By John Mauldin

Today’s Outside the Box is from my good friend George Friedman of Geopolitical Futures. George, who founded the well known Stratfor, is one of the world’s top geopolitical forecasters. I’m very excited to welcome him as a Contributing Editor for Mauldin Economics.

Starting today and every Monday, we’ll publish a regular feature from George called This Week in Geopolitics. In this weekly letter written for Mauldin Economics, George will highlight the top international events that investors and those with an interest in geopolitics should monitor. I am amazed by how quickly George slices through the media’s superficial stories to reveal what is really important.

What you read in This Week in Geopolitics will be a small sample of the research George and his team publish. His Geopolitical Futures premium service is off to a great start and I highly recommend you try it. We have a special offer for Mauldin Economics readers. Click here for details.

As a reminder, I interviewed George in last week’s Thoughts from the Frontline. He had some fascinating thoughts on the connection between politics and economics, the European refugee crisis, China’s economic future and more. Click here to read it.

Today he examines the origins of ISIS and looks at why they see their behavior as rational. It is a disturbing viewpoint, and not one that will make us comfortable, but we do need to understand this. And it highlights the almost no-win position that the United States and the rest of the world (specifically the Middle East) is in.
In order to make sure this gets out Monday evening, I need to go ahead and hit the send button without further comment so…. with that, let’s go straight to George’s first weekly contribution.

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Origins and Strategy of the Islamic State

By George Friedman for Mauldin Economics
Al-Qaida struck the United States on September 11, 2001 in order to pave the way for the caliphate, a multinational Islamic state governed by a caliph. From Osama Bin Laden’s point of view, the Christian world—as he thought of Euro-American civilization—had made a shambles of the Muslim world. Most Muslim lands had been occupied or controlled by Christians. After World War I the British and French, in particular, had reshaped these lands to suit them. They invented new countries that had never existed before like Jordan, Lebanon, and (in their minds) Israel and installed rulers on others, such as the Saudis in the Arabian Peninsula.

After World War II, the United States inherited a world the British had largely created. Where the British were the architects of this world, the Americans became its maintenance men. Since the Americans were caught up in a Cold War with the Soviets, the Soviets sought to create pro-Soviets as well. A new wave of rulers arose under Soviet tutelage. These were secularists, socialists, and militarists imposing military regimes.

Men like Gamal Abdul Nasser in Egypt, Saddam Hussein in Iraq, and Hafez al-Assad in Syria were all Soviet allies. They were despised by Islamists, as were the monarchies allied with the Americans. The secular Arab rulers were simply apostates. The monarchies, like Saudi Arabia, were corrupt hypocrites—formally Muslim but clinging to the Christians (now the Americans) for power and safety.

Al-Qaida did not yet exist, but there were those who dreamed of reclaiming the lands, expelling the apostates and hypocrites, and creating the caliphate. These men had learned the art of war under American tutelage in Pakistani camps after being recruited by the Saudis. They believed they had destroyed the Soviets and, as a result, destroyed the Soviet Union. True or not, this is what they believed.

When the Soviet Union fell, Iraq invaded Kuwait and the Saudis asked the American Christians to save them. Men who had fought in Afghanistan held the Saudis in contempt and were enraged by the Americans. To a great extent, the Americans were unaware of the response. The men they had trained for war in Afghanistan now saw the Americans as an obstacle to the caliphate.

This is the soil that gave rise to al-Qaida. Al-Qaida’s primary goal was to overthrow one of the secular or hypocritical regimes, create a Sharia-based caliphate, and use it as a base for creating a broader, transnational entity. Al-Qaida actually means “the base” in Arabic. It had excellent relations in Afghanistan, given the role it played there, but Afghanistan was too backward and geographically isolated to be the caliphate’s capital. It instead became the base where al-Qaida would begin the war.

In al-Qaida’s analysis, the weak and corrupt Islamic regimes could be overthrown, but the Muslim masses were inert, beaten into submission by Europeans and Americans, and convinced of American invincibility. They had no love for the Americans outside of some of the regimes, but saw their cause to be hopeless.

Al-Qaida needed to convince the masses that America was both vulnerable and hostile to Islam. It sought to strike the United States in a way that the Muslim world would take startled note, and that would compel America to go to war in the Muslim world. Al-Qaida’s experience in Afghanistan convinced it that the United States, caught in a war of attrition regardless of casualties, would eventually withdraw. The September 2001 attacks were meant to draw the Americans into combat but, even more, to convince the Muslim world that Muslims could strike at the heart of America, and then, when the Americans invaded, encourage Muslims to rise up in a long war America couldn’t win.

Part of the strategy worked, part of it didn’t. The attacks did galvanize the Muslim world. The United States showed itself to be Islam’s enemy by invading Afghanistan and later Iraq. The Muslim world saw that Muslims could fight Americans and not suffer defeat like the Jews had defeated the apostate Nasser’s army in 1967.

What did not happen was the essential step. While war raged in Afghanistan and Iraq, there was no uprising elsewhere in the Islamic world. When there were uprisings, as during the Arab Spring, they were put down (Egypt) or left in unending civil war (Syria and Libya). There was no foundation created for the caliphate, and over time American intelligence whittled down al-Qaida.

Others stepped into the vacuum as al-Qaida declined. Their opening occurred in Iraq and Syria. The Arab Spring in 2011 created an uprising against Bashar al-Assad, son of Hafez. Like much of the Arab Spring, the public faces of the protests were secular liberals, but they were unable to overthrow Assad. The resulting chaos and stalemate opened one door to al-Qaida’s heir.

At the same time, the U.S. decision to withdraw from Iraq, first made by George W. Bush and accelerated by Barack Obama, allowed a Shiite government to take power there. This forced their enemies, the Sunnis, back against the wall. Al-Qaida was Sunni and regarded Shiite Iran as an enemy. The rise of a Shiite government in Baghdad left the Iraqi Sunnis nowhere to go. It was out of this that the Islamic State arose. Syria and especially Iraq were its recruiting office and its battle ground.

Al-Qaida wanted an uprising in an existing country, but IS had a different strategy. Rather than overthrowing an existing government, it decided to create the state in a region that paid no attention to existing borders. Its goal, unlike al-Qaida’s, was to hold territory in which the caliph could rule and from which it could expand and guide the caliphate’s extension into noncontiguous Muslim lands.

The IS goal, therefore, was not to strike at the Americans as al-Qaida did. The 9/11 strikes had done their work. Their job was to create an area ruled under Sharia law with a governmental structure, financial system, welfare system, and the other things a state needs. In addition, and before this, IS had to create a military force that could take and seize land against the weak opposition it would face in Iraq and Syria.

The first step in the Islamic State’s strategy, therefore, was to put the caliphate before everything by taking control of substantial and contiguous territory. IS did this by carrying out a series of extremely competent military operations, seizing Mosul and Ramadi in Iraq as well as Palmyra in Syria. The result was a new state, no less artificial than those countries the British and French created after World War I, and governed from the capital in Raqqa.

In carrying out this operation, IS deliberately created a series of highly publicized atrocities. There were two reasons for this. The first was to intimidate the new Islamic State’s population. This region consisted of a wide variety of groups, many potentially hostile to the new state. The ruthless acts served to make clear to the population that IS was not merely claiming control of the region, but was in sufficient control that it was indifferent to what the outside world thought.

Having fought the Americans, IS knew that apart from special operations teams (the principle threat to IS in both Afghanistan and Iraq) which could not by themselves threaten the existence of IS, the United States took months to deploy forces. IS needed to show not only how ruthless it was, but that it would not be challenged as a result.

The second reason for creating this core was to lure the Americans into attacking it. The United States had grown wary of occupation warfare that required deploying a military force against scattered and persistent guerilla operations.

The Islamic State presented, and was, precisely the type of force the United States should be comfortable attacking. First, it occupied a clearly defined territory. Second, it contained a conventional military force. IS was not a guerilla organization or terrorist group, although it had elements capable of both kinds of operations.

The size of IS’ main military force (a force large enough to seize, occupy, and defend an area as large as some countries in the region) meant it could not be a guerrilla force. It appeared to be a mobile infantry force, moving by foot and truck, armed with infantry weapons as well as some small artillery and anti-tank weapons.

The exact size of IS forces remains a mystery, and that is a testament to its skills at camouflaging its activities from the ground to the electromagnetic sphere. Estimates of the size of its armed and trained force range from 20,000 to 200,000. Based on the extent of its frontiers and the casualties it seems to have taken, I estimate the force at about 100,000.

This, of course, leaves another mystery: where this force was trained—since training even 20,000 is a conspicuous activity. Units must train together to be effective. There are many mysteries about IS for which there is no consensus save educated guesses. We know the extent of its power. We know when this frontier is attacked, the attacker tends to encounter resistance. Beyond that, IS has protected its capabilities professionally.

Given all this, it would appear to be ripe for attack by American forces, which excel at this kind of warfare. That is precisely what IS wants. There has been much talk about IS believing that an apocalyptic battle must take place in order to establish the caliphate. This is a metaphysical concept on which I have no opinion.

However, from a political and military point of view, the caliphate must be founded on a decisive battle that forces capitulation from its main enemy. This would convince the US to respect the caliphate and the caliphate’s citizens to respect the power of the state. By this I don’t mean the guerrilla wars in which the conventional force simply withdraws; I mean a battle in which the enemy is defeated in detail.

The Americans prefer conventional attacks with tanks and infantry fighting vehicles. IS engaged and destroyed a Syrian armored brigade with anti-tank weapons. The United States uses air strikes and helicopters. IS may have man-portable surface-to-air missiles (and should have them from whatever source it secured the anti-tank missiles).

IS has a major advantage in one thing: the US is casualty averse. The US has a force operating at a distance for reasons that impact national security but don’t pose a direct threat to the homeland. Therefore, the American appetite for more serious military intervention is extremely limited. IS needs a decisive battle at any cost. Weapons aside, the outcome of this battle matters far more to IS than to the United States, and therefore IS’ threshold for pain is far higher.

The caliphate, having been established, must now be defended. It must be a territory and not a hideout, it must be coherent and not scattered tracts, and it must be defensible regardless of the cost. Having established its frontiers, the Islamic State intends to use minimal force to defend against minor attacks, as the Syrian Kurds carried out recently.

Most impressive about IS is its ability to retreat, regroup, and strike elsewhere. That is the measure of a military force. For example, the Americans proved themselves at the Battle of the Bulge when having been sent reeling, they regrouped, reinforced and struck back. It is in defeat that I judge a military force, and IS has handled defeat well. But we should also remember that IS will not waste force on marginal threats.

For IS, the main threat will come from the Americans and therefore it must preserve the ability to fight U.S. forces. Some point out that IS has been under pressure from all sides. This is because its leaders understand the maxim that he who defends everything defends nothing.

But the Americans have not come. Nor have other enemies like the Iranians or Israelis. Nor for that matter have the Turks. No one wishes to engage IS while it is on the defensive and at its best. There are many reasons, but the heart of the matter is that the battle, if lost, would be devastating for Americans, and if won by them opens the door to occupation warfare, as did the defeat of the Iraqi army in 2003.

IS must hold to save the caliphate now or, if it loses this battle, wait and fight another. And if the Americans don’t come and IS holds its territory, then IS can choose the time and place for its next strategic offensive.

Assuming that IS has 100,000 troops, the US must bring a force of 300,000 to bear under the old (and perhaps obsolete) rule of 3 to 1 on the offensive. It took six months to prepare for Desert Storm and longer for Iraqi Freedom with far fewer troops than 300,000. The terrain is desert, and supply lines will run from ports that have to be secured, along with roads that could be filled with IEDs. For the Americans, the logistics would be as tough as the battle.

Logically, the best course for the United States is not to engage. IS is beginning to realize this and seemingly prefers to force a battle. That is why we are beginning to see terrorist actions flaring in Western countries. The lesson al-Qaida taught IS is that the Americans have a threshold and that if you cross it, they will react dramatically.

Therefore, it appears to me that IS is searching for that threshold and probing to see responses. Attacks like the ones in Paris last month were not in response to French involvement in the region. These attacks are unconnected to that, but are designed to be as terrifying as possible—both in their suddenness and brutality—and compel a response.

It is odd to argue that someone wants to be attacked by the US. But IS needs the attack and also believes it can at least survive and likely defeat the Americans. It is clear that other countries in the region are steering clear of IS, and it is clear that President Obama is doing everything he can not to engage IS on the ground.

And it is clear that IS is doing what it can to drag the Americans deeper into the conflict. If the Americans don’t come, and no one else comes, the psychological demonstration might not take place - but the caliphate will exist. On the whole, IS has the strategic advantage in multiple ways. It behaves in its territory as if it intends to stay a long time.

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The article Outside the Box: Origins and Strategy of the Islamic State was originally published at mauldineconomics.com.

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Someone Is Spending Your Pension Money

By John Mauldin 

“Retirement is like a long vacation in Las Vegas. The goal is to enjoy it to the fullest, but not so fully that you run out of money.”– Jonathan Clements

“In retirement, only money and symptoms are consequential.”– Mason Cooley

Retirement is every worker’s dream, even if your dream would have you keep doing the work you love. You still want the financial freedom that lets you work for love instead of money. This is a relatively new dream. The notion of spending the last years of your life in relative relaxation came about only in the last century or two. Before then, the overwhelming number of people had little choice but to work as long as they physically could. Then they died, usually in short order. That’s still how it is in many places in the world.

Retirement is a new phenomenon because it is expensive. Our various labor-saving machines make it possible at least to aspire to having a long, happy retirement. Plenty of us still won’t reach the goal. The data on those who have actually saved enough to maintain their lifestyle without having to work is truly depressing reading. Living on Social Security and possibly income from a reverse mortgage is limited living at best.

In this issue, I’ll build on what we said in the last two weeks on affordable healthcare and potentially longer lifespans. Retirement is not nearly as attractive if all we can look forward to is years of sickness and penury. We are going to talk about the slow motion train wreck now taking shape in pension funds that is going to put pressure on many people who think they have retirement covered.

Please feel free to forward this to those who might be expecting their pension funds to cover them for the next 30 or 40 years. Cutting to the chase, US pension funds are seriously underfunded and may need an extra $10 trillion in 20 years. This is a somewhat controversial letter, but I like to think I’m being realistic. Or at least I’m trying.

The Transformation Project
But first, let me update you on the progress on my next book, Investing in an Age of Transformation, which will explore the changes ahead in our society over the next 20 years, along with their implications for investing. Our immediate future promises far more than just a lot of fast paced, fun technological change.

There are many almost inevitable demographic, geopolitical, educational, sociological, and political changes ahead, not to mention the rapidly evolving future of work that are going to significantly impact markets and our lives. I hope to be able to look at as much of what will be happening as possible. I believe that the fundamentals of investing are going to morph over the next 10 to 15 to 20 years.

I mentioned a few weeks ago at the end of one of my letters that I was looking for a few potential interns and/or volunteer research assistants to help me with the book. I was expecting 8 to 10 responses and got well over 100. Well over. I asked people to send me resumes, and I was really pleased with the quality of the potential assistance. I realize that there is an opportunity to do so much more than simply write another book about the future.

What I have done is write a longer outline for the book, detailing about 25 separate chapters. I’d like to put together small teams for each of these chapters that will not only do in-depth research on their particular areas but will also make their work available to be posted upon publication of the book. We’re going to create separate Transformation Indexes for many of the chapters, which will certainly be a valuable resource and a challenge for investors. And now let’s look at what pension funds are going to look like over the next 20 years.

Midwestern Train Wreck
Four months ago we discussed the ongoing public pension train wreck in Illinois (see Live and Let Die). I was not optimistic that the situation would improve, and indeed it has not. The governor and legislature are still deadlocked over the state’s spending priorities. Illinois still has no budget for the fiscal year that began on July 1. Fitch Ratings downgraded the state’s credit rating last week. It’s a mess.

Because of the deadlock, Illinois is facing a serious cash flow crisis. Feeling like you’ve hit the jackpot through the Illinois lottery? Think again. State officials announced Wednesday that winners who are due to receive more than $600 won’t get their money until the state’s ongoing budget impasse is resolved. Players who win up to $600 can still collect their winnings at local retailers. More than $288 million is waiting to be paid out. For now the winners just have an IOU and no interest on their money (Fox).

As messy as the Illinois situation is, none of us should gloat. Many of our own states and cities are not in much better shape. In fact, the political gridlock actually forced Illinois into accomplishing something other states should try. Illinois has not issued any new bond debt since May 2014. Can many other states say that?

Unfortunately, that may be the best we can say about Illinois. The state delayed a $560 million payment to its pension funds for November and may have to delay or reduce another contribution due in December.

Illinois and many other states and local governments are in this mess because their politicians made impossible to keep promises to public workers. The factors that made them so impossible apply to everyone else, too. More people are retiring. Investment returns aren’t meeting expectations. Healthcare costs are rising. Other government spending is out of control.

Nonetheless, the pension problem is the thorniest one. State and local governments spent years waving generous retirement benefits in front of workers. The workers quite naturally accepted the offers. I doubt many stopped to wonder if their state or city could keep its end of the deal. Of course, it could. It’s the government.

Although state governments have many powers, creating money from thin air is, alas, not one of them. You have to be in Washington to do that. Now that the bills are coming due, the state’s’ inability to keep their word is becoming obvious. Now, I’m sure that many talented people spent years doing good work for Illinois. That’s not the issue here. The fault lies with politicians who generously promised money they didn’t have and presumed it would magically appear later.

On the other hand, retired public workers need to realize they can’t squeeze blood from a turnip. Yes, the courts are saying Illinois must keep its pension promises. But the courts can’t create money where none exists. At best, they can force the state to change its priorities. If pension benefits are sacrosanct, the money won’t be available for other public services. Taxes will have to go up or other essential services will not be performed. This is certainly not good for the citizens of Illinois. As things get worse, people will begin to move.

What happens then? Citizens will grow tired of substandard services and high taxes. They can avoid both by moving out of the state. The exodus may be starting. Crain’s Chicago Business reports: High end house  hunters in Burr Ridge have 100 reasons to be happy. But for sellers, that’s a depressing number. The southwest suburb has 100 homes on the market for at least $1 million, more than seven times the number of homes in that price range – 14 – that have sold in Burr Ridge in the past six months.

The town has the biggest glut by far of $1 million-plus homes in the Chicago suburbs, according to a Crain’s analysis. “It's been disquietingly slow, brutally slow, getting these sold,” said Linda Feinstein, the broker-owner of ReMax Signature Homes in neighboring Hinsdale. “It feels like the brakes have been on for months.”

We don’t know why these people want to sell their homes, of course, but they may be the smart ones.

They’re getting ahead of the crowd – or trying to. Think Detroit. I have visited there a few times over the last year, and the suburbs are really quite pleasant (except in the dead of winter, when I’d definitely rather be in Texas). But those who moved out of the city of Detroit and into the suburbs many decades ago had a choice, because Michigan’s finances weren’t massively out of whack. I’ve been to Hinsdale. It’s a charming community and quite upscale. It is an easy train commute to downtown Chicago.

Look at it this way: with what you know about Illinois public finances, would you really want to move into the state and buy an expensive home right now? I sure wouldn’t. That sharply reduces the number of potential homebuyers. The result will be lower home prices. I’m not predicting Illinois will end up like Detroit…...but I don’t rule it out, either. Further, more and more cities and counties around the country are going to be looking like Chicago. Wherever you buy a home, you really should investigate the financial soundness of the state and the city or town.

Pension Math Review
Political folly is not the only problem. Illinois and everyone else saving for retirement – including you and me – make some giant assumptions. Between ZIRP and assorted other economic distortions, it is harder than ever to count on a reasonable real return over a long period. Small changes make a big difference. Pension managers used to think they could average 8% after inflation over two decades or more. At that rate, a million dollars invested today turns into $4.7 million in 20 years. If $4.7 million is exactly the amount you need to fund that year’s obligations, you’re in good shape.

What happens if you average only 7% over that 20 year period? You’ll have $3.9 million. That is only 83% of the amount you counted on. At 6% returns you will be only 68% funded. At 5%, you have only 57% of what you need. At 4%, you will be only 47% of the way there.

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: Someone Is Spending Your Pension Money was originally published at mauldineconomics.com.

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Riding the Energy Wave to the Future

By John Mauldin 

“Formula for success: rise early, work hard, strike oil.” –  J. Paul Getty

This week’s yuan devaluation was big news, but it’s really part of a much bigger saga. Events around the globe are combining to create huge economic change over the next few years. We are watching giant, multidimensional chess games played by some master players. Energy is the chessboard that connects all the players. What happens when the board changes shape in the middle of the game? If you don’t know the new energy landscape, you’ll have a hard time playing to a draw, much less winning.

Today I’ll tell you about some big shifts in the energy industry. These shifts are about as positive as can be, unless you need high oil prices to run your country. In the long run, these changes are bullish for the whole world, which I think this will surprise many of you. And though we’ve been used to thinking about energy and technology as two different facets of modern life, today they are inextricably linked.
When energy changes, everything else changes, too.

16 Candles

Thoughts from the Frontline is now entering its 16^th year of continuous weekly publication. I constantly meet readers who have been with me since the beginning – and even some who read an earlier print version of my letters. I put TFTF on the Internet in August 2000 as a free letter, starting with just a few thousand names, and was amazed at how rapidly it grew. It took just a few years for me to realize that this new thing called the Internet was the real deal, and I discontinued my print version. We now push the letter out to almost one million readers each week, and the letter is posted on dozens of websites.

I began to archive the letter in January 2001; and every issue – the good, the bad, and the sometimes very ugly – is still there in the archives, just as I wrote it. I will admit there are a few paragraphs, and maybe even a whole letter or two, that I would like to go back and expunge from the record. But I think it’s better just to let it all be what it is.

Investing in energy without the risk....Here's what our trading partner John Carter is doing.

I thank you for allowing me to come into your homes and offices each week. I consider it a privilege and honor to be able to offer you my research and thoughts. This letter has been free from the beginning, and my full intent is that it will always remain that way. Longtime readers know the topics can vary widely over the course of the year. I write about what I find interesting that week. I find that writing helps me focus my own thinking.

If you are reading this for the first time, you can go to www.mauldineconomics.com, subscribe by giving us your email address, and join my one million closest friends who get my letter each week. And if you’re a regular reader, why not give me a 16^th birthday present and suggest to your friends that they subscribe too! I also want to thank the staff and my partners, who make it possible for me to spend the bulk of my time thinking and writing. And traveling, of course. And now let’s think about energy.

The Cover Pic Indicator

Contrarian and value investors like to buy assets that are in distress, or at least “out of favor.” You don’t hear much about those assets at the time. That’s part of being distressed – everyone ignores you. So, following that logic, the last thing you want to buy is a stock or industry that appears on the cover page of popular financial publications. Commodity and energy bulls should take note of last weekend’s Barron’s cover.

“COMMODITIES: TIME TO BUY,” Barron’s practically screamed at its readers. In case you can’t read the fine print on the cover, it says, The harsh selloff in energy, gold, and other commodities is starting to look like capitulation. Opportunities in Exxon, Chevron, BHP, Goldcorp. Plus six funds and six ETFs to help build a position in this oversold sector.

I presume the photo is supposed to show the sun rising on an oil rig, not setting. The article quotes some very smart people who are bullish on commodities right now. Some energy stocks look like real bargains. Barron’s is simply repeating the market’s conventional wisdom: After a brutal decline, oil prices are stabilizing and should head higher as the global economy recovers.

That’s a perfectly defensible position – but I think it’s wrong.

It’s wrong because it misses a major shift in the way we produce energy. Many people think OPEC’s high oil and gas prices led to the US shale energy boom. That’s not right. The shale boom was born in a time of lower energy prices, and it was the result of new technologies that make recovering large quantities of oil and gas less expensive than ever.

I used to get the occasional letter from James Howard Kunstler, who would tell me that whatever letter I had just written was completely bass-ackwards, and how his books explained that we were going to run out of energy and then collapse. His books (Wikipedia lists about a dozen) and dozens of others warned us of Peak Oil. (For the record, James, a certain longtime editor on my staff made sure I got all your letters, reports, and more, as he is firmly in your camp! I kept smiling and saying that he was (and is) wrong; but Charley is a phenomenal editor, and you put up with a few quirks for brilliant editing that makes you look better. Besides, if the world does come to an end, I can wend my way to his survivalist farm and beg for a job and food, although I’m not exactly sure I’m ready to milk goats. Just for old time’s sake.)

I have written for years that Peak Oil is nonsense. Longtime readers know that I’m a believer in ever-accelerating technological transformation, but I have to admit I did not see the exponential transformation of the drilling business as it is currently unfolding. The changes are truly breathtaking and have gone largely unnoticed.

By now, you probably know about fracking, the technology where drillers pump liquids into a well to “fracture” the ground and release oil and gas deposits. It’s controversial in certain quarters, especially among those who hate anything carbon-related.

Fracking technology is moving forward like all other technologies: very fast. Newer techniques promise to reduce the side effects, at even lower operating costs. Furthermore, fracking is only the beginning of this revolution. The Manhattan Institute recently published an excellent (bordering on brilliant) report by Mark P. Mills, Shale 2.0: Technology and the Coming Big Data Revolution in America’s Shale Oil Fields. I highly recommend it.

Mills outlines the way the new technologies are turning this industry on its head. Shale production or “unconventional” production is really a completely new industry.

Here is a short quote: The price and availability of oil (and natural gas) are determined by three interlocking variables: politics, money, and technology. Hydrocarbons have existed in enormous quantities for millennia across the planet. Governments control land access and business freedoms. Access to capital and the nature of fiscal policy are also critical determinants of commerce, especially for capital-intensive industries. But were it not for technology, oil and natural gas would not flow, and the associated growth that these resources fuel would not materialize.

While the conventional and so-called unconventional (i.e., shale) oil industries display clear similarities in basic mechanics and operations – drills, pipes, and pumps – most of the conventional equipment, methods, and materials were not designed or optimized for the new techniques and challenges needed in shale production. By innovatively applying old and new technologies, shale operators propelled a stunningly fast gain in the productivity of shale rigs (Figure 4), with costs per rig stable or declining.

[Look at the above chart for a few moments; it’s truly staggering. In just seven years, the amount of oil per well in some shale plays has risen by a factor of 10! That is almost all due to new technologies that are increasingly coming online.]

Shale companies now produce more oil with two rigs than they did just a few years ago with three rigs, sometimes even spending less overall. At $55 per barrel, at least one of the big players in the Texas Eagle Ford shale reports a 70 percent financial rate of return. If world prices rise slightly, to $65 per barrel, some of the more efficient shale oil operators today would enjoy a higher rate of return than when oil stood at $95 per barrel in 2012.

Read that last paragraph again. Some shale operators can make good money at $55 a barrel. At $65, they can make higher returns than they did three years ago with oil at $95. I have friends here in Dallas who are raising money for wells that can do better than break even at $40 per barrel, although they think $60 is where the new normal will settle out. Texans are nothing if not optimistic.

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: Riding the Energy Wave to the Future 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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Cleaning Out the Attic

By John Mauldin

Three weeks ago I co-authored an op-ed for the Investor’s Business Daily with Stephen Moore, founder of the Club for Growth and former Wall Street Journal editorial board member, currently working with the Heritage Foundation. Our goal was to present a simple outline of the policies we need to pursue as a country in order to get us back to 3–4% annual GDP growth. As we note in the op-ed, Stephen and I have been engaging with a number of presidential candidates and with other economists around the topic of growth.

We spent a great deal of time going back and forth on a variety of topics, trying to get down to a few ideas that we think make the most sense. I should note that few people will read the piece below without being upset by at least one of our suggestions. The goal was to not just list the standard Republican “fixes” but to actually come up with a plan that might garner support across the political spectrum on ways to address the critical problem of how to get the country back to acceptable growth.

Part of the challenge was reducing what could have been a book to just 800 words. Today’s letter will start with the actual op-ed, and then I will expand on some of the points. Readers and friends have been pressing me to offer some ideas as to what policies I think we should pursue, so here they are. I hope the op-ed will create some thoughtful response. It would be nice if we could get a few candidates to embrace some or all of what we are suggesting, even (or maybe especially) some of the more radical parts.
(I have made a few very minor edits to the op-ed.)

A Six Point Plan to Restore Economic Growth and Prosperity

By John Mauldin and Stephen Moore

The dismal news of 0.2% GDP growth for the first quarter only confirmed that the US is in the midst of its slowest recovery in half a century from an economic crisis. Could it be that at least some of the rage we've seen in the streets of Baltimore is a result of a paltry recovery that hasn't benefited low-income inner-city areas? We are at least $1.5 trillion a year behind where we would be with even an average post-World War II recovery.

While many blame a lack of sufficient demand and even insufficient government spending, our view is that the primary factors behind the growth slowdown are an increasingly intrusive regulatory environment, a confusing and punitive tax scheme, and lack of certainty over healthcare costs.

Each of these factors has contributed to a climate where growth is slow and incomes are stagnant. These are problems that cannot be solved by monetary and fiscal policy alone. To get real growth and increased productivity, we need to deal with the real source of economic progress: the incentive structure. The coming presidential race offers an opportunity for candidates to put forth concrete and comprehensive ideas about what can be done to create higher economic growth – as opposed to platitudes and piecemeal ideas that don't address the entire problem. The two of us have met with several candidates and discussed tax reform and other economic growth issues.

We offer here some solutions of our own for them to consider.

1. Streamline the federal bureaucracy. 

Government has become much like the neighbor who has hoarded every magazine and odd knick knack for 50 years. The attic and every room are stuffed with items no one would miss. The size of the US code has multiplied by over 18 times in 65 years. There are more than 1 million restrictive regulations. Enough already. It's time to clean out the attic. The president, with some flexibility, should require each agency to reduce the number of regulations under its purview by 20%, at the rate of 5% a year. And then Congress should pass a sunset law for the remaining regulations, requiring them to be reviewed at some point in order to be maintained. Further, if new rules are needed, then remove some old ones. Stop the growth of the federal regulatory code. We have enough rules today; let's just make sure they're the right ones.

2. Simplify and flatten the income tax. 

Make the individual income rate 20% (at most) for all income over $50,000, with no deductions for anything. Reduce the corporate tax to 15%, again eliminating all deductions other than what is allowed by standard accounting practice. No perks, no special benefits. Further, tax foreign corporate income at 5%–10%, and let companies bring it back home to invest here. This strategy will actually increase tax revenues.

3. Replace the payroll tax with a business transfer tax of 15% 

which will give lower income workers a big raise. Companies would pay tax on their gross receipts, minus allowable expenses in the conduct of producing goods and services. Nearly every economist agrees that consumption taxes are better than income taxes. Further, this tax can be rebated at the border, so it should encourage domestic production and be popular with union workers since it makes US products more competitive internationally.

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: Cleaning Out the Attic was originally published at mauldineconomics.com.

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How Global Interest Rates Deceive Markets

By John Mauldin

 “You keep on using that word. I do not think it means what you think it means.”

– Inigo Montoya, The Princess Bride

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

“Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

– From an 1850 essay by Frédéric Bastiat, “That Which Is Seen and That Which Is Unseen”

All right class, it’s time for an open book test. I’m going to give you a list of yields on various 10 year bonds, and I want to you to tell me what it means.

United States: 1.80%

Germany: 0.36%

France: 0.54%

Italy: 1.56%

UK: 1.48%

Canada: 1.365%

Australia: 2.63%

Japan: 0.22%

I see that hand up in the back. Yes, the list does appear to tell us what interest rates the market is willing to take in order to hold money in a particular country’s currency for 10 years. It may or may not tell us about the creditworthiness of the country, but it does tell us something about the expectations that investors have about potential returns on other possible investments. The more astute among you will notice that French bonds have dropped from 2.38% exactly one year ago to today’s rather astonishing low of 0.54%.

Likewise, Germany has seen its 10-year Bund rates drop from 1.66% to a shockingly low 0.36%. What does it mean that European interest rates simply fell out of bed this week? Has the opportunity set in Europe diminished? Are the French really that much better a credit risk than the United States is? If not, what is that number, 0.54%, telling us? What in the wide, wide world of fixed-income investing is going on?

Quick segue – but hopefully a little fun. One of the pleasures of having children is that you get to watch the classic movie The Princess Bride over and over. (If you haven’t appreciated it, go borrow a few kids for the weekend and watch it.) There is a classic line in the movie that is indelibly imprinted on my mind.
In the middle of the film, a villainous but supposedly genius Sicilian named Vizzini keeps using the word “inconceivable” to describe certain events. A mysterious ship is following the group at sea? “Inconceivable!”

The ship’s captain starts climbing the bad guys’ rope up the Cliffs of Insanity and even starts to gain on them? “Inconceivable!” The villain doesn’t fall from said cliff after Vizzini cuts the rope that all of them were climbing? “Inconceivable!” Finally, master swordsman – and my favorite character in the movie – Inigo, famous for this and other awesome catchphrases, comments on Vizzini’s use of this word inconceivable:

“You keep on using that word. I do not think it means what you think it means.”

(You can see all the uses of Vizzini’s use of the word inconceivable and hear Inigo’s classic retort here.)
When it comes to interpreting what current interest rates are telling us about the markets in various countries, I have to say that I do not think they mean what the market seems to think they mean. In fact, buried in that list of bond yields is “false information” – information so distorted and yet so readily misunderstood that it leads to wrong conclusions and decisions – and to bad investments. In today’s letter we are going to look at what interest rates actually mean in the modern-day context of currency wars and interest-rate manipulation by central banks. I think you will come to agree with me that an interest rate may not mean what the market thinks it means.

Let me begin by briefly summarizing what I want to demonstrate in this letter. First, I think Japanese interest rates not only contain no information but also that markets are misreading this non-information as meaningful because they are interpreting the data as if it were normal market information in a familiar market environment, when the truth is that we sailed beyond the boundaries of the known economic world some time ago. The old maps are no longer reliable. Secondly, Europe is making the decision to go down the same path as the Japanese have done; and contrary to the expectations of European central bankers, the potential to end up with the same results as Japan is rather high.

The false information paradox is highlighted by the recent Swiss National Bank decision. Couple that with the surprise decisions by Canada and Denmark to cut rates, the complete retracement of the euro against the yen over the past few weeks, and Bank of Japan Governor Kuroda’s telling the World Economic Forum in Davos that he is prepared to do more (shades of “whatever it takes”) to create inflation, and you have the opening salvos of the next skirmish in the ongoing currency wars I predicted a few years ago in Code Red. All of this means that capital is going to be misallocated and that the current efforts to create jobs and growth and inflation are insufficient. Indeed, I think those efforts might very well produce a net negative effect.

But before we go any farther, a quick note. We will start taking registrations for the 12^th annual Strategic Investment Conference next week. There will be an early bird rate for those of you who go ahead to register quickly. The conference will run from April 29 through May 2 at the Manchester Grand Hyatt in San Diego.

For those of you familiar with the conference, there will be the “usual” lineup of brilliant speakers and thought leaders trying to help us understand investing in a world of divergence. For those not familiar, this conference is unlike the vast majority of other investment conferences, in that speakers representing various sponsors do not pay to address the audience. Instead, we bring in only “A list” speakers from around the world, people you really want to meet and talk with. This year we’re going to have a particularly large and diverse group of presenters, and we structure the conference so that attendees can mingle with the speakers and with each other.

I am often told by attendees that this is the best economic and investment conference they attend in any given year. I think it is a measure of the quality of the conference that many of the speakers seek us out. Not only do they want to speak, they want to attend the conference to hear and interact with the other speakers and conference guests. This conference is full of speakers that other speakers (especially including myself) want to hear. And you will, too. Save the date and look for registration and other information shortly in your mail.
Now let’s consider what today’s interest rates do and do not mean as we navigate uncharted waters.

Are We All Turning Japanese?

Japan is an interesting case study. It’s a highly developed nation with a very sophisticated culture, increasingly productive in dollar terms (although in yen terms nominal GDP has not moved all that much), and carrying an unbelievable 250% debt to GDP burden, but with a 10 year bond rate of 0.22%, which in theory could eventually mean that the total interest expenses of Japan would be less than those of the US on 5 - 6 times the amount of debt. Japan has an aging population and a savings rate that has plunged in recent years.

The country has been saddled with either low inflation or deflation for most of the past 25 years. At the same time, it is an export power, with some of the world’s most competitive companies in automobiles, electronics, robotics, automation, machine tools, etc. The Japanese have a large national balance sheet from decades of running trade surpluses. If nothing else, they have given the world sushi, for which I will always hold them in high regard.

We talk about Japan’s “lost decades” during which growth has been muted at best. They are just coming out of a triple dip recession after a disastrous downturn during the Great Recession. And through it all, for decades, there is been a widening government deficit. The chart below shows the yawning gap between Japanese government expenditures and revenues.



This next chart, from a Societe Generale report, seems to show that the Japanese are financing 40% of their budget. I say “seems” because there is a quirk in the way the Japanese do their fiscal accounting. Pay attention, class. This is important to understand. If you do not grasp this, you will not understand Japanese budgets and how they deal with their debt.

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: How Global Interest Rates Deceive Markets was originally published at mauldineconomics.com

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Is this the "Sea Change" some have warned us about?

By John Mauldin

Did you feel the economic weather change this week? The shift was subtle, like fall tippy toeing in after a pleasant summer to surprise us, but I think we’ll look back and say this was the moment when that last grain of sand fell onto the sand pile, triggering many profound fingers of instability in a pile that has long been close to collapse. This is the grain of sand that sets off those long chains of volatility that have been gathering for the last five years, waiting to surprise us with the suddenness and violence of the avalanche they unleash.

I suppose the analogy sprang to mind as I stepped out onto my balcony this morning. Texas has been experiencing one of the most pleasant summers and incredibly wonderful falls in my memory. One of the conversations that seem to occur regularly among locals who have a few decades under their belts here, is just how truly remarkable the weather has been. So it was a bit of a surprise to step out and realize the air had turned brisk. In retrospect it shouldn’t have fazed me. The air has been turning brisk in Texas at some point in October for the six decades that my memory covers, and for quite a few additional millennia, I suspect.

But this week, as I worked through my ever-growing mountain of reading, I felt a similar awareness of a change in the economic climate. Like fall, I knew it was coming. In fact, I’ve been writing about it for years! But just as fall tells us that it’s time to get ready for winter, at least in more northerly climes, the portents of the moment suggest to me that it’s time to make sure our portfolios are ready for the change in season.

Sea Change

Shakespeare coined the marvelous term sea change in his play The Tempest. Modern day pundits are liable to apply the word to the relatively minor ebb and flow of events, but Shakespeare meant sea change as a truly transformative event, a metamorphosis of the very nature and substance of a man, by the sea.
In this week’s letter we’ll talk about the imminent arrival of a true financial sea change, the harbinger of which was some minor commentary this week about the economic climate. This letter is arriving to you a little later this week, as I had quite some difficulty writing it, because, while the signal event is rather easy to discuss, the follow on consequences are myriad and require more in-depth analysis than I’ve been able to bring to them on short notice. As I wrestled with what to write, I finally came to realize that this sea change is going to take multiple letters to properly describe. In fact, it might eventually take a book.

So, in a departure from my normal writing style, I am going to offer you a chapter by chapter outline for a book. As with all book outlines, it will be simply full of bones but without much meat on them, let alone dressed up with skin and clothing. I will probably even connect the bones in the wrong order and have to go back later and replace a leg bone with a rib, but that is what outlines are for. There is clearly enough content suggested by this outline to carry us through the next several months; and given the importance of the subject, I expect to explore it fully with you. Whether it actually becomes a book, I cannot yet say.

I should note that much of what follows has grown out of in depth conversations with my associate Worth Wray and our mutual friends. We’ve become convinced that the imbalances in the global economic system are such that the risks are high that another period of economic volatility like the Great Recession is not only likely but is now in the process of developing. While this time will be different in terms of its causes and symptoms (as all such stressful periods differ from each other in many ways), there will be a rhyme and a rhythm that feels all too familiar. That should actually be good news to most readers, as the last 14 years have taught us a little bit about living through periods of economic volatility. You will get to use those skills you learned the hard way.

This will not be the end of the world if you prepare properly. In fact, there will be plenty of opportunities to take advantage of the coming volatility. If the weatherman tells you winter is coming, is he a prophet of doom? Or is it reasonable counsel that maybe we should get our winter clothes out?

Three caveats before we get started. One, I am often wrong but seldom in doubt. And while I will marshal facts and graphs aplenty to reinforce my arguments, I would encourage you to think through the counter factuals presented by those who will aggressively disagree.

Two, while it goes without saying, you are responsible for your own decisions. It is easy for me to say that I think the bond market is going to go in a particular direction. I can even bet my personal portfolio on my beliefs. I can’t know your circumstances, but if you are similar to most investors, this is the time to make sure you have a truly balanced portfolio with serious risk management in the event of a sudden crisis.

Three, give me (and Worth, whom I am going to draft to write some letters) some time to develop the full range of our ideas. To follow on with my weather analogy, the air is just starting to get crisp, and winter is still a couple months away. Absent something extraordinary, we are not going to get snow and a blizzard in Dallas, Texas, tomorrow. We may still have some time to prepare, but at a minimum it is time to start your preparations. So with those caveats, let’s look at an outline for a potential book called Sea Change.

Prologue

I turned publicly bearish on gold in 1986. At the time (a former life in a galaxy far, far away), I was actually writing a newsletter on gold stocks and came to the conclusion that gold was going nowhere – and sold the letter. I was still bearish some 16 years later. Then, on March 1, 2002, I wrote in Thoughts from the Frontline that it was time to turn bullish on gold. Gold at that time was languishing around $300 an ounce, near its all time bottom.

What drove that call? I thought that the future directions of gold and the dollar were joined at the hip. A bit over a year later I laid out the case for a much weaker dollar in a letter entitled “King Dollar Meets the Guillotine,” which later became the basis for a chapter in Bull’s Eye Investing. As the chart below shows, the dollar had risen relentlessly through the early Reagan years, doubling in value against the currencies of America’s global neighbors, causing exporters to grumble about US dollar policy. Then the bottom fell out, as the dollar made new lows in 1992. From 1992 through 2002 the dollar recovered about half of its value, getting back to roughly where it was in 1967. Elsewhere about that time, I predicted that the euro, which was then at $0.88, would rise to $1.50 before falling back to parity over a very long period of time. I believe we are still on that journey.



One of the biggest drivers of economic fortunes in the global economy is the currency markets. The value of your trading currency affects every aspect of your business and investments. It is fundamental in nature. While most Americans never even see a piece of foreign currency, every time we walk into Walmart, we are subject to the ebb and flow of global currency valuations, as are Europeans and indeed every person who participates in the movement of goods and services around the globe. In fact, globalization means that currency values are more important than ever. The world is more tightly interconnected now than it has ever been, which means that events which previously had no effect upon global affairs can trigger cascades of events that affect everyone.

I believe we are in the early stages of a profound currency valuation sea change. I have lived through five major changes in the value of the dollar in the 45 years since Nixon closed the gold window. And while we are used to 40% to 50% moves in the stock market and other commodity prices happening in just a few years (or less), large movements in major trading currencies typically take many years, if not decades, to develop. I believe we are in the opening act of a multi-year US dollar bull market.

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: Sea Change was originally published at mauldin economics

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