 5.1%. Core intermediate goods were up 0.7%, and intermediate goods were up 8.9% year over year. If the economy is slowing down, then inflation should begin turning over as well. But if not, then the Fed will have to attack it. Either way, that does not seem like a good overall environment for stocks.
WSJ.com: You recently wrote a note entitled "The Return of Stagflation." A lot of people scoff at the idea, saying we are nowhere near the ugly stagflation of the 1970s.
Mauldin: We have a slowing economy and inflation that is too high by anyone's measure -- by any other name that's stagflation. And given all the excesses of the 1990s and the excesses of the housing market, a little stagflation -- maybe including a mild recession -- may be about the best outcome we could ask for. I think, 10 or 15 years from now, historians will say the Fed did a pretty good job. But while you are in the middle of the storm, the criticism will be harsh.
WSJ.com: But a recession is no picnic.
Mauldin: Well, if we do have a recession, I don't think it will be severe. Eighty percent of our economy is service-oriented, not subject to the ups and downs of manufacturing. Meanwhile, a lot of our manufacturing is export-driven, and a weaker dollar is just going to help that.
So I'm not looking for a repeat of 1980 or 1982, barring some silly Fed mistake. I think we're going to have another 1990/91, 2000/01 kind of slowdown. If there's a recession, it will be a mild recession, and then another long, weak recovery, leading to a Muddle Through Economy before we start the next real boom.
My thanks to Mark Gongloff at the Wall Street Journal Online.
Bird Flu Conference
Although I have not written anything about it in this column, I do follow the news on the potential for avian bird flu to be a real problem. I take the potential seriously. I am glad that there are people who are working on plans in case of an outbreak, although there is far too much complacency. Good friend David Kotok at Cumberland Advisors is helping to sponsor a conference called "Avian Flu, Pandemic Diseases, and Their Economic and Social Consequences: A Template for Preparedness" It will be held September 29 in Philadelphia under the auspices of The Global Interdependence Center. The speaker line-up is impressive. For those of you involved in contingency planning for your business, or just simply want to learn more, you can go to http://www.cumber.com/special/ev060928_AvianFlu.pdf to learn more.
New York, Art and Heat
OK, I just thought I was not going to get on an airplane. My friends and partners at Altegris Investments want me to come up to New York Tuesday, September 19 for a prospects and clients dinner (at Per Se) where they will introduce some very interesting hedge fund managers. Space is limited.
My daughter has me lined up to go to a special event at the Dallas Art Museum tonight, and so I am working hard to finish up on time tonight. While I have been to museums all over the world, and to the really special ones we have in Fort Worth (the Kimball and the Amon Carter), I have never availed myself of the Dallas Museum and am looking forward to it.
I note that good friend Bill Bonner says it has turned cold at his home in France. A little cool would be nice in Texas. In addition to the drought, it has been 106 degrees here for several days in a row. Walking into the office on a paved parking lot literally feels like you are in an oven. Texas set a record for energy use yesterday, up 4% over the previous highs.
But as my Less-Than-Sainted-Dad used to say, if it weren't for the heat, there would just be more Yankees coming to live here. That used to be funny, but after 56 years of the heat, I am not so certain. I have penciled in that I intend to be somewhere else in August of next year. Somewhere with a lot less heat.
Enjoy your week, as I will mine, even if it will be indoors.
Your dreaming of cool breezes analyst,