Financial

Are We There Yet?
July 30, 2010
By John Mauldin

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“… [this economic condition] has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things.”

- Friedrich August von Hayek, Nobel Speech 1974

Those of us who have taken young children on long road trips to somewhere they wanted to go are familiar with the plaintive question “Are We There Yet?” As a nation and indeed the developed world, it is not unreasonable to be asking “Are We There Yet?” about the road to recovery. The NBER, those self-appointed economists who are the official keepers of the score sheet of recessions and recoveries, have yet to tell us we are out of recession. Yet the economy is growing. Kind of. Today we look at the most recent data on second-quarter US GDP (which came out this morning), and even though it is backward-looking data, we’ll see what we can discern that might help us chart the direction of the future. And then, if there is time, I’ll highlight what is a very serious and growing problem for our state and local governments. There is a lot to cover and so, with no “but firsts,” let’s dive in.

The economy of the US grew at a weaker than expected 2.4% in the second quarter, but the first quarter was revised back up to 3.7% on the strength of stronger-than-projected inventory rebuilding. But the recession years were revised downward rather significantly for this late in the cycle. We find now that the recession was worse than we thought, taking the economy down a total of 4.1% during the recession. As of today, we are not quite back to where we started, still down 1%. That means it is quite possible that we could finish the year and still not be “there yet.” (To see a 1% rise in GDP we would need to see a 2% annualized rise for the rest of the year. We’ll look at that possibility in a few paragraphs.)

Let’s look at a few charts courtesy of the Dismal Scientist, at www.economy.com. First, recent GDP numbers:

If this were an average recovery, the economy would be growing at a 6% rate at this point, which pretty much says it all about our current 2.4% number. Further, 2.5 years after the beginning of a recession, we are typically already 8% higher than the prior high. This is a very tepid recovery, indeed.

Now, let’s look at the actual numbers.

There is a category called “Final Real Sales” you can create by subtracting the inventories number from the real GDP number. That reveals that final real sales grew by 1.3% last quarter. This is against what is normally a 4% number this far into a recovery. Is it any wonder that small businesses are asking “When will we get there?”

Next, look at the contribution from fixed residential investment. It has been negative or flat for six of the previous seven quarters. This time it added 0.6% to last quarter’s GDP. But the housing market is lousy. What gives?

It seems that the housing tax credits induced home builders to increase construction by an annualized 28% last quarter. That was in spite of there being 18.9 million homes vacant in the US (an all-time high), and the number of foreclosures rising by as much as 100% in some cities. (Hat tip: David Rosenberg)

“Lenders are accelerating foreclosures as borrowers fall behind in mortgage payments after the worst housing crash since the Great Depression. A record 269,962 US homes were seized in the second quarter, according to RealtyTrac Inc. Foreclosures probably will top 1 million this year, the Irvine, California-based data company said in a July 15 report.” (Daily Reckoning)

Ownership rates are falling and heading back to more traditional levels. Mortgage delinquencies are rising as the unemployment level stays persistently high. It is my guess that residential real estate will not contribute much if anything to GDP this quarter.

What about inventories? That has been a strength the last few years, adding a lot to our national growth. But inventory-to-sales ratios are at an 8-month high, which suggests that businesses may back off from increasing inventories at the recent pace.

Government spending? The bulk of the stimulus programs are going away in the latter half of the year, especially those that benefited state and local governments. Governments are slated to cut back spending or raise taxes by almost 1% of GDP. As many as 500,000 government employees may lose their jobs.

On a positive note, fixed nonresidential investments were the best they have been in several years. Let’s hope that businesses keep it up!

All that being said, if we take away housing and project slower inventory growth and less government spending, we could see the GDP number for this quarter fall to the 1% range and stay there for the rest of the year. Even the normally bullish Economy.com suggests that growth will be “sluggish” in the last half of the year. All in all, the very definition of a Muddle Through Economy.

Until we start to see a real rise in employment, it is hard to get too enthusiastic. Everyone seems to be happy that initial claims have come down from their highs. But they have gone sideways for almost a year. Let’s look at two charts. First, the last five years of initial claims.

Then a chart (courtesy of Bill King) which shows that continuing claims are at levels typically associated with recessions. This is not the stuff that “V”-shaped recoveries are made of.

I was on CNBC and Fox this last Thursday to talk about deflation. On CNBC I was side by side with my good friend Paul McCulley. It is no secret that Paul is a rather liberal Democrat. He is all for increasing taxes on the rich. This spring he told me at my conference that tax increases on the rich do not have the same multiplier as those for everyone else, and so therefore taking the Bush tax cuts away will not threaten the economy. I, of course, think it will.

I called Paul up to chat before we went on together. I was quite surprised to learn that he now thinks the Bush tax cuts should be extended for maybe another two years.

Why? We are both concerned about an unwelcome bout of deflation stemming from lack of final demand (as opposed to falling prices from increased productivity). Look at the graph below. Notice that prior to the beginning of the last recession inflation was running at a 4% clip and actually rose to above 5% before falling to a minus 2% and then rising to almost 3%. Since the beginning of the year, as the economy has softened, inflation has been steadily falling and is now at 1%. If the economy continues to falter, one would suspect that inflation could fall even lower.

If the economy were to tip into a recession with inflation so very low (or even near zero at the end of the year), the results could be very toxic. As Paul’s colleague and my friend Mohamed El-Erian writes, we are driving our economic car without a spare tire. If we were to go into a deflationary recession, there is not much that government could do. Our deficits are already at dangerous levels, and a recession would mean that tax collections would fall further. The Fed has some policy room, but it is of a variety that has not been tried for a very long time. Frankly, we cannot be sure of the unintended consequences.

One of the guest hosts on Fox informed me that double-dip recessions are very rare things. And I agree. Absent a policy mistake it should not happen. But increasing taxes to the level that is now contemplated, along with spending cuts and tax increases at the state and local levels, is a very dangerous experiment with the economy being as soft as it is.

The key words are “absent a policy mistake.” If the economy is growing at 3% and inflation is over 2%, if a majority thinks that taxes should be raised, then so be it. We would survive. But raising taxes in January is an experiment on our economic body without benefit of anesthesia.

Mark Haines (host at CNBC) rightly pointed out that there is a lot of sentiment for reducing the deficit, and was I against reducing the deficit? The answer is “no.” But I want to do it with spending cuts and spending freezes until the economy is more vigorous and inflation is above target levels. And then let’s see what Obama’s tax commission comes up with in December.

This is a variant on Pascal’s Wager. The losses are very large if we fall back into recession: Increased unemployment on top of already high levels. Reduced tax receipts. A very sick stock market. The world will suffer from our reduced demand. The cost to prevent that outcome? We forego a few hundred billion in the next year against the deficit.

One last thought. The correlation between CPI and M2 has risen to -.85 in the last 15 or so years. M2 is continuing to fall, as is the velocity of money. Just one more reason to wait until there is clear evidence of a real recovery.

Ok, one more last thought. One of the guys on Fox (you can’t see who, in a remote studio) said we shouldn’t worry about inflation because corporate profits are doing well. Really? That seems to be the bull argument everywhere for everything. Look at the above chart. Corporate profits have been rising as inflation and M2 have been falling, as bank lending is imploding, as capacity utilization is at recession-era levels, unemployment is outrageously high, savings rates are back up to 6% (see below), and consumer spending is abnormally weak compared to what it should be after a recession.

When those corporate profits start turning into jobs, when we can see pricing power in the markets, then we can possibly say that there is a correlation between profits and inflation.

I fly to Minneapolis on Sunday for a speech on Monday morning, then back to Dallas that afternoon. On Wednesday I fly with my youngest son, Trey (16), to New York. Larry Kudlow is planning on working me into the show on Wednesday, so watch or hit your record button. Then Trey and I are off to Maine for the annual Shadow Fed fishing trip hosted by David Kotok. This year Bloomberg will be covering it on Friday. Then it’s back to NYC on Sunday for some meetings, on to Washington DC for a Tuesday consulting gig for the Defense Department, and then down to Miami and off for five days to the Turks and Caicos with Barry Habib and his family.

I am still working on the book, and we will have a full rough draft in the next few days. I am very happy with the way it is coming together.

Some of my readers know that every year for the last four years Trey has caught more fish than I have. That is a little frustrating. This year, one of my readers has sent me some special hi-tech lures. If they work, I will give you a link. Maybe Dad can finally come into camp without Trey bragging about how much better a fisherman he is (which is unfortunately true).

It is time to hit the send button. Have a great week.

Your hoping for lots of tight lines analyst,

John Mauldin
John@frontlinethoughts.comCopyright 2010 John Mauldin. All Rights Reserved

Goldcorp Inc. (GG)

Q2 2010 Earnings Call Transcript

July 29, 2010 1:00 pm ET

Carpenter Technology Corporation (CRS)

F4Q10 Earnings Conference Call

July 29, 2010 10:00 AM

Agnico-Eagle Mines Limited (AEM)

Q2 2010 Earnings Conference Call

July 29, 2010 11:00 AM ET

Lundin Mining Corp. (LUNMF.PK)

Q2 2010 Earnings Call

July 28, 2010 10:00 am ET

Are you looking for companies that can sustain and grow their dividend? In making that determination, a company’s Statement of Earnings is one of the last places you should look. Cash is king for the dividend investor and the Statement of Cash Flows is where astute investors begin when they want to understand the viability of a company. To succeed as a dividend investor, you must find companies that can sustain and grow dividends by focusing on their ability to generate cash. You can fake earnings, but you can’t fake cash.

Molycorp (MCP), a rare earth oxide, or REO, producer in the Western hemisphere and oustside China, priced its IPO on 28th July at $14 per share, below the original range, generating a first day return of -8.2%.

Business Overview (from prospectus)

by Brad Zigler

Real-time Monetary Inflation (last 12 months): -1.6%

Reserve currencies continued to take ground from gold this week. Sterling appreciated 4.1 percent against bullion while the euro rose 3.2 percent. Both the yen and the Swiss franc climbed 1.2 percent.

Although gold continues to grab most of the attention in the precious metal world, its less glamorous sister, silver, may be more appealing and for good reason.

First off, silver has many more uses than gold does. It is used for numerous industrial purposes and nearly 55% of total silver fabrication is used for industrial purposes. Silver is commonly used in the electronics space and can be found in plasma display panels and printed circuit boards, as well as in the lining of refrigerators, for food storage containers and for water purification. Additionally, the metal can be used as an antimicrobial to fight bacteria and as an antiseptic to treat fungal infections. Silver’s industrial uses even span to the solar energy industry. As economies around the world continue to expand, the industrial demand for silver will likely follow.

With consumer confidence plunging and governments around the world racking up seemingly unpayable bills, many investors have sought refuge outside of fiat currencies in order to help protect some of their assets from the ravages of inflation which is sure to come eventually. Almost by default, investors have piled into gold which has seen its price soar to $1250/oz. before dropping back to the $1160/oz. level it is at currently. This recent pullback has left gold investors will an interesting dilemma; buy more assuming that the economy or the dollar collapse, or sell as the economy picks back up on the back of solid corporate earnings in a variety of sectors. Although gold remains an excellent hedge against failing currencies, it does not offer the same upside in good times that its cousin silver does which is extremely important in these uncertain times. This is because gold has virtually no industrial uses while silver finds its way into a host of critical applications ensuring that the metal will be in demand no matter if a boom or a bust is in our immediate future. This is especially important in today’s economic climate since the economy could seemingly turn in either direction at any time; there is plenty of data to support both sides of the debate. Due to this conflict, we believe that silver could make an interesting choice for investors who are concerned about the world’s fiscal condition but also realize that things are not all bad in the world.

Not only does silver have a variety of uses but demand is currently outstripping supply. In fact, it is estimated that for every 1.5 ounces of silver that are consumed, 1 oz. is produced, suggesting that as time goes on silver only becomes more in demand for its multitude of uses. So while gold receives the bulk of the attention due to its high price and rarity, an excellent case can be made for investing in silver as well. Below, we profile the seven best reasons why demand for this metal is likely to stay high no matter what the economic situation.

I have written extensively about the extremely strong relationship (.pdf) between gold ETF holdings and gold prices. For much of this year, that relationship benefitted gold, as both holdings and prices relentlessly increased. The trend has obviously reversed over the past month, but interestingly, prices led the decline in holdings.

It is important to remember that gold investors are not a homogenous group. There are gold bugs— perennial bulls who most likely hold physical gold rather than shares in ETFs, there are momentum traders who sell on the first sign of weakness, and then there is everyone in-between. One of the most significant differences between these groups is their respective levels of conviction. Gold bugs will never sell. Momentum traders will sell in a heartbeat. Importantly, the liquidity of gold ETFs makes them a very appropriate vehicle for those closer to the momentum trader side of the spectrum of conviction. Without a doubt, many of these traders bought gold ETFs simply because prices were rising. As prices fall, the process works in reverse.

By Brad Zigler

Real-time Monetary Inflation (last 12 months): -1.6%

After the break in gold prices this month, a fair amount of questions popped up ‘round the water cooler about the money flows into and out of the iShares Silver Trust (SLV). The queries were prompted by the dissonance between the money flows and share prices in the SPDR Gold Shares Trust (GLD) examined in a preceding column (see "Gold's Waning Strength").

There are certain periods of time in history when seemingly obscene prognistications are right. I believe we are in one of those times. It is at times like these that "conspiracy theorists" (whatever that means) become what I like to call "reality theorists."

Economic shocks come from nowhere. One day the global economy is humming along; the next day it collapses. Crashes don't occur because the fundamentals suddenly change; they occur because the public at large recognizes the fundamentals and heads for the exit at the same time. What's crashing next is the public's confidence in governments across the Western world. You can guess how that will affect the price of gold.

Barrick Gold Corporation (ABX)

Q2 2010 Earnings Call

July 29, 2010 9:30 a.m. ET

New Gold (NGD) has been a long term recommendation for my readers since May of 2009 when it was selling at $2.50. I have always been impressed by the quality of assets New Gold owns. New Gold is unique in the mining sector as they are leading the sector in increasing production and reducing cash costs. In two years, this company has gone from being in debt to having a comfortable net cash position.

They have three operating mines in mining friendly jurisdictions and cash costs have significantly decreased. Costs are expected to go down further when New Afton in British Columbia and El Morro in Chile get started. Both mines have huge amounts of copper. The copper byproduct decreases the cash costs of the gold to almost nil. It becomes pure profit. Their major development project, El Morro in Chile is one of the world’s major gold copper mines and New Afton is an exciting mine that has close to a billion pounds of copper reserve and a million ounces of gold.

Newmont Mining (NEM)

Q2 2010 Earnings Call

July 28, 2010 9:30 am ET

Most traders I have been talking with are feeling the same thing. Something big is brewing for the equities market but most do not want to get heavily involved until there is a clear direction. The broad market has been consolidating for almost 3 months and it’s important to remember that the larger the consolidation the bigger the move.

Also the biggest and best moves come from failed patterns. So is the big head & shoulders pattern on the S&P 500 which everyone is yelling about (the sky is falling) really going to happen or is this the BIG FAKE OUT? Only time will tell, either way no matter which way it goes I will be sure to catch some of it.

At the end of May I reviewed a very simple ETF rotation system using the free tools available at ETF Replay involving GLD, SPY, and SHY (low duration Bond ETF, used as a proxy for cash). Using the average of the 3 month return (weighted 40%), 20 day return (weighted 30%), and 20 day volatility (30%), SHY is currently ranked highest among the three. If we lengthen the time frame to average the 6 month return (weighted 40%), 3 month return (weighted 30%), and 3 month volatility (weighted 30%), GLD is surprisingly still ranked highest.

Given that SPY has been caught in a range of late, I thought it would be helpful to test a similar system using DBC (PowerShares Commodity ETF), SPY, EFA (MSCI EAFE), SHY, and TLT (long-term Treasuries). The shorter term system (3-20-20) ranks the fives ETFs as SHY, TLT, EFA, SPY, DBC. The longer term system (6-3-3) ranks long term Treasuries (TLT) as the top ranked, SHY second, and PowerShares Commodity ETF the lowest.

Sherritt Intl Corp Restr Vtg (SHERF.PK)

Q2 2010 Earnings Call Transcript

Mining giant Newmont Mining Corporation’s (NEM) second quarter 2010 earnings (excluding extraordinary charges) of $377 million or 77 cents per share fell short of the Zacks Consensus Estimate of 87 cents. However, earnings jumped 79% from $211 million or 43 cents in the year-ago period.

Including one-time charges, the company earned $382 million or 78 cents per share. Robust earnings were helped by higher gold prices, which reached a two-month high in June this year. Newmont realized gold prices of $1,200 per ounce, while copper prices were $2.33 per pound.