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November 11, 2006

Honey, I Created A Bubble
by John Mauldin

We have been told for months that the next interest rate move by the Federal Reserve is dependent upon what the data tells us prior to each meeting. If the data tells us that inflation is too high and/or the economy too strong, the Fed will continue in its pause mode or maybe even hike rates. If inflation comes down and the economy begins to soften, the next interest rate moves will be down.

But that begs the questions, "How reliable is the data?" and "How does one interpret the data?" This week we start with a look at a remarkably candid speech by Richard Fisher, the president of the Dallas Federal Reserve. We then look at what the data tells us about inflation, the relationship between housing construction and GDP, and the disconnect between the bond and stock market.

Honey, I Created a Bubble

The more I learn of Richard Fisher, the more I like. He is refreshingly clear, as well as candid, in his presentations. He will tell you he is not a trained economist, but rather a Harvard MBA with a focus on decision making under conditions of uncertainty. In a speech this week to the New York Association for Business Economics, he talked about the need for more and better data to help in the decision-making process.

"I hardly need to explain," he said, "the importance of good data to any of you. We all know the consequences of data being wrong or arriving too late. Our reputations rest on the data we use. The better the data, the less our uncertainty. And the less our uncertainty, the better our ability to make sound decisions.

"... To begin with, most economic data are inherently backward looking, often to a disconcerting degree. Obviously, there is no way around this. Obtaining completely accurate forward-looking data would require extensive investment and research into that other dismal science, science fiction. Yet time-travel aside, we must strive to develop reliable real-time data collection technologies and ever more practicable models based on the limited framework of historical observations. That process is ongoing. To paraphrase singer-songwriter Robert Earl Keen, the road goes on forever and the analytical party never ends.

"This is not to suggest that simply developing more enhanced models using available data is all that is needed for us to do our job better. In a rapidly changing world where microeconomic operators, enabled by expanding economic geography and technological innovation, are constantly pushing the envelope of production and profits, one can never be confident in the insights provided by even the most sophisticated econometric models."

So far, so good. He makes a solid case in the speech for needing to incorporate more global data into the Fed models, as the global economy is influencing the US economy to an ever greater degree.

What if Texas issued its own currency and had its own central bank? Texas as a nation would not be a small player. In dollar terms, it is larger than Korea or Brazil or Mexico and 25% larger than India. But even given that, a Texas central bank could not discern proper and prudent monetary policy by just looking at Texas data. They would clearly have to take into account the data from the US and the rest of the world in order to maintain price stability and full employment.

All very reasonable and thoughtful, and an explanation why the Dallas Fed is beefing up its economic staff in search or more and better data. But that, gentle reader, is not the reason we are looking at his speech today.

What if the data we so meticulously collect is wrong? Might that not lead to mistakes in policy? Then he gives us the following paragraphs, saying out loud what everyone knows but no Fed official has uttered: the Fed lowered rates too far and held them down too long, based on faulty inflation information. (Emphasis below is mine.)

"A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent 'lower boundary.' At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

"In retrospect, the real Fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth."

Talk about an "oops" moment. I remember clearly writing in 2002 about an inflation rate that was below 1% and the danger of deflation. But now we find out that the published figures were about a half percent to low. Not seem like all that much? That is a large and critical difference in the realm of monetary policy.

(You can read the whole rather thoughtful speech at http://dallasfed.org/news/speeches/fisher/2006/fs061102.cfm)

Inflation falling below 1% in a recessionary environment, as we were in, is quite worrisome. Economists openly speculated about the problems of keeping an economy from entering a deflationary cycle. Ben Bernanke gave his famous helicopter speech assuring the markets that the Fed had the policy tools do deal with deflation. We were not going to succumb to "Japanese disease."

But as the revised data comes in years later, we find that inflation was not below 1%, but around 1.5%, right in the middle of the Fed's comfort zone of 1-2%. It was right to lower rates, as the economy was slowing, but there was no need to do so as much or for as long. Turns out that deflationary scare was based on bad data. What in effect happened was a monetary policy fighting the wrong data that encouraged speculation in all sorts of financial assets and eventually brought back inflation to levels well above 3%, too high for a central banker's comfort level.

Besides hurting those retirees dependent on interest income, it aided and abetted what became a housing bubble, as people bid up housing prices as the cost of financing plummeted. And the housing construction market responded, building more and more homes to satisfy that demand. Now, we can see they overestimated demand and built too much. But that is the way of all booms.

How much of a boom? Housing construction soon rose to over 6% of GDP, higher than at any time since the immediate post WW2 construction boom. Vancouver buddy Matt Blackman, sent me the following chart.

"Residential fixed investment (RFI) topped 6 percent of U.S. GDP in 2005, the highest level since the early 1950s. Since WWII, every time RFI has topped 5.5% of GDP and then dropped 10%, a recession has followed, according to Hugh Moore of Guerite Advisors. RFI declined 10.1% from its peak of 6.3% of GDP in Q4-2005 to 5.66% in Q3-2006 and then dropped another 17.4% in the latest quarter."

Figure 2 - Graph showing changes in residential fixed investment (RFI) to GDP since 1947 with recessions marked by cyan vertical bands. Chart by Guerite Advisors.

RFI is going to continue to shrink. Look at the chart. Drops of over 30% are common when FRI is above the 5.5% level. We are a long way from a bottom.

And a recent article on Fortune makes that very case. "In many once-hot regions, order cancellation rates are running above 40%, new home sales volume has dropped 50% and new home prices are down 10 to 25%. Bruce Karatz (CEO of national homebuilder KB Homes) says the current downturn is worse than any he has seen - even the early 1990s market that left so many big builders reeling.

"If housing starts and sales were the only casualty, the economy probably wouldn't be in such peril. Gary Gordon, an executive vice president at mortgage investment firm Annaly Capital and a former chief US equity strategist at UBS, expects construction to fall to 4% of gross domestic product from 6% today - itself not enough to push the economy (now growing at 2.6%annual rate) into recession.

"The big risk is the ripple effect." New home buyers typically buy new furniture as well. "Housing turnover is a leading indicator of furniture sales, which is why analysts keep trimming earnings estimates for home furnishing retailers."

Not to mention the problems if falling values make it more difficult for homeowners to borrow against their equity. Gordon estimates that if cash-out refinancing falls to 2001 levels, it would drain $300 billion from the economy, or roughly the same impact as another $60 increase in the price of a barrel of oil. And did I mention the increase in interest expenses for adjustable-rate mortgages?

The Complications of Fed Policy

The bubble and its aftermath are "complicating" the role of monetary policy, says Fisher. In speech after speech, Fed governors are telling us that they are concerned about inflation, and that inflation is going to have to fall into a comfort zone before they can move to lower rates. Even if the economy is moving into recession, if you can believe them, they will not lower rates until inflation is under control.

The good news on that front is that last month we finally saw the inflation data begin to recede. One month does not make a trend, but it is a start. Let's look at the data from the last month. Again we will look at the Fed's favorite measure of inflation, the PCE (Personal Consumption Expenditures) and the alternative trimmed mean PCE inflation rate, calculated by staff at the Dallas Fed, using the same data from the Bureau of Economic Analysis (BEA).

Basically, the trimmed PCE includes food and energy but factors out the volatility, giving a more balanced and full view of inflation. Pay particular attention to the 6-month inflation, as that is probably the best judge of recent inflation. What we see is that inflation did indeed drop by all measures in September, and is likely to be dropping again in October. But it is not yet below 2%, which is where it will need to be to make central bankers comfortable. Or at least that is what they are saying.

It is not just a housing slowdown pointing to a recession. Paul Kasriel of Northern Trust writes:

"The ISM survey results, year-to-year change in seasonally unadjusted initial jobless claims, the 10-year federal funds rate spread, and the average manufacturing workweek are strong leading indicators of economic activity. Each of these indicators is pointing in the same direction, at the present time, warning of weakening economic conditions. There is sufficient evidence to justify a lower federal funds rate, but the FOMC is unlikely to take action until inflation data show moderation."

And the growth in consumer spending is slowing down. Wal-Mart is slashing prices on a number of items in advance of the normal Thanksgiving sales. October sales were punk and they are projecting flat November sales, the worst performance for Wal-Mart in a decade. Upper-end stores seem to be holding up, but those are typically the last to feel the pinch.

Yield Curve Says Probable Recession

The yield curve became more inverted this week, with the negative differential between the 3-month and the 10-year at -49 basis points and a -76 basis point differential between the 10-year and the Feds fund rate. According to a Fed paper, that level of an inversion suggests there is now an over 40% probability of recession next year. This same model only predicted a 50% chance of recession in 2000, and as the paper authors acknowledge, the model probably understates risk in recent decades.

For the record, the yield curve and interest-rate data as of Friday afternoon looks like this:

The Disconnect Between Stocks and Bonds

We are watching yields on the 10-year drop back into the lower end of its recent range. The yield curve is seriously inverted. That is the bond market clearly projecting a slowing economy. Third-quarter GDP was anemic at 1.6%, with a statistical overstatement of 0.7% because of the way they calculate auto sales. There is nothing to suggest that a strong rebound is in the offing this quarter, as same-store sales are flat, auto sales are sluggish, manufacturing is almost in recession, and consumer durable goods (furniture, home appliances, etc., which are allied with the housing market) are not healthy.

Yes, the service sector, which is 70% of the economy, is strong. And that is going to be important. It is one reason I think we get another mild recession rather than the typical serious recession that normally follows a housing bust. The overall economy is not as dependent on manufacturing and housing as it has been in past cycles.

But that is not what the stock market is saying. Even though S&P projects lower real earnings in the last two quarters of next year, the stock market is acting as if double-digit growth is still in the cards.

And that brings us full circle back to the problem with data we began discussing at the top of the letter. Even if the backward-looking data is calculated correctly, it is subject to interpretation. And market players bring their biases to the table with them.

When you hear or read someone who is bullish, check to see what they do. If you make your money by running a fund that is long-only the stock market, the glass has to look half full. Otherwise, you have to tell your current and potential investors that they should take their money off the table.

Of course, if you are running a short or hedged portfolio, it is tempting to see the glass as half empty. But the problem with almost all data is that it looks backward. We take the current trends and project them out.

Thus the bond market focuses on its biggest risks and sees a slowdown (and rising value in bonds), and the stock market sees the double-digit growth in earnings and a rise in the value of stocks.

We have very few reasonably reliable forward-looking indicators. But all the ones I look at suggest a slowdown next year, perhaps as early as the first quarter. And I still think this makes it a tough environment for stocks at some point in the not too distant future. It is a frustrating and somewhat lonely position, although there are a few more of us with each passing month and more housing data.

The End of The Contract With America

A number of readers have asked me my opinion of the last elections and whether they will affect the economy. Full disclosure requires me to say I used to be on the Texas State Executive Committee for the Republican Party, so I do have a bias.

Was I surprised? No. The GOP had forgotten the reasons voters put them in power. It was a sad ending to The Contract with America, which was the reason the GOP came into power. Rather than stick to those original principles, they chose to become part of the problem. Budget deficits, sex scandals, corruption, and a frustrating war was simply too much. The voters took the party to the woodshed and gave it a good working over. And frankly it was well deserved.

For my foreign readers, despite the headlines in your papers, such a turn of events is actually quite common in American politics. Such a large swing has happened a dozen times or more in the past. And it will happen again. That is the nature of our system.

But what will this mean for the economy? Probably nothing. Gridlock is now the order of the day. Most of the new Democrats who were elected are actually more conservative than the national party, and will have to go back to conservative districts in two or six years. If they move too far to the left, they will be one-term politicians. It is going to be hard for the Democratic leadership to forge a real working majority for their national liberal agenda. You can expect immigration reform, but this time it will be the reform George Bush was working for and that was rejected by his own party. Beyond that? Not much, although there is a drum beat for a carbon tax (which the Democrats love) in exchange for making the Bush tax cuts permanent.

No social security reform. Little in health care reform. It is doubtful that taxes will be raised over a Bush veto. There are some compromises that could be had, but that would take some real leadership on both sides, and right now it looks like the Democrats want to start holding hearings and blasting their opponents. Not a good atmosphere for compromise.

Republicans should change their leadership. Perhaps they will remember what fiscal responsibility looked like. If that is the case, by simply holding down the growth in spending, the budget will start to balance. What a concept. Spend less than you make.

If we enter a recession, there is little Congress can do anyway. Stimulus in the form of tax cuts is a non-starter. Maybe a program to help those who are threatened with losing their homes, but that is a minor economic deal.

In short, little will change. There will be a lot of rhetoric, a few compromises for appearance sake here and there, but not much else. Gridlock was not all that bad for the economy during the '90s. The reality is that Congress can mess things up with bad legislation, but it takes time to get bad or good legislation through. I doubt that much will happen one way or the other in the next two years.

New Orleans and New York

I fly to the Big Easy next Wednesday. I have been to New Orleans scores of times over the years and love the city. It will be interesting to see firsthand how she fares. I love the New Orleans Conference, as it brings a lot of old friends together. If you are coming, I look forward to seeing you. I will be doing some receptions and dinners, so let me know if you are coming.

I will be going to New Orleans with my oldest daughter and business associate, Tiffani. She is a very integral part of the business, and literally runs most of our operations, leaving me more time to think and write. Besides being young, beautiful, and smart, she is just a lot of fun. I get a lot of pleasure working with her. If you are in New Orleans, make sure you get to meet her.

It looks like I (and Tiffani) will be doing a quick trip to New York after Thanksgiving to meet with partners and a few managers. Funny, my trip last month had me paying an outrageous almost $700 a night for an average hotel room. This trip I am paying $250 for a much nicer room. I was expecting to have to pay a lot more because of the holiday season. Not sure what that means. Other than hotel occupancy is down for some reason.

It is time to hit the send button and go home. I intend to relax and enjoy the weekend, and see if I can work off a few pounds, because I know what will happen in New Orleans. Laissez les bon temps rouler.

Your seeing some serious culinary adventure in his future analyst,

John Mauldin
Frontlinethoughts.com

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended by Mauldin may pay a portion of their fees to Altegris Investments who will share 1/3 of those fees with MWS and thus to Mauldin. For more information please see "How does it work" at www.accreditedinvestor.ws. This website and any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement or inducement to invest with any CTA, fund or program mentioned. Before seeking any advisors services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Please read the information under the tab "Hedge Funds: Risks" for further risks associated with hedge funds.

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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.

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