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2006 Mid-Year Forecast
by John Mauldin
June 24, 2006
Introduction
A Few Good Calls
A Slowing Economy Is Not the Issue
R.I.P, The Yen Carry Trade
Information on Gold Stocks
Vancouver, Atlanta, La Jolla and a Personal Intervention |
Introduction
This week we will venture into the always hazardous area of making my
semi-annual forecast. I make some non-consensus projections as to the economic
climate for the next six months, and of course look at Fed policy. We will also
quickly review my beginning of the year (2006) forecast and see what changes
should be made. I also point you to a solid resource on gold and gold stocks at
the end of the letter. It will be a very interesting letter, I think.
But first, a quick note on today's reversal by the District of Columbia Court of
Appeals on the SEC requirement for hedge funds to register. If you read the
brief 19 page ruling, it is clear that the Court did not buy into the argument
of the SEC about the meaning of the word client, which was the legal basis for
the SEC to require hedge funds to register. While I am neither a lawyer nor the
son of a lawyer, it appears to me that they did not offer any other suggestions
for the SEC to take another tack in their effort to regulate hedge funds. It
will be interesting to see if the SEC tries to appeal what the court felt was
such a clear cut case.
That should put it back where it should have been three years ago, squarely in
the lap of Congress. Congress needs to re-visit the whole body of rules
surrounding hedge funds. They were written in a bygone era when hedge funds did
not exist, and have forced what is now a significant portion of the investment
world into participating in unnatural business practices in an effort to remain
legal in the US.
What other industry would limit the number of customers or not be allowed to
advertise when they have good results, let alone be required to discriminate
based upon the wealth of their clients? These are just of few of the unnatural
acts which I think should be eliminated.
I testified before Congress three years ago that we needed to create a "Hedge
Fund Investment Company Act" which would normalize the industry and allow for
hedge funds to come out from in the cold. It would provide practical business
incentives for even a small fund to register (rather than being very punitive as
the recent ruling was), allow for common sense regulation where needed and level
the playing field for all investors.
For those interested, you can see read that testimony at
http://www.accreditedinvestor.ws/.
The Congressional testimony button is on the
right hand side of the page.
A Few Good Calls
Let's quickly review my 2006 forecast from last January. All in all, not bad,
but we still have six months of the year to go, so there is plenty of time for
my calls to still be wrong. I suggested we would have a second half slowdown,
thus it would be a rough time for stocks. This implies a lower interest rate on
the long side at the end of the year. I still think those are the correct
positions.
I suggested that we were near the end of the inflation cycle, and that has been
wrong so far. I think that will be the right call for the last half of the year.
I also called for a major correction in copper, and while copper continued to
rise for some time, we did get what can only be called a major correction. I was
quite bullish on gold and energy.
But there was one paragraph that was particularly on target. I wrote:
"There are a lot of potential variables which could cause any number of my
predictions to be wrong. But chief of my concerns is Fed policy. When will they
stop raising rates? In my mind, I see Ben Bernanke playing Clint Eastwood, doing
the Dirty Harry role, looking into the face of the housing market and saying,
'Do you feel lucky punk? Well, do you?' As we will see, this is the wild card
upon which the economy will turn."
I still think that today. "How far will the Fed go?" is the question of the
moment. With that as a backdrop, let's look at how things might play out over
the next six months.
First, as I have maintained for over two years, the Fed is going to raise rates
higher than most market observers anticipate. That has been the unerring pattern
for 90 plus years. When the May Fed rate hike was announced, most observers saw
the accompanying release as a message that the Fed was going to pause in June. I
disagreed. It is now almost a lock that they will raise rates by at least
another 25 basis points next week.
The next Fed meeting is August 8. They will have the first estimates of GDP for
the second quarter. My guess now is the number comes in above 3%, which along
with another uncomfortable inflation number in July will give them reason to
raise rates yet one more time. That will take the Fed funds rate to 5.5%.
Unless, and this is a big unless, the August and September inflation numbers
come in sequentially higher than July's number, I think we will see the Fed
finally pause in September. But the Fed will be driven by the inflation data.
The yield curve will be fully and decidedly inverted in August, as opposed to
flat which it will be after next week's raise it rates. The economy will be
starting to slow and we should see long rates begin to drop, which will make the
yield curve even more inverted by the end of the third quarter.
What could change that scenario? If the July inflation numbers come in somewhat
lower than 2% on an annual basis, thus indicating that inflation is already
peaking and if the GDP number comes in less than 3%, suggesting the economy is
slowing. That would let the Fed pause in August.
In that case, long bond rates will still drop and the yield curve inverts and
the economy slows anyway.
A Slowing Economy Is Not the Issue
Let me emphasize again, the Fed is aware that the economy may be slowing. A
slowing economy is not their primary issue. The Leading Economic Indicators
index declined 0.6% after a 0.1 % drop in April, the Conference Board said
today. The last time the gauge fell in consecutive months was February and March
2001. Seven of 10 leading indicators had a negative effect on the May index.
Dennis Gartman pointed out to me this morning that his favorite predictor of the
direction of the economy and recessions once again dropped. He watches the ratio
of the current to the lagging indicators. As he wrote:
"Worse, however, for the economy was the fact that the Coincident indicators
rose 0.1% while the Laggers rose 0.2%. Although both were higher, the ratio
continues to fall, and as long as the ratio falls we are more and more confident
that the US economy is headed at least toward a material slowing of economic
growth in the 3rd or 4th quarter of this year, or that it is heading for
recession itself."
Also note that the current data still suggests the economy is strong. Unless
something changes in the next 10 days, I think the August GDP data and the July
inflation numbers will force the hand of the Fed to raise at the August meeting.
Why? Because of the sacrifice ratio. Bernanke is a big believer in this arcane
number. In a very imprecise definition, it is the amount of sacrifice you make
in unemployment today to ward off inflation and bigger problems tomorrow. The
sacrifice ratio is still high, which suggests that the Fed needs to err on the
side of fighting inflation. The absolute worst situation would be for inflation
expectations and actual inflation to take hold while an economy is slowing. Can
you say stagflation, boys and girls?
(To read my letter on the sacrifice ratio, you can go to
http://www.investorsinsight.com/thoughts_va_print.aspx?EditionID=259.)
It would force the Fed to induce a serious recession, as Volker was forced to do
in 1980 and 1982. That is not an outcome the Fed wants to ever see again, or
even get close to. Flirting with a return of inflation on the chance the economy
might soften later is a very big risk. So, I think they risk an economy which
might soften more than market participants are comfortable with.
If it does start to soften and inflation starts to fall, then they can always
come in and lower rates. In fact, it would not surprise me to see them do so
before the end of the year or at least in the first quarter of next year.
Let me make one prediction that is almost 99% certain to come true. If we do
enter a recession or a real slowdown, the public will blame poor Ben Bernanke.
Media mobs will form, looking for rhetorical rope with which to hang him. I read
with interest an article on day trading in India quoting small traders that
blamed Bernanke for the recent severe weakness of the Indian stock market.
R.I.P, The Yen Carry Trade
Poor Ben. The real culprit is one Mr. Fukui, who is the Governor of the Bank of
Japan. (Do not ask me how to pronounce that name.) While central bankers
everywhere are in a struggle to prove their manliness by being harder on
inflation than their peers, Mr. Fukui has shown to be the clear cut champion.
They have taken massive amounts of liquidity out of the Japanese system in the
past few months.
George Soros, commenting last week, brought home the point:
"I think we are in a situation where almost all the asset classes will be under
pressure or are under pressure and the main reason for that is the reduction in
liquidity. What people do not realize is that the Japanese Central Bank has
withdrawn something over $200 billion worth of excess liquidity from Japanese
banks. Now that money was not put to work in Japan because there was no room for
it, a lot of that went abroad, went into emerging markets, there was a so-called
carry trade and it is not that suddenly people are risk averse. It is really
that liquidity has been drawn out of the market and that is affecting emerging
markets."
$200 billion in a global economy may not sound like a lot. But remember this was
money in fractional reserve banks. They could easily multiply it several times.
Pretty soon we could be talking a trillion dollars. Much of it went into
providing cheap liquidity to global hedge funds and aggressive investors and
banks. Thus, as the leverage went away, these groups started liquidating their
very profitable emerging market trades, their commodity trades, and so forth.
Everything began to go down at once. Markets that had not been historically
correlated all of a sudden went down in tandem to the drumbeats of margin clerks
everywhere.
To get an idea of how seriously the Bank of Japan has reduced liquidity, let's
look at the following chart from my friends at GaveKal.
There have been three large run-ups in the Japanese monetary base in the last 30
years. Not so coincidentally, there were three large periods of asset inflations
which accompanied them. When the Bank of Japan began to tighten, we had
resulting deflation of those assets. As I quoted GaveKal last April:
"Looking at the past thirty-five years, we find that the Japanese monetary base
has been allowed to double over short periods (i.e.: less than three years)
three times. Each time, it led to massive bull markets (real estate, share
prices, commodities, gold, etc...), followed, some time after the expansion of
Japan's money supply was over, by a serious market downturn. Will this time
prove any different? So far, it has."
That was at the end of April. At the end of June we can see that it has not been
any different. World stock markets have dropped precipitously along with
commodity prices.
For several years, speculators have been able to get very low interest rate
money in a currency that was purposely being held down. It doesn't get any
better than that. Low cost money encouraged speculation in every corner of the
investment world. Not just stocks and commodities, but high yield and emerging
market debt. The yen carry trade fueled the investment world.
Now Japan has said not only are we going to take massive amounts of money supply
from the world, we are going to raise rates and allow the yen to rise. All that
"free" money investors and businesses around the world borrowed is going away.
It is going to become far less than free. By-by carry trade. Fukui indeed.
We are now going to look at three charts from GaveKal's latest quarterly. They
tell a chilling story.
"In our world, two actors can create money out of thin air: the central banks,
and the commercial banks. Over the past year, the world's central banks have
been busy draining liquidity from the system.
"While the central banks were busy taking money away, the commercial banks were
happy to multiply whatever money they had at an ever faster pace. This is now
changing; with the increase in volatility, commercial banks are pulling back. As
Mark Twain once said, commercial banks lend you an umbrella, then take it away
once it is raining."
(Velocity in the next chart is a way to measure commercial lending growth.)
"The divergence between the action of central banks and the action of commercial
banks recently reached unprecedented levels. In the past (1997, 2000), once the
commercial banks got a whiff of the message the central banks were attempting to
convey, they changed their behavior rapidly, and uniformly. Will we now witness
a sharp snapback as we did in 1997 and 2000?"
OK, remember they asked the question in April whether Japan taking liquidity off
the table would be different this time? It wasn't. And my bet is that commercial
banks will also start the process of taking liquidity off the table as well.
Loan committees are going to tighten their requirements on all types of lending.
Get used to it.
Between the central banks of the world almost universally tightening, commercial
banks poised to tighten and the US housing market looking like it is going to
slow as interest rates rise, it is very likely the US economy is going to slow
down in the last half of the year. The question is, "How much?"
I do not think we will be in an actual recession by the end of the year. But a
recession is not out of the question for 2007. If the Fed does not have to go
too far (and 5.5% may be too far given the other conditions in the world), then
we could see a slowdown on the order of what we saw in the mid-90's. We will
have to watch the yield curve and other indicators.
In any event, whether it is slowdown or recession, I think investing in the
broad stock market is particularly risky. If you are good at picking stocks and
know the companies you are investing in, that is one thing. But most readers
invest in mutual funds and broadly diversified stock portfolios. Bluntly, I
think there is some real risk to the downside.
And if the US economy slows down, so will the housing market and so will the US
consumer. That will be a drag on the world economy and world growth in
consumption. If the world slows down too much, you could see oil drop back into
the $50's or even $40s!
Information on Gold Stocks
I have been getting a lot of questions about gold. I am still bullish on the
metal, especially now that there has been a much needed correction. And in
response to questions about gold stocks, let me clearly state that I do not
comment except in general on specific stocks. But my friend Doug Casey does. I
made my first dollar on gold stocks back in the mid-1980s when Doug Casey
personally called me up and told me to buy a particular stock. It was quite a
home run and I have paid attention to what Doug says on gold stocks ever since.
Lately he has been on a roll in his newsletter as well.
If you are interested in specific gold stocks and gold stock investing, I really
suggest you subscribe to Doug's letter. They will send you his recent update
which covers in-depth all the stocks he likes and a few he says to avoid. Below
is a link to information on subscribing to his letter.
http://www.caseyresearch.com/crpmkt/crpSolo.php?id=30&ppref=CSN031ED0606C
Vancouver, Atlanta, La Jolla and a Personal Intervention
"Dad, we need to talk," my oldest daughter said to me in that very serious tone
I recognize all too well at my conference in La Jolla last month. "What had I
done?" I wondered. What faux pas had I unwittingly committed now? All my
international partners were there, and of course my partners from Altegris
Investments. It seems that some of them (I cannot find out who!) came to Tiffani
(who works closely with me) and asked her to talk to me.
"Dad, you dress like an economist. You should be dressing like a guru. We need
to get you some new clothes." Ouch. I am pretty certain that I am not a guru,
and not a very good economist, or one that would pass academic muster, but
nonetheless I got the point.
I have been wearing pretty much the same clothes for three years. I have been
losing weight slowly and just did not want to buy more clothes when I knew they
would not fit in the future. It is probably Art Laffer's fault. He spoke at the
conference and most decidedly was not dressed like an economist, or at least not
like Martin Barnes or I did. He was pretty spiffy, actually.
And now, I am getting close to my target weight. I am down more than 25 pounds
in the last two years. Close enough that I can actually go out and get some new
clothes and they will fit this time next year, even if I lose another 5-6
pounds.
So tomorrow, my kids (and their various spouses, boyfriends, etc.) are
celebrating Father's Day with me. They are taking me to Nordstrom's where we are
all going to spend three hours with a personal shopper picking out a whole new
set of clothes. This should be interesting. 14 people in a small room, with what
can only be described as a very wide variety in personal tastes.
We have already spent a few hours in a pre-shopping mode getting measured, etc.
In this preliminary episode, I quickly learned that to dress better than an
economist is going to be expensive. Al least Nordstrom's having a big sale this
weekend. It will be interesting to see what I will be wearing in a few weeks. If
nothing else, my wardrobe should look younger, even it is still on the same old
body.
So, when I go to Atlanta for great friend Chip Wood's 65th birthday next
weekend, I should be dressing better than an economist. And in Vancouver this
next Tuesday as well. I will be doing a lunch presentation next week in
Vancouver on June 27. If you would like more information, you can contact my
associates at Pro-Hedge at 877-566-5145.
I will also be in La Jolla June 11-12 working with my partners at Altegris
Investments. While my youngest son Trey (12) will be surfing, I will be meeting
with clients and prospects looking at their alternative investment portfolios.
If you would like to meet with me, just drop me a note. If there is enough
interest, we might organize a dinner one of those nights.
If you are interested in learning more about, or investing in, alternative
investments, hedge funds and commodity funds, I suggest you go to
http://www.accreditedinvestor.ws/ and sign up. You can learn how I work with my various
partners like Altegris Investments around the world to bring you our best ideas.
(In this regard, I am president and a registered representative of Millennium
Wave Securities, LLC, member NASD. Please read the risk disclosures about hedge
funds carefully.)
Sadly, the Mavericks collapsed. Choked is more like it. And they knew it. The
officiating in the 5th game was the worst I have ever seen. That last foul call
which allowed the Heat to win by one point was clearly not a foul when you
watched the replay. Dirk did not touch him. Could not have been a foul. But when
you shoot 32% from the field for the last 3 quarters of the most important game
in franchise history, you cannot point to the refs, as bad as they were. You
can't make an excuse with 32% shooting.
I was down underneath the stadium after the last game, watching with a friend of
one of the players as the Mavs came out of the locker room. You could see the
anguish on their faces. It almost hurt to watch. Oh, well. Wait till next year.
Your still not believing we could lose analyst,
John Mauldin
John@FrontLineThoughts.com
www.frontlinethoughts.com/gateway.htm
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