Balloons in Search of Needles

By John Mauldin

I love waterfalls. I’ve seen some of the world’s best, and they always have an impact. The big ones leave me awestruck at nature’s power. It was about 20 years ago that I did a boat trip on the upper Zambezi, ending at Victoria Falls. Such a placid river, full of game and hippopotamuses (and the occasional croc); and then you begin to hear the roar of the falls from miles away.

Unbelievably majestic. From there the Zambezi River turns into a whitewater rafting dream, offering numerous class 5 thrills. Of course, you wouldn’t want to run them without a serious professional at the helm. When you’re looking at an 8 foot high wall of water in front of you that you are going to have to go up (because it’s in the way); well, let’s just say it’s a rush.

If there were rapids like this in the United States, it’s doubtful professional outfits could get enough liability insurance to make a business of running them. In Zimbabwe we just signed a piece of paper. Our guides swore nobody had ever been lost – well, except for a few people who disobeyed the rules and leaped in the water in the calm sections because it was 100° out. That’s where the crocs are.

They promised we wouldn’t run into any in the rapids, which was good. More than a few of us got dumped in the water trying to run the rapids, but they had teams of kayakers who got you out quickly. The canyon below the falls is unbelievable, and below that is the even more impressive Bakota Gorge.

And yes, you then had to walk to the top of the canyon up a switchback trail to get home. I would do it all over again in a heartbeat, but I would spend at least three months training for the hike out. That was most definitely not in the full-disclosure-of-risks one-page piece of paper.

It would be hard to miss an analogy to the stock market. Everything’s peaceful and calm, you’re drinking some fabulous wine, eating some fantastic fresh game and fish, looking at all the beautiful animals as you drift easily with the current. Anybody can steer the boat in a bull market. Until the rapids hit and the bottom falls out.

As an aside, while the large waterfalls are majestic and awe-inspiring, the smaller ones are more hypnotic. I love the sound of falling water. I could listen for hours. The one place I don’t like to see waterfalls is on stock charts. Those leave me awestruck at the market’s power. They do have the power to focus the mind, however, especially when we own the shares that just went over the falls.

The US stock market is having the most turbulent year we’ve seen in a while.  It’s not terrible by historical standards, but we have a full quarter to go. And next week it’ll be October, a month in which the stock market has run into trouble before. With all that in mind, this week I want to take a look at where stocks stand and maybe offer a thought or two about the events that could bring us to the next waterfall.

Not Niagara Falls Yet
Here is how the waterfall looks so far this year. Barely a 10% move peak to trough, and it lasted for just a few days. We see a lot of jostling, followed by the harrowing plunge in August, and then a partial (less than halfway) recovery. Where do we go from here?

Let’s start with the macro view. Back in July I showed you some research that I did with Ed Easterling of Crestmont Research. This was before the China sell-off accelerated into the headlines, so it is very interesting to read again in hindsight. (See “It’s Not Over Till the Fat Lady Goes on a P/E Diet”).

Our view is that we are still in a secular bear market, and have been since the 2000 Tech Wreck. You may find that view surprising, since the benchmarks have roughly tripled since the 2009 low. Our analysis looks at price/earnings ratios to identify when bull and bear markets begin or end. P/E multiples were close to 50 in year 2000. In order for that bear market to end, they needed to drop into the very low double digit or single-digit range, which has been the signal for the end of every long term secular bear cycle for over 100 years. That hasn’t happened during the intervening 15 years.

Can a secular bear market last 15 years? Yes. Some have lasted even longer, like 1966-1981 and 1901-1920. So this one isn’t unprecedented. And please note that the long-term secular cycles can have cyclical movements inside them. Again, we see secular cycles in terms of valuation and the shorter cyclical cycles in terms of price. (Unless this time is different) long-term secular bear market cycles will always end in a period of low valuations.

Currently, P/E ratios (or any other valuation metric you want to use) are not low enough to provide the boost that typically starts a new bull market. They were closer in 2009 than today, but have never dipped into the area that would mark the end of the bear market and the onset of the new bull. We’re still riding the same bear.

What’s taking so long? Our best guess is that stocks were so richly valued at the 2000 peak that it is taking the better part of a generation to work off that excess. In order for this bear to end – and the new bull cycle to begin – valuations need to tumble. That can happen only if prices drop considerably or earnings rise without pulling prices higher.

Obviously, there can be many trading opportunities within a secular bull or bear cycle, but Ed’s research says we have three long-term options from here.

1. If P/E ratios decline toward 10 or below, we will be near the end of this secular bear. A new bull cycle should follow.
2. If P/E ratios stay near where they are, we will be in what Ed calls “secular hibernation.” This would mean a lot of sideways price movement, with dividends having to deliver the lion’s share of stock market returns.
3. If P/E/ ratios rise further, we will go back into the kind of “secular bubble” that created the Tech Wreck. I recall those years vividly, and I would rather not relive them.

Now, combine this market situation with what appears to be a global economic slowdown. China is a big factor, but not the only one. The entire developed world is in slow-growth mode. At some point it will likely dip into recession territory. Canada is already there. I don’t think they will be alone for long. Japan and Europe are weak.

I think the next true move to lower valuations will be a cyclical bear market combined with a recession. Can the stock market hold on to today’s valuations in a recession? Nothing is impossible, but I wouldn’t bet the farm on it, either. I can’t find an example of stock prices and valuations staying in place in the midst of a recession. Prices can fall slowly or they can fall fast, but I feel confident they will do one or the other.

Speaking of Bubbles
Our old friend Robert Shiller popped up last week in a Financial Times interview. Shiller is the father of CAPE, the cyclically adjusted price/earnings multiple, which looks back ten years to account for earnings cyclicality. He is also a Yale professor and a Nobel economics laureate.

Shiller’s CAPE has been saying for several years that stocks are seriously overvalued. In his FT interview, Shiller dropped the “B” word: It looks to me a bit like a bubble again, with essentially a tripling of stock prices since 2009 in just six years and at the same time people losing confidence in the valuation of the market.

When will the bubble burst? Shiller is less helpful there. He said the recent bout of volatility “shows that people are thinking something, worried thoughts. It suggests to me that many people are re-evaluating their exposure to the stock market. I’m not being very helpful about market timing, but I can easily see aftershocks coming.

Now, if you aren’t very confident about timing, it’s arguably better not to use words like bubble and aftershock. You can be sure the media and analysts will jump all over them, just as I’m doing right now.
In any case, Ed Easterling and Bob Shiller reach similar conclusions (though for different reasons). Neither sees a very bullish future, though both are unsure about timing. So when will we know the end is nigh? Sadly, we probably won’t, unless we begin to see signs that a recession is building in the United States.

Balloons in Search of Needles
As the old proverb goes, no one rings a bell at the top. The same applies at the bottom. Let’s imagine the stock market as a whole bunch of balloons. One or two can pop loudly and everyone will jump and then laugh it off. You now have deflated debris hanging from your string. Eventually, enough balloons will pop that the weight of the debris overwhelms the remaining balloons’ ability to keep the string aloft. Then your whole bunch falls down.

The last balloon to pop wasn’t any bigger or smaller than the others; it just happened to be last. In like manner, some kind of catalyst sets off every market collapse. It is usually something that would be survivable by itself. The plunge occurs because of all the previous balloons that bit the dust, but pundits and the media always like to point the finger at the most recent event.

So, if Easterling and Shiller are right, balloons are popping and making investors nervous, but there’s not enough damage yet to drag down the whole bundle. What are some candidates for the last balloon? A Chinese “hard landing” is probably the biggest, most obvious balloon right now. And actually, China is big enough for multiple balloons. Their stock market downturn produced one pop already. Beijing’s currency adjustment may have been another one.

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.

The article Thoughts from the Frontline: Balloons in Search of Needles was originally published at mauldineconomics.com.

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Muddling Through Shanghai

By John Mauldin

“He who knows when he can fight and when he cannot, will be victorious.”

– Sun Tzu

A couple of weeks ago I was complaining about 47,000 China reports clogging my email. The number now feels like it is well into six figures (perhaps a slight exaggeration). Maybe my memory is going, but there wasn’t nearly as much China talk on the way up. Funny how that works.

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Is China collapsing? I think parts of China are under severe pressure if not outright recession, and clearly the stock market is a disaster. Anyone who bought Shanghai or Shenzhen stocks on margin this year is probably on the brink.

That said, China itself is not collapsing. There are parts of China that are doing just fine, thank you very much. It does have serious problems, though. The Pollyannas and the Cassandras are both wrong. The change in tone in the Financial Times is quite amusing. Their recent hyperbolic, bearish section called “China Tremors” is a case in point. Of the last 30 articles on China on their website, I found less than a handful that were positive on China. My take? China will muddle through, at least for the near term.

China is in transition, a transition that was clearly telegraphed if you have been paying attention. Our recent book on China (A Great Leap Forward?) clearly laid out this new path. Today we are going to talk about this precarious, difficult transition, which may impose profound impacts on much of the rest of the world. This transition is going to change the way global trade has worked in the past. There will be winners and losers.
But first, a brief comment on today’s employment report and how it impacts the need for a rate hike by the Federal Reserve in September. I offer a little different perspective on the coming decision.

To Hike or Not To Hike – That Is the Question

Today’s unemployment report was lackluster, as has been the case for the initial reporting for the last two Augusts. Both were revised significantly upward – August 2012 was eventually revised up 96,000 jobs, while August 2013 saw a final revision upward of 69,000 jobs, and August 2014 saw a final count of +213,000 jobs. Part of the reason for the major revisions is that only some 70% of the potential survey participants actually responded (hat tip Joan McCullough).

Evidently the United States is becoming like Europe, and we are all going on vacation in August. Or at least the department personnel responsible for handling employment figures are. Expect to see significant upward revisions in the coming months, just as July saw another 30,000 added and June saw a plus 14,000.

This report was not so ugly that it would take the breath away from hawks wanting to raise rates or force doves into agreeing to a rate increase. Nothing changed, really. That is illustrated by the two articles below that were side-by-side on the New York Times website within an hour of the release of the report (hat tip Brent Donnelly). Everybody got to see what they wanted to see.

I can’t remember a time when there was such serious disagreement over what the Federal Reserve should do regarding a rate hike. I have been in several groups of analysts and economists in the last few months, and I must confess to being surprised at the split in opinions.

Upon reflection, I think I can actually understand both positions. First, the Fed keeps reiterating that they are “data dependent” – thus the focus on every little bit of data, no matter how trivial. Let me see if I can explain why both sides can feel they are right and then why, to my way of thinking, they are missing the point.

On the side of those who feel that a rate hike should be postponed at the September meeting, it must be remembered that most rate hikes are in anticipation of an economy beginning to pick up speed. The Fed has said they want to see low unemployment, and under the leadership of Bernanke and now Yellen, they have a 2% inflation target. Remember, their congressional mandate is to promote stable prices and full employment.

While unemployment did drop to 5.1%, that is a “soft” unemployment figure. The participation rate is down. The number of part time workers wanting full time jobs is still high. And the new employment trend is not encouraging.

August's gains were well below trend. The average of the previous five months is 211,000; for the previous six before that it was 282,000. The yearly employment gain, 2.1%, is off 0.2 point from the late 2014/early 2015 rate. The private sector gain is 60,000 below the average of the previous six months. (The Liscio Report)

We are not close to 2% inflation; and, frankly, it doesn’t look like we’re going to get there for a while. The economy is, at best, stuck in a low, Muddle Through gear (as I predicted years ago); and getting back to a stable 3% growth rate, let alone the occasional 4–5% that we used to see, seems out of reach. The dollar is strong and getting stronger and is not only holding down inflation but also, anecdotal evidence suggests, slowing down exports in various sectors of the economy.

There were those who argued that a bubble was developing in the stock market, but it appears the stock market is taking care of itself to make sure it doesn’t become overheated. There is no need to pile on to see if we can drive asset prices even lower. Further, we are just in the beginning of a housing recovery. Why raise mortgage rates, etc., at the beginning?

In such an environment, why would you raise rates in order to keep the economy from overheating? The last thing we seem to be doing is overheating, let alone even getting to a slow boil. Instead, we may already be cooling down. If the economy does start to pick up and inflation becomes an issue, we could raise rates then as fast as we would need to. Or so Kocherlakota and his friends on the FOMC say. And thus we should postpone a rate increase until we see a reason for it. Kind of like, don’t shoot till you see the whites of their eyes.

Those who think we should raise rates likewise have an array of data to support their case. GDP grew 3.7% in the second quarter. If you take out the weather related first quarter 2015 GDP figure, GDP growth is running well over 3%. Given the global headwinds currently buffeting economies, that’s about as good as it’s going to get.

This economy has weathered tax increases and the abrupt changes of Obamacare, as well as a significant drop in capital spending related to oil production and has “kept on ticking.” If there is a recession in our near future, as David Rosenberg points out, it would be the first recession ever that did not see consumer spending or employment go down for the count.

We’ve always been able to find negatives in the unemployment rate. Even if unemployment were somehow to ratchet down to less than 200,000 per month, it will be for only two quarters at the most; and it may be that before the end of the year we will be under 5% unemployment. We just set a record for all measures of corporate profits in absolute terms. We finally set a new record for real disposable personal income in July, again in absolute terms. As Jim Smith says,

What all this means is that when the FOMC meets on September 16 and 17, they will be looking at a US economy in which more people are employed than ever before, earning more money than ever before, producing more goods and services than ever before, and with personal consumption expenditures and corporate profits at the highest levels ever seen. If that is not a prescription for finally raising the Fed Funds rate, then I can't imagine what it would take to get them to move. (source)

Despite the significant slowdown in the oil patch, the level of investment in the second quarter was almost 4% higher than last year. Businesses are optimistic. Even given the turmoil in Canada, China, the Eurozone, and the rest of the BRICS, and even though global trade is beginning to fall off a little bit, the US economy seems to be doing quite well in spite of it all.

What else do you need in order to begin to normalize rates? Inflation is under control and according to most Fed economists seems to be ticking higher. Unemployment is moving lower. The economy is doing quite well. If not now, when? How much better do you want things to get before rates are taken back to something close to normal?

I must confess that I personally lean toward the latter argument, but I have a few additional reasons for thinking the Federal Reserve should act in September. As I have presented in previous letters, there are real reasons to think that low interest rates are not only creating malinvestment but also encouraging companies to use financial engineering and to buy their competition rather than purchasing the tools of production and actually competing head on. These behaviors distort an economy over the long term. They frustrate Schumpeter’s forces of creative destruction.

Further, what policy tools does the Federal Reserve still have available if we enter a recession? I admit that doesn’t seem to be a likely possibility today, but there are many potentials for exogenous shocks to the US economy that could cause a recession. Further, in the history of the United States we have never had a period longer than nine years without a recession. This recovery, relatively weak though it is, is getting long in the tooth. Do we want the Fed to confront the next recession with another round of massive quantitative easing as the only policy tool left to deploy? When their own research shows that QE wasn’t very useful and when we can clearly see the distortions caused by QE in emerging markets around the world?

The Federal Reserve is functionally incapable of not feeling the need to “do something” in the midst of a recession. If the only tool they have is further massive quantitative easing, they will use it. Damn the distortions, full speed ahead!

I would not argue for a rapid rate hike. In fact, I would prefer 1/8 of a point at every meeting, rather than the typical quarter point. But there is no reason not to raise a quarter of a point at this meeting, skip a meeting to make sure everybody can take a deep breath, and then raise once more before the end of the year.

I mean, really? Does the Fed think this economy is so fragile that it can’t take a lousy quarter of a point increase in interest rates? The Federal Reserve needs to begin to restock its policy tool chest now. While I personally think we are a long way from ever seeing 5% Fed funds rates again, a 2% rate can probably easily be absorbed if it comes slowly. And that rate would give the Fed some policy tools when, not if, we enter the next recession.

Now, let’s turn back to China.

Repeat After Me: Chinese Stocks Are Not the Chinese Economy

It’s easy to assume that a country’s stock market reflects the condition of its economy, but that is not always the case. Further, what the stock market really does reflect is the consensus estimate of an economy’s future condition. More specifically, stock prices reveal future expectations for corporate profits.

This generally applies to both the United States and China. One key difference, though, is that most American stocks represent companies that seek to make profits. In China, that isn’t necessarily the case. The Chinese stock market includes many state-owned enterprises (SOEs), whose executives answer to bureaucrats in Beijing. The government views them as public policy tools. Everyone is happy if the SOEs make a profit, but profit is not the first priority.

If US stock prices generally tell us more about the future than the present, except in times of serious over- or undervaluation, then Chinese stock prices tell us even less about either. Just as last year’s incredible run-up in Chinese stocks did not signal an economic boom, the ongoing decline does not signal an economic bust. The correlations aren’t just weak, they are nonexistent. China’s official economic data is also questionable and would be so even if GDP were a precise measurement tool. As we discussed last week, it usually isn’t.

It is no stretch to say we are flying blind about China.

Fortunately, we have diligent researchers like Leland Miller of China Beige Book, whose research firm does the hard work of gathering reliable data each quarter from thousands of companies in China and assembling it in comprehensible form. His data shows that China’s economy has actually been in good shape since China stopped acting Chinese last year. But even then, you have to separate the Chinese economy into several categories.

China Good, China Bad, & China Ugly

Among the many letters and reports on China that I received over the last month, I’d like to single out an excellent research note that the team at Gavekal Dragonomics published last week, called “What to Worry About and What Not to in China.” I appreciated this piece, because it really helped me structure my worrying. I dislike spending energy worrying about the wrong things. Further, worrying about the wrong things can be dangerous. It’s when you are paying attention to the wrong things that what you should have been paying attention to jumps up and bites you on the derrière.

In the spirit of the Gavekal note, here is the good side of China. We’ll get to the bad and the ugly below.
Chinese real estate prices will stabilize. We hear a lot about China’s massive infrastructure boom and the resulting “ghost cities.” These aren’t just rumors. The government mandated the construction of entire cities to house the formerly agrarian population as it shifts to industrial jobs. Provincial governments earned as much as 80% of their revenues from land sales. Essentially, this is a process where they take possession of rural land that has very little value in price terms, declare it to be available for development, and can make profits several orders of magnitude greater than their costs. Nice work if you can get it.

The ghost cities will not stay empty forever. They will fill with people over the next few years (in some cases more than a few). The recent housing bubble is more a function of young people wanting to cram into certain popular areas. The broader internal migration will support housing prices even as the bubble areas pop.

It might be helpful to think of the Chinese ghost cities as analogous to the overbuilt condos in Florida. Prices in Florida did in fact collapse, and places were selling for a fraction of their construction cost. I wrote at the time that I thought they would be very good investments, because the number of people wanting to retire to Florida is actually a fairly steadily growing figure. Low taxes, good weather, positive infrastructure, excellent medical care – what’s not to like, other than it’s not Texas? Just saying…..

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.

The article Thoughts from the Frontline: Muddling Through Shanghai was originally published at mauldineconomics.com.

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A Great Insight into Why Commodity Weakness Will Persist

By John Mauldin 

In today’s Outside the Box, good friend Gary Shilling gives us deeper insight into the global economic trends that have led to China’s headline making, market shaking devaluation of the renminbi. He reminds us that today’s currency moves and lagging growth are the (perhaps inevitable) outcome of China massive expansion of output for many products that started more than a decade ago. China was at the epicenter of a commodity bubble that got underway in 2002, soon after China joined the World Trade Organization.

As manufacturing shifted from North America and Europe to China –with China now consuming more than 40% of annual global output of copper, tin, lead, zinc and other nonferrous metal while stockpiling increased quantities of iron ore, petroleum and other commodities – many thought a permanent commodity boom was here.

Think again, Australia; not so fast, Brazil. Copper prices, for instance, have been cut nearly in half as world growth, and Chinese internal demand, have weakened. Coal is another commodity that is taking a huge hit: China’s imports of coking coal used in steel production are down almost 50% from a year ago, and of course coal is being hammered here in the US, too.

And the litany continues. Grain prices, sugar prices, and – the biggee – oil prices have all cratered in a world where the spectre of deflation has persistently loomed in the lingering shadow of the Great Recession. (They just released grain estimates for the US, and apparently we’re going to be inundated with corn and soybeans. The yield figures are almost staggeringly higher than the highest previous estimates. Very bearish for grain prices.)

Also, most major commodities are priced in dollars; and now, as the US dollar soars and the Fed prepares to turn off the spigot, says Gary, “raw materials are more expensive and therefore less desirable to overseas users as well as foreign investors.” As investors flee commodities in favor of the US dollar and treasuries, there is bound to be a profound shakeout among commodity producers and their markets.

See the conclusion of the article for a special offer to OTB readers for Gary Shilling’s INSIGHT. Gary’s letter really does provide exceptional value to his readers and clients. It’s packed with well-reasoned, outside-the-consensus analysis. He has consistently been one of the best investors and analysts out there.

There are times when you look at your travel schedule and realize that you just didn’t plan quite as well as you could have. On Monday morning I was in the Maine outback with my youngest son, Trey, and scheduled to return to Dallas and then leave the next morning to Vancouver and Whistler to spend a few days with Louis Gave. But I realized as Trey and I got on the plane that I no longer needed to hold his hand to escort him back from Maine. He’s a grown man now. I could’ve flown almost directly to Vancouver and cut out a lot of middlemen. By the time that became apparent, it was too late and too expensive to adjust.

Camp Kotok, as it has come to be called, was quite special this year. The fishing sucked, but the camaraderie was exceptional. I got to spend two hours one evening with former Philadelphia Fed president Charlie Plosser, as he went into full-on professor mode on one topic after another. I am in the midst of thinking about how my next book needs to be written and researched, and Charlie was interested in the topic, which is how the world will change in the next 20 years, what it means, and how to invest in it. Like a grad student proposing a thesis, I was forced by Charlie to apply outline and structure to what had been only rough thinking.

There may have been a dozen conversations like that one over the three days, some on the boat – momentarily interrupted by fish on the line – and some over dinner and well into the night. It is times like that when I realize my life is truly blessed. I get to talk with so many truly fascinating and brilliant people. And today I find myself with Louis Gave, one of the finest economic and investment thinkers in the world (as well as a first class gentleman and friend), whose research is sought after by institutions and traders everywhere. In addition to talking about family and other important stuff, we do drift into macroeconomic talk. Neither of us were surprised by the Chinese currency move and expect that this is the first of many
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I did a few interviews while I was in Maine. Here is a short one from the Street.com. They wanted to talk about what I see happening in Europe. And below is a picture from the deck of Leen’s Lodge at sunset. Today I find myself in the splendor of the mountains of British Columbia. It’s been a good week and I hope you have a great one as well.

Oops, I’ve just been talked into going zip-trekking this afternoon with Louis and friends. Apparently they hang you on a rope and swing you over forests and canyons. Sounds interesting. Looks like we’ll do their latest and greatest, the Sasquatch. 2 km over a valley. Good gods.

Your keenly aware of what a blessing his life is analyst,

John Mauldin, Editor

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Commodity Weakness Persists

(Excerpted from the August 2015 edition of A. Gary Shilling’s INSIGHT)

The sluggish economic growth here and abroad has spawned three significant developments – falling commodity prices, looming deflation and near-universal currency devaluations against the dollar. With slowing to negative economic growth throughout the world, it’s no surprise that commodity prices have been falling since early 2011 (Chart 1). While demand growth for most commodities is muted, supply jumps as a result of a huge expansion of output for many products a decade ago. China was the focus of the commodity bubble that started in early 2002, soon after China joined the World Trade Organization at the end of 2001.

China, The Manufacturer

As manufacturing shifted from North America and Europe to China – with China now consuming more than 40% of annual global output of copper, tin, lead, zinc and other nonferrous metal while stockpiling increased quantities of iron ore, petroleum and other commodities – many thought a permanent commodity boom was here.

So much so that many commodity producers hyped their investments a decade ago to expand capacity that, in the case of minerals, often take five to 10 years to reach fruition. In classic commodity boom-bust fashion, these capacity expansions came on stream just as demand atrophied due to slowing growth in export-dependent China, driven by slow growth in developed country importers. Still, some miners maintain production because shutdowns and restarts are expensive, and debts incurred to expand still need to be serviced. Also, some mineral producers are increasing output since they believe their low costs will squeeze competitors out. Good luck, guys!

Copper, Our Favorite

Copper is our favorite industrial commodity because it's used in almost every manufactured product and because there are no cartels on the supply or demand side to offset basic economic forces. Also, copper is predominantly produced in developing economies that need the foreign exchange generated by copper exports to service their foreign debts. So the lower the price of copper, the more they must produce and export to get the same number of dollars to service their foreign debts. And the more they export, the more the downward pressure on copper prices, which forces them to produce and export even more in a self reinforcing downward spiral in copper prices. Copper prices have dropped 48% since their February 2011 peak, and recently hit a six year low as heavy inventories confront subdued demand (Chart 2).

Even in 2013, after two solid years of commodity price declines, major producers were in denial. That year, Glencore purchased Xtrata and Glencore CEO Ivan Glasenberg called it “a big play” on coal. “To really screw this up, the coal price has got to really tank,” he said at the time. Since then, it’s down 41%. But back in February 2012 when the merger was announced, coal was selling at around $100 per ton and Chinese coal demand was still robust.

Nevertheless, Chinese coal consumption fell in 2014 for the first time in 14 years and U.S. demand is down as power plants shift from coal to natural gas. Meanwhile, coal output is jumping in countries such as Australia, Colombia and Russia. China’s imports of coking coal used in steel production are down almost 50% from a year ago. Many coal miners lock in sales at fixed prices, but at current prices, over half of global coal is being mined at a loss. U.S. coal producers are also being hammered by environmentalists and natural gas producers who advocate renewable energy and natural gas vs. coal.

Losing Confidence?

Recently, major miners appear to be losing their confidence, or at least they seem to be facing reality. Anglo-American recently announced $4 billion in writedowns, largely on its Minas-Rio $8.8 billion iron ore project in Brazil, but also due to weakness in metallurgical coal prices. BHP took heavy writedowns on badly timed investments in U.S. shale gas assets. Rio Tinto’s $38 billion acquisition of aluminum producer Alcan right at the market top in 2007 has become the poster boy for problems with big writeoffs due to weak aluminum prices and cost overruns.

Glencore intends to spin off its 24% stake in Lonmin, the world’s third largest platinum producer. Iron ore-focused Vale is considering a separate entity in its base metals division to “unlock value.” Meanwhile, BHP is setting up a separate company, South 32, to house losing businesses including coal mines and aluminum refiners. That will halve its assets and number of continents in which it operates, leaving it oriented to iron ore, copper and oil.

Goldman Sachs coal mines suffered from falling prices and labor problems in Colombia. It is selling all its coal mines at a loss and has also unloaded power plants as well as aluminum warehouses. The firm’s commodity business revenues dropped from $3.4 billion in 2009 to $1.5 billion in 2013. JP Morgan Chase last year sold its physical commodity assets, including warehouses. Morgan Stanley has sold its oil shipping and pipeline businesses and wants to unload its oil trading and storage operations.

Jefferies, the investment bank piece of Leucadia National Corp., is selling its Bache commodities and financial derivatives business that it bought from Prudential Financial in 2011 for $430 million. But the buyer, Societe Generale, is only taking Bache’s top 300 clients by revenue while leaving thousands of small accounts, and paying only a nominal sum. Bache had operating losses for its four years under Jefferies ownership.

Grains and other agricultural products recently have gone through similar but shorter cycles than basic industrial commodities. Bad weather three years ago pushed up grain prices, which spawned supply increases as farmers increased plantings. Then followed, as the night the day, good weather, excess supply and price collapses. Pork and beef production and prices have similar but longer cycles due to the longer breeding cycles of animals.

Sugar prices have also nosedived in recent years (Chart 3). Cane sugar can be grown in a wide number of tropical and subtropical locations and supply can be expanded quickly. Like other Latin American countries, Brazil – the world's largest sugar producer – enjoyed the inflow of money generated from the Fed’s quantitative easing. But that ended last year and in combination with falling commodity prices, those countries’ currencies are plummeting (Chart 4). So Brazilian producers are pushing exports to make up for lower dollar revenues as prices fall, even though they receive more reals, the Brazilian currency that has fallen 33% vs. the buck in the last year since sugar is globally priced in dollars.

Oil Prices

Crude oil prices started to decline last summer, but most observers weren’t aware that petroleum and other commodity prices were falling until oil collapsed late in the year. With slow global economic growth and increasing conservation measures, energy demand growth has been weak. At the same time, output is climbing, especially due to U.S. hydraulic fracking and horizontal drilling. So the price of West Texas Intermediate crude was already down 31% from its peak, to $74 per barrel by late November.

Cartels are set up to keep prices above equilibrium. That encourages cheating as cartel members exceed their quotas and outsiders hype output. So the role of the cartel leader – in this case, the Saudis – is to accommodate the cheaters by cutting its own output to keep prices from falling. But the Saudis have seen their past cutbacks result in market share losses as other OPEC and non-OPEC producers increased their output. In the last decade, OPEC oil production has been essentially flat, with all the global growth going to non-OPEC producers, especially American frackers (Chart 5). As a result, OPEC now accounts for about a third of global production, down from 50% in 1979.

So the Saudis, backed by other Persian Gulf oil producers with sizable financial resources – Kuwait, Qatar and the United Arab Emirates – embarked on a game of chicken with the cheaters. On Nov. 27 of last year, while Americans were enjoying their Thanksgiving turkeys, OPEC announced that it would not cut output, and they have actually increased it since then. Oil prices went off the cliff and have dropped sharply before the rebound that appears to be temporary. On June 5, OPEC essentially reconfirmed its decision to let its members pump all the oil they like.

The Saudis figured they can stand low prices for longer than their financially-weaker competitors who will have to cut production first. That list includes non-friends of the Saudis such as Iran and Iraq, which they believe is controlled by Iran, as well as Russia, which opposes the Saudis in Syria. Low prices will also aid their friends, including Egypt and Pakistan, who can cut expensive domestic energy subsidies.

The Saudis and their Persian Gulf allies as well as Iraq also don’t plan to cut output if the West's agreement with Iran over its nuclear program lifts the embargo on Iranian oil. As much as another million barrels per day could then enter the market on top of the current excess supply of two million barrels a day.

The Chicken-Out Price

What is the price at which major producers chicken out and slash output? It isn’t the price needed to balance oil-producer budgets, which run from $47 per barrel in Kuwait to $215 per barrel in Libya (Chart 6). Furthermore, the chicken out price isn’t the “full cycle” or average cost of production, which for 80% of new U.S. shale oil production is around $69 per barrel.

Fracker EOG Resources believes that at $40 per barrel, it can still make a 10% profit in North Dakota as well as South and West Texas. Conoco Phillips estimates full cycle fracking costs at $40 per barrel. Long run costs in the Middle East are about $10 per barrel or less (Chart 7).

In a price war, the chicken out point is the marginal cost of production – the additional costs after the wells are drilled and the pipelines laid – it’s the price at which the cash flow for an additional barrel falls to zero. Wood Mackenzie’s survey of 2,222 oil fields globally found that at $40 per barrel, only 1.6% had negative cash flow. Saudi oil minister Ali al-Naimi said even $20 per barrel is “irrelevant.”

We understand the marginal cost for efficient U.S. shale oil producers is about $10 to $20 per barrel in the Permian Basin in Texas and about the same on average for oil produced in the Persian Gulf. Furthermore, financially troubled countries like Russia that desperately need the revenue from oil exports to service foreign debts and fund imports may well produce and export oil at prices below marginal costs – the same as we explained earlier for copper producers. And, as with copper, the lower the price, the more physical oil they need to produce and export to earn the same number of dollars.

Falling Costs

Elsewhere, oil output will no doubt rise in the next several years, adding to downward pressure on prices. U.S. crude oil output is estimated to rise over the next year from the current 9.6 million level. Sure, the drilling rig count fell until recently, but it’s the inefficient rigs – not the new horizontal rigs that are the backbone of fracking – that are being sidelined. Furthermore, the efficiency of drilling continues to leap. Texas Eagle Ford Shale now yields 719 barrels a day per well compared to 215 barrels daily in 2011. Also, Iraq’s recent deal with the Kurds means that 550,000 more barrels per day are entering the market. OPEC sees non-OPEC output rising by 3.4 million barrels a day by 2020.

Even if we’re wrong in predicting further big drops in oil prices, the upside potential is small. With all the leaping efficiency in fracking, the full-cycle cost of new wells continues to drop. Costs have already dropped 30% and are expected to fall another 20% in the next five years. Some new wells are being drilled but hydraulic fracturing is curtailed due to current prices. In effect, oil is being stored underground that can be recovered quickly later on if prices rise Closely regulated banks worry about sour energy loans, but private equity firms and other shadow banks are pouring money into energy development in hopes of higher prices later. Private equity outfits are likely to invest a record $21 billion in oil and gas start ups this year.

Earlier this year, many investors figured that the drop in oil prices to about $45 per barrel for West Texas Intermediate was the end of the selloff so they piled into new equity offerings (Chart 8), especially as oil prices rebounded to around $60. But with the subsequent price decline, the $15.87 billion investors paid for 47 follow-on offerings by U.S. and Canadian exploration and production companies this year were worth $1.41 billion less as of mid-July.

Dollar Effects

Commodity prices are dropping not only because of excess global supply but also because most major commodities are priced in dollars. So as the greenback leaps, raw materials are more expensive and therefore less desirable to overseas users as well as foreign investors. Investors worldwide rushed into commodities a decade ago as prices rose and many thought the Fed’s outpouring of QE and other money insured soaring inflation and leaping commodity prices as the classic hedge against it.

Many pension funds and other institutional investors came to view them as an investment class with prices destined to rise forever. In contrast, we continually said that commodities aren’t an investment class but a speculation, even though we continue to use them in the aggressive portfolios we manage.

We’ve written repeatedly that anyone who thinks that owning commodities is a great investment in the long run should study Chart 9, which traces the CRB broad commodity index in real terms since 1774. Notice that since the mid-1800s, it’s been steadily declining with temporary spikes caused by the Civil War, World Wars I and II and the 1970s oil crises that were soon retraced. The decline in the late 1800s is noteworthy in the face of huge commodity-consuming development then: In the U.S., the Industrial Revolution and railroad building were in full flower while forced industrialization was paramount in Japan.

At present, however, investors are fleeing commodities in favor of the dollar, Treasury bonds and other more profitable investments. Gold is among the shunned investments, and hedge funds are on balance negative on the yellow metal for the first time, according to records going back to 2006. Meanwhile, individual investors have yanked $3 billion out of precious metals funds.

Commodity Price Outlook

Commodity prices are under pressure from a number of forces that seem likely to persist for some time.

1. Sluggish global demand due to continuing slow economic growth.
2. Huge supplies of minerals and other commodities due to robust investment a decade ago.
3. Chicken games being played by major producers in the hope that pushing prices down with increasing supply will force weaker producers to scale back. This is true of the Saudis in oil and hard rock miners in iron ore.
4. Developing country commodity exporters’ needs for foreign exchange to service foreign debt. So the lower the prices, the more physical commodities they export to achieve the same dollars in revenue. This further depresses prices, leading to increased exports, etc. Copper is a prime example.
5. Increased production to offset the effects on revenues from lower prices, which further depresses prices, etc. This is the case with Brazilian sugar producers.
6. The robust dollar, which pushes up prices in foreign currency terms for the many commodities priced in dollar terms. That reduces demand, further depressing prices.

It’s obviously next to impossible to quantify the effects of all these negative effects on commodity prices. The aggregate CRB index is already down 57% from its July 2008 pinnacle and 45% since the more recent decline commenced in April 2011. To reach the February 1998 low of the last two decades, it would need to drop 43% from the late July level, but there’s nothing sacred about that 1998 number.

In any event, ongoing declines in global commodity prices will probably renew the deflation evidence and fears that were prevalent throughout the world early this year. And they might prove sufficient to deter the Fed from its plans to raise interest rates before the end of the year.

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The article Outside the Box: Commodity Weakness Persists was originally published at mauldineconomics.com.

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Closing the Sausage Factory

By John Mauldin

“Bureaucracy destroys initiative. There is little that bureaucrats hate more than innovation, especially innovation that produces better results than the old routines. Improvements always make those at the top of the heap look inept. Who enjoys appearing inept?”

– Frank Herbert, Heretics of Dune

“Economies naturally grow. People innovate as they go through life. They also look around at what others are doing and adopt better practices or tools. They invest, accumulating financial, human and physical capital.

Something is deeply wrong if an economy is not growing, because it means these natural processes are impeded. That is why around the world, since the Dark Ages, lack of growth has been a signal of political oppression or instability. Absent such sickness, growth occurs.”

– Adam Posen, “Debate: The Case for Slower Growth”

Today’s letter will be shorter than usual, because I’m at Camp Kotok in Grand Lake Stream, Maine, where the first order of business today is trying to outfish my son (not likely to happen, this year). But I’ve been looking closer at productivity barriers, and I want to give you some points to ponder.

The New Normal?

Like many of you readers, I’m old enough to remember a time when 2.3% annual GDP growth was a disappointment. We always knew America could do better. Not anymore, apparently. Some people actually cheered last week’s first estimate for 2Q real GDP growth. It was 4.4% in nominal terms, but inflation brought the figure back down. While certain segments are growing like crazy, for the most part we are muddling along in a slow growing malaise. You might even call it “stagnant.”

I for one still think the United States can do more. We have a large population of intelligent people who want to build a solid future for their children. They’re willing to work hard to do it. If that’s not happening – and clearly it isn’t – some barrier must be standing in their way. What is this barrier to productivity and growth? There are actually several, but government red tape is one of the biggest. I thought about this after reading an excellent Holman Jenkins column in the Wall Street Journal last week.

Jenkins led me to an audio recording of an interesting discussion on “The Future of Freedom, Democracy and Prosperity,” conducted at a symposium held at Stanford University’s Hoover Institution last month.
Government research & development funding has fallen off considerably from its peak in the 1970s moonshot days. This holds back worker productivity. The federal government is doing too much to slow down business and not enough to boost it.

The three economists who spoke at Stanford all pointed to important productivity barriers emanating from Washington DC.....

One of the participants, Hoover economist John Cochrane, spoke of fears that America is drifting toward a “corporatist system” with diminished political freedom. Are rules knowable in advance so businesses can avoid becoming targets of enforcement actions? Is there a meaningful appeals process? Are permissions received in a timely fashion, or can bureaucrats arbitrarily decide your case by simply sitting on it?

The answer to these questions increasingly is “no.” Whatever the merits of 1,231 individual waivers issued under ObamaCare, a law implemented largely through waivers and exemptions is not law-like. In such a system, where even hairdressers and tour guides are subjected to arbitrary licensing requirements, all the advantages accrue to established, politically connected businesses.

The resources that businesses put into complying with government regulations is staggering. I have often envied people outside the highly regulated financial industry for their freedom to operate rationally. In my business we seem to spend half our time – and an ungodly fraction of our money – just maneuvering through the regulatory morass.

Intrusive federal regulations touch every part of the economy:

• Energy and mining companies have to deal with environmental protection rules.
• Drug companies and health care providers must satisfy the FDA and Medicare.
• Cloud technology companies have to process FBI and NSA demands for user information.
• Retailers and consumer product makers are required to abide by the fine print on millions of product labels.

I could go on, but you get the point. Anything you do attracts bureaucratic oversight now. We may laugh at “helicopter parents” hovering over their children at school, but we all have a helicopter government looking over our shoulders at work.

Before anyone calls me an anarchist, I think some government regulation is perfectly appropriate. We all want clean drinking water. Everyone appreciates knowing our cars meet crash survival standards. I’m glad FAA is keeping order in the skies.

The problem arises when agencies enforce confusing, contradictory, and excessive regulations and try to micromanage the nation’s businesses. Every business owner I know is glad to play by the rules. They just want to know what the rules say, and that is frequently very hard to do.

A few weeks ago, in “Productivity and Modern-Day Horse Manure,” I explained that growth is really quite simple: if we want GDP to grow, we need some combination of population growth and productivity growth.

The US population is growing, thanks mainly to immigration, but the effectiveness of the workforce is another matter. Baby Boomer retirements are rapidly removing productive assets from the economy. To offset that trend, we need to make younger workers more productive.The red tape that constantly spews out of Foggy Bottom is not helping matters.

Regulatory Capture

The red tape hurts the economy overall, but it does help certain parties. The largest players in any niche often “capture” their regulators. Then they use their influence to tilt enforcement away from themselves and toward smaller competitors.

Put simply, new regulations can be great for your business if you are already well established and have the resources to comply with government mandates. New entrants rarely have those resources. The resulting lack of competition boosts profits for the big players but hurts consumers. The competition that would normally lead to better, less expensive goods and services never happens.

Holman Jenkins makes another great point about how over regulation affects growth.

Another participant, Lee Ohanian, a UCLA economist affiliated with Hoover, drew the connection between the regulatory state and today’s depressed growth in labor productivity. From a long-term average of 2.5% a year, the rate has dropped to 0.7% in the current recovery. Labor productivity is what allows rising incomes. A related factor is a decline in business start ups. New businesses are the ones that bring new techniques to bear and create new jobs. Big, established companies, in contrast, tend to be net job shrinkers over time.

Recall our economic growth formula: population growth plus productivity growth. The US population grew at a peak rate of 1.4% in 1992, and growth has been trending down ever since. Now it is around 0.75% per year. Add that to 0.7% productivity growth, and you see why Jeb Bush’s 4% growth target will be so hard to hit.

Blame Flows Downhill

Business leaders love to complain about the bureaucrats who run Washington’s alphabet-soup agencies. I think the problem goes deeper. With only a few exceptions, the regulators I’ve met over the years have been competent professionals. They weren’t intentionally trying to hurt my business. Often the regulations confused them as much as they confused me.

The real blame, I think, starts on Capitol Hill. Our legislative process is a sausage factory. Congress passes vague, complicated laws riddled with exceptions for this and zero tolerance for that. The result is superficially attractive but a mess inside. People in the alphabet agencies then have to remove the sausage skin and make sense of the contents. This would be a tough job for anyone. I certainly don’t envy them.

Jenkins mentions Obamacare’s convoluted waivers and exemptions. Even its advocates admit the law is a crazy mess. But how and why did it get that way?

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.

The article Thoughts from the Frontline: Closing the Sausage Factory was originally published at mauldineconomics.com.

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When China Stopped Acting Chinese

By John Mauldin

“The one thing I know for sure about China is, I will never know China. It's too big, too old, too diverse, too deep. There's simply not enough time.”

– Anthony Bourdain, Parts Unknown

Much of the world is focused on what is happening in Greece and Europe. A lot of people are paying attention to the Middle East and geopolitics. These are significant concerns, for sure; but what has been happening in China the past few months has more far reaching global investment implications than Europe or the Middle East do. Most people are aware of the amazing run up in the Shanghai stock index and the recent “crash.” The government intervened and for a time has halted the rapid drop in the markets.

There have been a number of concerns about what this means for the Chinese economy. Is China getting ready to implode? Certainly there are those who have been predicting that outcome for some time. In this week’s letter I am going to try to explain both what caused the Chinese stock market to rise so precipitously and then fall just as fast and why we have to view China’s stock market differently from its economy.

As I have been saying for several years, in order for the Chinese economy to continue to grow, the Chinese must shift their emphasis from industrial production and infrastructure investment to a services oriented economy. That is indeed what they are trying to do, and we are beginning to see signs of the services sector taking on a role as important to the Chinese economy as services are to the US economy. They have a long way to go, but they have begun the trip.

A Transformation Like No Other

When the US stock market crashed in October 1987, commentators on that era’s primitive financial media (I recall seeing them on the large wooden box in my living room) rushed to distinguish between the country’s economy and its stock market.

The American economy, they said, is just fine. Life will go on, and businesses will make money. As it turned out, that was good analysis – and it still is today – and not just for the United States. Stock markets do reflect the economy over time, but they can lead it or lag it for years.

Anyone who owns China stocks has probably sought solace in such thinking the last few weeks. The Chinese stock bubble is deflating in spectacular fashion. The sharp decline and Beijing’s flailing efforts to stabilize the market have many economists seeing deeper trouble.

We’ll compare and contrast the Chinese stock market and economy by looking at an unusual but very reliable data source. With apologies to Anthony Bourdain, whom I quoted at the beginning of the letter, we can know China. We just have to ask the right people the right questions.

Back in 1987, as American investors were licking their wounds, the Shanghai skyline looked like this:

Here is a 2013 view from the same spot:

Photo credit: Carlos Barria, Reuters

A lot can change in 26 years. Transformations like this are commonplace in China. Gleaming cities now tower over what was undeveloped land a decade or two ago. Most of those cities even have people living in them, although the ghost cities are legendary.

You can crunch any numbers you like in any way you like, and it will be clear that China’s rapid growth is unprecedented. It is changing the course of human history. China has moved more than 250 million people from living a medieval lifestyle in the country to living and working in these fabulous new cities. And they have built the infrastructure to connect and supply them.

Worth Wray and I explored China from many different perspectives in our e-book, A Great Leap Forward? Our all-star cast of China experts variously see both opportunity and risk. The book is getting rave reviews. If you’re interested in an in-depth analysis of China, it’s the place to start (Click here for more information and to order the book.)

In thinking about China last week, I skimmed through the book and noticed something that, with the benefit of hindsight, is simply stunning. The paragraphs I read brought all the pieces together to explain the Chinese stock market’s epic drawdown.

China GDP Versus China Beige Book

The part that made me sit up straight was in the contribution by Leland Miller of China Beige Book. His chapter “How Private Data Can Demystify the Chinese Economy” comes at the Chinese economy from a unique angle.

We all know government economic data isn’t always reliable. That is especially true in China. It is the only country in the world that can report its GDP quarter after quarter and never have to revise its calculations. That is just the most obvious of its economic data manipulations.

Even knowing that, most China analysts still rely on that GDP number, because it is all they have. That is beginning to change because of the work of Leland Miller. Leland, along with his colleague Craig Charney, decided to build an alternative analysis to government GDP numbers. Using the same methodology that the Federal Reserve uses in its quarterly Beige Book, they gather data from a network of observers all over China. Their clients – who include the world’s largest central banks – provide granular data that gives a much deeper view of the Chinese economy.

In A Great Leap Forward? [get it here on Amazon] Leland describes how China Beige Book picked up on a major change in Chinese businesses. He says the country’s 2014 slowdown was different.

The slowdown of 2013 was the result of subtle credit tightening, few signs of which were evident in official data right up until the June interbank credit crunch caused a market panic. Small and medium-sized companies during that period still wanted to access credit but found – TSF data notwithstanding – that it was difficult if not impossible to do so. 2014, intriguingly, has proven to be a very different story.

One of the most interesting dynamics we’ve tracked across corporate China has been the historical disconnect between company performance and the willingness of those companies to continue to borrow and spend. In many sectors, particularly troubled ones such as mining and property, firms typically reacted to poor results in a peculiarly Chinese way: they doubled down.

Too often, the thinking appeared to be: good results were good, but bad results were not necessarily bad, because the government was expected to step in and bail them out. Perhaps with subsidies, perhaps by ordering loans to be rolled over to another day. Firms often chose to act in demonstrably non-commercial ways.

Since early 2014, however, our data suggest a startling transformation. During the second quarter, CBB data showed a particularly broad deceleration in revenue growth nationwide: for the first time in our survey, not one sector showed on quarter improvement. Yet firms reacted to this slowdown in a surprisingly rational way: capital expenditure growth fell broadly, as did capex expectations, as did loan demand – all to the lowest levels in the history of our survey. The third quarter then showed yet another quarter of weak loan demand, with even lower levels of current and expected capex.

Firms watching the economic slowdown didn’t want to spend – and they didn’t want to borrow either. For the time being, they preferred to watch events unfold from the sidelines.

Leland says, and I agree, that this was a positive development. Both businesses and investors need the discipline of free markets. Experiencing failure forces everyone to learn what works and what doesn’t work.

In a phone call this week, Leland told me their data actually pinpointed this change in the second quarter of 2014. He thinks it was the most important single quarter in Chinese economic history. I’m sure that Leland, as an Oxford educated China historian, doesn’t say that lightly. It was in that quarter, Leland thinks, that Chinese business leaders “stopped acting Chinese.” Faced with falling demand, they did the rational thing and stopped adding new capacity. As he says in the excerpt above, they didn’t want to spend or borrow.

They just sat on the sidelines. That was a good business decision. Unfortunately, it wasn’t consistent with Beijing’s master plan.

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.

The article Thoughts from the Frontline: When China Stopped Acting Chinese was originally published at mauldineconomics.com.

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Europe: Running on Borrowed Time

By John Mauldin 

“I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created.”

– Romano Prodi, EU Commission president, December 2001

Prodi and the other leaders who forged the euro knew what they were doing. They knew a crisis would develop, as Milton Friedman and many others had predicted. It is not conceivable that these very astute men didn’t realize that creating a monetary union without a fiscal union would bring about an existential crisis. They accepted that eventuality as the price of European unity. But now the payment is coming due, and it is far larger than they probably anticipated.

Time, as the old saying goes, is money. There are lots of ways that equation can work out. We had an interesting example last week. Europe and the eurozone pulled back from the brink by once again figuring out how to postpone the inevitable moment when all and sundry will have to recognize that Greece cannot pay the debt that it owes. In essence they have borrowed time by allowing Greece to borrow more money.

Money, I should add, that, like all the other Greek debt, will not be repaid.

I’ve probably got some 40 articles and 100 pages of commentary on Greece and the eurozone from all sides of the political spectrum in my research stack, and it would be very easy to make this a long letter. But it’s a pleasant summer weekend, and I’m in the mood to write a shorter letter, for which many of my readers may be grateful. Rather than wander deep into the weeds looking at financial indications, however, we are going to explore what I think is a very significant nonfinancial factor that will impact the future of Europe. If it was just money, then Prodi would be right – they could just create new economic policy instruments, whatever the heck those might be. But what we’ve been seeing these last few months is symptomatic of a far deeper problem than can be addressed with just a few trillion euros, give or take.

But first, I’m going to reach out and ask for a little help. I have just signed an agreement with my publisher, Wiley, to do a new book called Investing in an Age of Transformation. I’ve been thinking about this book for many years, and it is finally time to write it. As my longtime readers know, I believe we are entering a period of increasingly profound change, much more transformative than we’ve seen in the past 50 years. And not just technologically but on numerous fronts. There are going to be substantial social implications as well. Imagine the entire 20^th century fast-forwarded and packed into 20 years, and you will get some idea of the immensity of what we face.

Now think about investing in this unfolding era of change. Companies will spring up and disappear faster than ever. Corporations will move into and out of indexes at an increasingly rapid rate, making the whole experience of index investing – which constitutes the bulk of investing, not just for individuals but for pensions and large institutions – obsolete.

Just as we wouldn’t think of relying on the medical technology of the early 20^th century, I’m convinced that we need a significantly new process for investing that doesn’t depend on the concept of indexing created deep in the last century. In an age of exponential change, being wrong in your investment style will no longer mean you simply underperform: you will not merely be wrong; you will be exponentially wrong.

Of course, the flipside is that if you get it right, you will be exponentially right. We will be exploring some new investing concepts in Thoughts from the Frontline as I write the book, since this letter is actually part of my thinking process. I’ve been spending a great deal of time lately exploring new ways of thinking about the markets, different ways to manage risk, and strategies to take advantage of overwhelming change.

This project will be significantly more complex than any book I’ve attempted so far. I’m looking for a few research interns or assistants to help me on various topics. Some topics are technological in nature, and some are investment-oriented. You can be young or old, retired or working in any number of fields; you just have to be passionate about thinking about the future and be able to spend time exploring a topic and going back and forth with me through shared notes and conversations. It’s a plus if you write well. If you are interested in exploring a topic or two, drop me a note at transformation@2000wave.com, along with a resume or a note about your background, plus your area of interest. Now let’s jump to the letter.

The More Things Change

Almost four years ago, in an article on Bloomberg with the headline “Germany Said to Ready Plan to Help Banks If Greece Defaults,” we read this paragraph:

“Greece is ‘on a knife’s edge,’” German Finance Minister Wolfgang Schäuble told lawmakers at a closed-door meeting in Berlin on Sept. 7 [2011], a report in parliament’s bulletin showed yesterday. If the government can’t meet the aid terms, “it’s up to Greece to figure out how to get financing without the euro zone’s help,” he later said in a speech to parliament.

Over the last few weeks he took a similar hard line, offering the possibility that Greece could take a “timeout,” whatever in creation that is, and only the gods know how it could work for five years.
Reports of the final meeting before the agreement with Greece was reached demonstrated that there is little solidarity in the European Union. The Financial Times offered an unusually frank report of the meeting:

After almost nine hours of fruitless discussions on Saturday, a majority of eurozone finance ministers had reached a stark conclusion: Grexit – the exit of Greece from the eurozone – may be the least worst option left.

Michel Sapin, the French finance minister, suggested they just “get it all out and tell one another the truth” to blow off steam. Many in the room seized the opportunity with relish.

Alexander Stubb, the Finnish finance minister, lashed out at the Greeks for being unable to reform for half a century, according to two participants. As recriminations flew, Euclid Tsakalotos, the Greek finance minister, was oddly subdued.

The wrangling culminated when Wolfgang Schäuble, the German finance minister who has advocated a temporary Grexit, told off Mario Draghi, European Central Bank chairman. At one point, Mr Schäuble, feeling he was being patronised, fumed at the ECB head that he was “not an idiot”. The comment was one too many for eurogroup chairman Jeroen Dijsselbloem, who adjourned the meeting until the following morning.

Failing to reach a full accord on Saturday, the eurogroup handed the baton on Sunday to the bloc’s heads of state to begin their own an all night session.”

That meeting ended with Angela Merkel and Alexis Tsipras arguing for 14 hours and giving up. Donald Tusk, the president of the European Council (and former Polish Prime Minister), forced them to sit back down, saying, “Sorry, but there is no way you are leaving this room.”

Essentially, they were arguing over what form of humiliation Greece would be forced to swallow.
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.

The article Thoughts from the Frontline: Europe: Running on Borrowed Time was originally published at mauldineconomics.com.

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It’s Not Over Until the Fat Lady Goes on a P/E Diet

By John Mauldin

For the vast majority of investors, portfolio returns are generated by the equity markets or at a minimum heavily influenced by the equity markets. We have enjoyed an almost six year bull market run in the stock market, which has helped heal portfolios after the devastating market crash of the Great Recession. So much so that many prominent market analysts have proclaimed the beginning of a new secular bull market.

If we have indeed entered such a new phase, we need to recognize it for what it is, because – as I’ve written for 17 years – the style of investing that is appropriate for a secular bull market is almost the exact opposite of what is appropriate for a secular bear market. I think that most analysts would agree with that last statement.

The disagreements would revolve around whether we are in a secular bull or a secular bear market.
Thus the answer to the seemingly arcane question of whether we are in a secular bull or bear market makes a great difference in the proper positioning of your portfolios. And getting it wrong can have serious consequences.

Towards the latter part of the ’90s and especially in the early part of last decade, I was rather aggressively asserting in this letter that we should look at whether we are in a secular bull or bear market – not in terms of price but in terms of valuation. Early in that period, Ed Easterling of Crestmont Research, who was then based in Dallas, reached out to me; and we began to collaborate on a series of articles on the topic of secular bull and bear markets, a series that we want to continue today. Longtime readers know that I’m a big fan of Ed’s website at www.CrestmontResearch.com. It’s a treasure trove of fabulous charts and data on cycles and market returns. Ed has been working on a video series (we will offer a few free links below) to explain market cycles.

I want to provide a little current context before we jump into the argument about whether we are in a secular bull or bear market. For some time now, I’ve been saying that the US economy should bump along in the Muddle Through range of about 2% GDP growth. The risk to that forecast is not from something internal to the United States but from what economists call an exogenous shock, that is, one from outside the US. In particular I have said that a crisis in both Europe and China at the same time would be very negative for both US and global growth.

We now see potential crises in both regions. It would be convenient if they could arrange not to have them at the same time. But those who are paying attention to global markets are certainly experiencing a bit of market heartburn as they watch both China and Europe manifest the volatility that they have over the last few weeks. I will become far less sanguine about the US economy if full blown crises develop in those two regions.

There are observers who think the Greek crisis will be contained, and then there are equally astute but pessimistic observers, like Ambrose Evans-Pritchard, who wrote this week about the potential for a full-scale European meltdown. His recent column entitled “Europe Is Blowing Itself Apart over Greece – and Nobody Seems Able to Stop It” is reflective of those who think the European monetary experiment is problematic. It now appears that Tsipras has essentially caved on a number of issues in order to get a deal. The deal he has proposed reads almost exactly like the one the Greek referendum overwhelmingly rejected.

My own personal view is that, if this deal is agreed upon, it simply postpones the crisis for a period of time, as Greece simply has no way to grow itself out of its debt dilemma. And it is not altogether clear that Tsipras can hold his coalition together, given the referendum. He might actually need the opposition to get this deal passed, which becomes problematical for him, as it might force him to call an election. But the banks would open, and Greek life would go on until the Greeks run out of money again in the sadly not too distant future, as there is no way on God’s green earth they can meet the growth requirements that this deal demands.

The monetary union is an absurd creation based on political hopes, not economic reality. Politics can keep it together for longer than it should otherwise exist, but unless the entire southern periphery of Europe turns German in character, the peripheral nations are going to suffer under a monetary policy not designed for their economies. That ill-fitting economic straitjacket is going to mean slower growth and higher unemployment and fiscal instability. How long will they endure that? So far, a lot longer than I thought they could, 15 years ago.
China’s stock markets are having a meltdown, although there has been a rebound the last few days as the Chinese government has stepped in with the decision to destroy their markets in order to save them. My friend Art Cashin commented that it is amazing what you can do if you tell people that they will either buy stocks and make them go up or get executed. It certainly clarifies your trading position.

Further, the Chinese government basically created a rule which said that anybody who owns more than 5% of any particular equity issuance is not allowed to sell for the next six months. Neither are directors, supervisors, or senior management of any public company. The government has evidently pressured banks into creating a buying consortium. Historians who are familiar with the stock market crash of 1929 will see an interesting parallel, illustrated in the chart below (sent to me by my friend Murat Koprulu).



Hundreds of Chinese stocks have been taken off the market because they are essentially locked limit down or because company management simply halted trading in their shares, as there seemed to be no bottom to the pricing. That is an interesting way to run a supposedly liquid equity market exchange. And it creates an overhang, in that, under the current rules of the exchange, those hundreds of stocks have to go back on the market within 30 days. Theoretically, they were falling in value, which was why they were taken off the market to begin with. Will their valuations somehow magically change?

I wonder if all the major indexing firms are happy with their recent decisions to include China as a major portion of their indexes, given that liquidity in their markets is available only when markets are going up. Just curious, but how in the Wide, Wide World of Sports do you price or even maintain an index if you can’t sell and have daily liquidity and price discovery? If 7% of your index is based on a valuation that is not real, what price do you then base daily liquidity on? The last trade? So the seller gets out at a price that might be significantly higher than what the issue would actually trade at? Who sues whom? Or maybe the issue then trades higher, not lower, so that the seller should have gotten more? Index fund managers have to be pulling their hair out over this one.

Is this collapse of the Chinese market just the result of irrational exuberance, or is there something more fundamental going on? We will have to watch the situation carefully in the coming weeks.
By the way, China is far more critical to the global economy than Greece is. So much so that I recently asked a number of my friends to give me their best thoughts on China. These are experts in markets, demographics, economics, geopolitics, and so on, all with specialties in China. I’ve compiled those thoughts along with my own and those of my co-author, Worth Wray, in an e-book called A Great Leap Forward? You can get it on Amazon, iTunes, and Nook for a mere $8.99. It is an easy read that will give you an understanding of China’s challenges, from the best China experts we could find. Now, let’s talk about where the market is going in the US.

Are We There Yet? Secular Stock Market Cycle Status
By John Mauldin and Ed Easterling

We were both talking about secular bear markets back in 1999 and 2000. It’s been 15 years. Aren’t we there yet? Isn’t the stock market rising?

Of course you’re getting impatient; so are we. When will the stock market shift from secular bear to secular bull – or did it already? The implications are significant. Through much of the 2000s and into the 2010s, individual and institutional investors have weathered quite a storm of low returns and high volatility. Are we done being battered? From today, can you reasonably expect above average secular bull returns like we saw in the 1980s and ’90s … or do we face another decade or longer of below average secular bear returns? [For a 3-minute video explaining the term secular, click this link.]

In short, we use secular to describe a particular valuation environment. If you use valuations as a tool for thinking about cycles, the cycles become much more clear and easily understandable. Simply using price gives you no objective criterion for determining where you are in a long term cycle. Within our longer term secular designations there can be numerous and significant cyclical bull and bear markets, which are determined by price and not valuations.

For years, analysts and pundits throughout the industry have agreed (though it took a number of years for many of them to come around) that the new millennium brought with it secular bear conditions. In the past few years, however, opinions have once again diverged. Notable heavyweights, including Guggenheim Investments, Raymond James, and BofA Merrill Lynch, are on the record that the stock market has now entered a long-term secular bull market. (They are certainly not the only ones, but they do provide nifty charts that make it easy to analyze their thoughts.)

As shown in Figure 1, Guggenheim clearly marks the transition point between the end of the secular bear that got underway in January 2000 and the start of the new secular bull market. They place that transition point at December 2010, so that by their reckoning the secular bear lasted eleven years and produced near zero annualized returns. Then, according to Guggenheim, a new secular bull market was unleashed with New Year 2011.

Figure 1. Guggenheim Secular Bull Started January 2010

From today, can you reasonably expect above-average secular bull returns like we saw in the 1980s and ’90s … or another decade or more of below average secular bear returns?

Now, four years and a cumulative +54% later, the Guggenheim chart appears to lead investors to expect a future of above-average secular bull returns. They are somewhat subtle about it: note the implicit investment advice in the upper-left area of the chart: “Investment strategies that work in bull markets may not be effective in flat or bear markets.”

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.

The article Thoughts from the Frontline: It’s Not Over Till the Fat Lady Goes on a P/E Diet was originally published at mauldineconomics.com.

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