Why the Fed Will Cut and Cut Again
The economy added 166,000 new jobs last month, almost double the average estimate. GDP for the US came in at a blowout 3.9% growth, well above trend. The Fed cut its rate by another 25 basis points, but many observers see language in the accompanying statement which they think suggests the Fed is done with cutting, at least for now, as the economy appears stronger.
But appearances can be deceiving. This week I lay out a partial case for why the Fed will cut again and yet again (all the reasons would take a book). There are good reasons to doubt the jobs number, but unless you get into the details of how the number is created, you might never know. "Laws are like sausages, it is better not to see them being made," said Otto von Bismarck in the late 19th century. I would add to that list government statistics. While this week's letter may not be for the squeamish, we are going to look into how the sausage of the jobs report is made.
And in response to some questions from the recent survey we took, I finish with a few thoughts on the biases I have in writing this letter.
One quick note before jumping into the letter. We are in the process of completely redoing our various websites. Some of the changes will make it easier for you to search the archives, send links, etc. But one site that is completed that is partially cosmetic is a new and cleaner version of www.johnmauldin.com. Tiffani and chief designer Matt Dandurand of Media Contour (www.mediacontour.com) have created a clean new site which I like. There is a list of most of the information sources I read each week, a picture gallery, and a new bio, for those that are interested. Matt did the design and implementation in a few months and was quite reasonable with the pricing. He is a very solid, competent designer.
And now, let's jump into the letter.
Payroll Survey Sausage
The Federal Reserve Open Market Committee cut both the Fed funds and discount rates by 25 basis points. As is customary, they also released a statement, with the typical five paragraphs, to give some perspective on the action they took. Two of the paragraphs are pro forma, so the meat is in the middle three. A great deal of attention is paid to how these paragraphs change from meeting to meeting. Let's look at some of the changes:
Last month they said that "Readings on core inflation have improved modestly this year." On Wednesday they said, "Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation."
In the September meeting they wrote: "Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally."
And the last Wednesday: "Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction."
It is clear they are concerned about inflation, irrespective of the Commerce Department saying it was only 0.8% last quarter. (How bogus!) Numerous commentators read into the statements on inflation and the credit crisis seeming to get better, that the Fed is signaling it will not cut rates at its December 11 meeting. Further, there was one vote on the committee to not cut rates, so there is some discussion in that direction.
However, I think the important sentence is the last one: "However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction."
If the economy is slowing, then the Fed will cut and cut again. "But John," I hear you ask, "the economy is not doing that badly. There were 166,000 jobs created last month, over double the average estimate."
Well, maybe. The Bureau of Labor Statistics actually does two different surveys. One is called the payroll or establishment survey, which is comprised of calling approximately 160,000 businesses (out of 9,000,000) and seeing how many workers they have that month. They survey enough businesses to cover about 1/3 of non-farm employees. And that should be enough to get a good idea of where things are going, right?
Close, but not exactly. They do not contact very many small businesses, and of course cannot call new businesses. And since small and new businesses are the engine of job growth in the US, it is important to include an estimate for them. And they do this by estimating the number of new jobs in various categories that are created or lost in something called the birth-death (BD) ratio.
The BD ratio estimate is based upon past history. While estimating the most recent month's employment picture is quite difficult, you can do a fairly accurate job when you go back a few years, using other government data, tax information, etc. And so you can create a trend for how many jobs you miss due to the birth and death of jobs in the small business area. Now, remember, that number is an average of many years of history.
But there is one flaw in this methodology: it will tend to underestimate new jobs when the economy is recovering from recession and overestimate them when the economy is slowing down. Thus, in 2003-4, the Democrats were beating up Bush about the jobless recovery. As it turns out, those employment numbers were massively revised upward a few years later. There was in fact a powerful recovery going on, just not in the statistics. However, nobody but a few economic geeks paid attention, as it was last year's news.
Now, I mentioned that the Bureau of Labor Statistics does two surveys. The other one is the household survey, where they simply call 60,000 homes (at random) and ask how many people are in the home and who has jobs (part-time or full-time), does anyone want a job who doesn't have one, and so on. This survey covers people who are employed both by large and small employers, illegal immigrants, etc.
These surveys tend to parallel each other, except at turning points in the economy. Then there can be some large discrepancies. As an example, take this month's household survey.
When a Positive 166,000 Jobs Number is Really a Negative 211,000
According to the household survey, there was no growth in jobs last month. "The labor force contracted by 211,000, total household employment fell by 250,000, and employment adjusted to match the payroll concept was off by 55,000. The year-to-year gain in adjusted household employment is 0.7%, compared to 1.2% for the establishment survey, a gap of 0.5 point; just six months ago, the household measure was 0.6 point ahead of the payroll number." (The Liscio Report)
Let's put aside the fact that 166,000 jobs is not enough to keep up with growth in the population, and certainly well below the average for the past four years. Let's look at how the establishment survey found 166,000 jobs when the household survey says we lost 211,000. To do that we need to go to the birth-death ratio. Below is the table from the BLS web site. (http://www.bls.gov/web/cesbd.htm)
In October, the BLS added 103,000 jobs as an estimate of the BD ratio. They added 14,000 jobs in the construction industry. Does anyone really think that we saw an increase in construction jobs last month? Supposedly we saw an increase of 25,000 jobs in the financial industry. The reality is that financial jobs, especially in the mortgage industry, are being shed left and right.
As I noted above, when the economy is slowing the BD ratio will overestimate the number of jobs being created. And I think the household survey is suggesting just that.
Look at the chart from Lombard Street Research below. It shows the employment surveys on a 3-month moving average. You can see that the two surveys tend to move together, except at times when the economy changes direction.
Quoting Charles Dumas (and emphasis mine): "The payroll jobs number of 1% growth [for three months] is 1% or more below its long-run average, ... If the implied GDP variance - 2-2 1/2% below trend - Lombard Street Research proves to match the past average, the GDP is growing at or slightly below 1%. The same analysis applied to the household number gives GDP growth close to zero. If either is true, these numbers are inconsistent with the results for Q2 and Q3, which ought - given that labor market data are usually lagging indicators - to have produced payroll jobs growth at well over 2%."
Employment is a lagging indicator. Typically, employment does not turn down until after a recession has already started. However, the unemployment level has already risen from 4.4% to a current 4.7%. And the household survey suggests that the rate is rising faster than in the payroll survey. As unemployment rises, consumer spending will also soften. And the Slow Motion Recession will become evident.
Round Two of the Credit Crunch
The credit crisis this summer ended up with the Fed and central banks worldwide adding massive amounts of liquidity into the system. This last two weeks have seen one bank after another make large write-downs of subprime debt on their books. Merrill found a few billion dollars more in losses than they had only a few weeks ago. My bet is that Citi will find a lot more as well.
The problem is that more and more CDOs and other forms of mortgage debts are being downgraded. It is highly doubtful that banks have written down assets in anticipation of future downgrades. As Dennis Gartman says, there is never just one cockroach. The Fed injected $42 billion into the system in the last few days. I believe that is the largest injection that has ever been made.
Take this to the bank: There are going to be more write-downs as more and more mortgages go into foreclosure, forcing more downgrades of mortgage asset-backed paper. Foreclosures are up over 200% in a number of states, and 800-900-1000% in some. Scary. Look at this list of the rise in foreclosures over the last year, from Greg Weldon (www.weldononline.com).
Arizona up + 201.7%, Arkansas up + 254.2%, Connecticut up + 920.7%, Delaware up + 389.4%, Florida up + 130.6%, Iowa up + 180.5%, Maryland up + 491.0%, Massachusetts up + 1,127.7%, Minnesota up + 124.9%, Nevada up + 212.2%, Ohio up + 136.0%, Vermont up + 400.0%, Virginia up + 516.4%, Wisconsin up +155.6%, Georgia up +84.5%, Michigan up + 78.6%, New Jersey up + 56.7%, New York up + 66.7%, North Carolina up + 99.0%, North Dakota up + 85.7%, Tennessee up + 57.3%. And on and on.
A Congressional report suggests that over 2,000,000 homes financed by subprime loans will go into foreclosure in the next 18 months. This means that more and more of the mortgage-backed assets on the books of banks, CDOs, and SIVs are going to become losses.
I think we should be getting ready for a second round of the credit crisis. And I would certainly be uncomfortable with owning any financial stock with exposure to the mortgage markets. We may not know the full exposure of many banks until the middle of next year.
The SIV Superfund is just one signal that this is serious. Last week I gave you charts that showed even AAA assets associated with recent-vintage subprime mortgages securities losing 20% of their value. That is going to bleed over into Alt-A mortgage assets, as home values drop 10 and then 15 and then 20 percent.
The asset-backed commercial paper market declined another $9 billion last week, down for the 12th straight week. It has dropped 26% since August 8, and there is no reason to think that trend will not continue for several months, as commercial paper linked to mortgage assets is simply not being rolled over. The Financial Times talks of one banker who is bartering his mortgage assets to avoid setting a price.
Bottom line? With rising unemployment, a credit crisis, and a housing bubble imploding, this is not a market or an economy where the Fed will be able to sit tight. We are going to see a Fed funds rate below 4% in two more meetings, at a minimum.
And yes, I did notice that gold went over $800 and oil almost hit $96 today. Neither are good signals. With oil jumping $2-3 up and down almost every day, the chiropractors must be doing good business with oil traders suffering from the whiplash they get almost every day.
And the dollar? It hit $1.45 on the Euro. I actually have a regulated financial entity in Canada for which I have to pay fees about this time each year, and they are of course denominated in Canadian dollars. This year the fee was 40% higher in US dollar terms than it was a few years ago. But then, my income from European-based funds is rising as well. My belief is that markets of all types are going to get ever more volatile. Stay tuned.
A Few Thoughts on Bias
I want to finish this letter with a few thoughts on my personal investment biases. In our recent reader survey, we provided a space for comments, and I have gone through more than 3,000 so far. An interesting question came up in several different ways, so let me combine the questions into one and then see if I can answer it.
"John, since your business is involved with hedge funds and alternative investments, does that bias your economic views toward being more bearish? Would you be more bullish if you sold mutual funds?"
While I know that some think of me as bearish, I think I am middle of the road. After all, my designation of the US as the Muddle Through Economy is a term for someone in the middle. (It should be noted that others think I am way too optimistic.) And I am bullish and bearish on lots of different markets. I am uncomfortable with being characterized as bullish or bearish. I take a position and then change it as the facts suggest. As I have written on numerous occasions, I expect to be very bullish on the US economy when we get through the current problems.
But it is still a very legitimate and good question. To answer it, I need to talk a little about what it is that I actually do for a living - since this letter is free - so if you would, please indulge me for a few paragraphs. For readers who do not know, I am basically a manager of managers. I started out in the late '80s as a partner in a firm which offered commodity funds of funds and then individual managed accounts, representing a select group of recommended investment advisors around the country. I sold out to my partner in 1999, and basically started over, doing essentially the same thing as Millennium Wave Investments (but with a definite focus on alternative investments), with a few side trips along the way.
I put my newsletter on the internet in the fall of 2000 and a few years later started getting a lot of response. It became obvious that I was going to need to expand my staff in order to handle the potential volume of business. About that time, Mark Finn introduced me to Jon Sundt at Altegris Investments in La Jolla, California. Jon was in the process of taking his division of Man Financial private. He had a great research team, a good staff, and clearly knew how to run a growing financial services business. We also shared a very deep and mutual agreement over what types of investments we liked and how clients should be treated.
If I was going to grow my business (and I certainly planned to), I was going to have to duplicate much of what he had already put together. And I knew from experience (I was and am a serial entrepreneur) how much of my time that would take in managing people, growth, etc. What I really love to do is research and write, travel, and speak and talk with clients. Building a business with dozens of employees is not conducive to creating an atmosphere which allows a lot of time for thoughtful research.
I knew that to continue to do the research I wanted I was going to have to take in a managing partner for the operations side of the business, plus make a large time commitment to the process. Jon suggested that instead of adding more employees to my staff, we partner our firms to accomplish both our goals. Essentially, his firm does the research and sales that I would need to do. I direct those in the US who are interested in alternative investments to my accredited investor website, and they are contacted by someone from Altegris.
This model has expanded to include Niels Jensen and his team from Absolute Return Partners in London, where they cover Europe; Stuart McKinnon of Pro-Financial in Toronto in Canada; and Prier du Plessis in South Africa and now the Middle East. While each country and partner have their own unique flavor, essentially we all spend our time looking for absolute-return (in terms of style) types of managers and funds. I think it has worked well for all concerned, and hopefully our mutual clients most of all.
There were a lot of readers who asked if I could offer more specific advice for the "smaller" investor. I am working on that. Some of you already know that we are adding an additional partner in the US who will focus on funds and managers for investors whose net worth is less than $1.5 million. Steve Blumenthal at CMG, who is a long-time close friend, and I are creating a platform of advisors who manage money in an absolute-return style of investing and are willing to do so in direct managed accounts, and can take smaller minimum accounts. We already have 4 managers on that platform and expect to add 2-3 more over the next few months.
(If you are a manager and would like to be considered for the platform, send me your information and we will be glad to look at it. Also, by the end of the year, we plan on making that platform available to other investment advisors and/or brokers. Details will follow.)
Basically, my business model in the US is that the managers pay us a portion of their fees. I have the complete freedom to choose any style of manager I want. There are (literally) thousands of managers, advisors, and funds who would like to have us raise money for them.
Now, with that as background, let's get into the bias part. First, I do have an absolute-return bias as my preferred investment style. But that is because I think that is the proper stance given today's markets. If broad stock market valuations were below a P/E (price to earnings) of 12, I would start thinking a lot more about using long-only funds and long-biased managers (or a relative-return-style bias) for the longer term.
Analysts like Ed Easterling, Rob Arnott, and a host of others demonstrate in their research that there is a high correlation between long-term future returns from the stock market and current valuations. While that correlation in any given year is random (who knows what the market will do in any given year?), it does seem to become more reliable as time goes on. As Benjamin Graham said, "In the short term the market is a voting machine. In the long term it is a weighing machine." And what it weighs is valuation. As much as 80% of the returns in the bull market of the '80s and '90s were from the multiple expansion of the P/E ratio from below ten to over 30.
Remember, my partners and I could choose any style of manager. Thus, my bias toward alternative investments and the absolute-return style investing is one that is self-consciously chosen, given today's economic landscape and valuations. If I thought that a relative-value style of investment approach would be better, I could readily find managers who would supply me with product.
In point of fact, it would be a lot easier to do so, as most alternative investments have severe restrictions on what you can say about them and to whom you can market them. Relative-return-style investments (like mutual funds) are far easier to market and find. There are tens of trillions of dollars more in relative-return investments than in alternative, absolute-return investments.
I occasionally look wistfully at some of my fellow advisors who manage billions of dollars in relative-value funds. They can advertise to their heart's content and take money from anyone. It is a lot easier to find managers, as there are lots of public databases. It looks easy (although I know it is not).
But frankly, I don't have the stomach for relative-value investing at this time, given my analysis of the markets and the economy. It would just not square with my understanding of the economic and investment world in which we live.
As a matter of fact, most (but not all) of the funds in which we invest perform better in a bull market. Some are neutral as to a direction bias, and many have no stock market exposure. They work in altogether different markets. We have no explicit short-bias funds in our stables. So in general I actually prefer a rising market, but look for investments that don't depend on it.
Do I actually think about such a potential bias when I write - that I might be wearing alternative investment rose-colored glasses? Yes I do, and I try and check them at the door when I walk into my writing room, so to speak. I do my best to call it as I see it, and not the way I want it to be.
I write an occasional, free accredited investor e-letter on various aspects of absolute-return investing. If you would like to see that letter and you are an accredited investor (net worth $1.5 million or more) and are interested in alternative investments such as hedge funds and other private offerings, you can go to www.accreditedinvestor.ws and I will have one of my partners contact you.
And if you have a net worth of less than $1.5 million, simply reply to this letter and I will have Steve or one of his team call you and show you what is on our platform today.
New York, the Marines, and the Mavericks
I knew it was too good to be true. It looks like I am going to have to make a quick trip to New York at the end of next week. I hope to get some time to be with friends while I am there, and maybe catch a theater or museum or two. I do love that town.
Tomorrow night is the home opener for the Dallas Mavericks. One of my pleasures in life is watching NBA basketball. I think it is the most beautiful of all professional sports. What those guys can do is simply amazing. Last year we had the best record in the NBA before we folded in the first round of the playoffs. This year we are a better team. Hopefully we can go all the way this time.
And finally, Chad came home last night. "Dad, we need to talk." Ok, come on in. (I am wondering if something came up at his job.) "I did it. I signed up with the Marines. It is a deferred enlistment, and there are some things I need to do, but I think before the end of next year, I will be at basic camp."
There are moments in every kid's life you will remember. We had been discussing this for over a year. He has wanted to be a Marine for many years. I had left it up to him, even though as a Dad I don't like the possibility of my son going to places where there is potentially lead in the air aimed at him. But you could see it in his face. He was, well, proud. And so is Dad.
This has been a stressful week. I am looking forward to the weekend and some down time with kids and friends and basketball. Just me and Mark Cuban and 18,000 of his closest friends. Life is good.
Your luckier than I deserve to be analyst,