Ask Mauldin

John, it appears that you're arguing that two contradictory things have the same effect: adding government spending doesn't help the economy, and reducing government spending hurts the economy. Which is it? At first, you say that adding government spending doesn't help, no new jobs are actually created, it fails the sharp pencil test, etc. So, we should reduce this waste, right? Well, yes, you say, but that will reduce GDP too. I just don't get it. You seem to have it both ways: increasing government spending is bad, and reducing it is bad. What is your point?

I totally get the seeming contradiction. It is part of several chapters in Endgame. Let me see if I can summarize. Yes, cutting government spending will reduce GDP for about 4-5 quarters, just as increasing government spending will increase GDP for only about 4-5 quarters. No long term effect except we add to the debt. But when you come to the point where leverage is too much, you HAVE to cut. This drives the Keynesians nuts. But if you allow the debt to rise to much, eventually the bond market starts to want higher yields. Look at what is happening in Italy. Italy matters. It is the third largest issuer of sovereign debt by size in the world. And their yields are rising rapidly as the market seemingly overnight sees risk. It is that BANG! Moment I keep writing about. Nothing happens, we get complacent and then BANG! The bond vigilantes show up. The US is not different than Greece or Italy. There is a limit.

So we are now in the place where we must cut the deficit but also we need to recognize the consequences. As I keep writing, we are down to difficult choices and bad choices. If we make the choice to kick the can down the road, the pain will be much worse. The good news from Europe is that maybe our political leaders can see what is happening and see what happens when you let debt and deficits get too high and act now.

And note that even if they do a $4 trillion deal, we will need another $4 trillion in 2013. Or we risk becoming Greece. We made multiple years of bad choices and now we have to “own it.” As Obama said, we have to eat our peas, even if we don’t like them.

John Mauldin

There has been some talk in the media recently of a wave of municipal bond defaults in the coming future. What are your thoughts on the matter? -Petros

Good question. I respect Meredith Whitney but I just don’t get her re-iterated call for massive defaults. There are always debt restructurings in the muni world, mostly around revenue bonds which get paid back from a (supposedly) dedicated stream of income from something like a business park or hospital which just does not make necessary income. Very clear risk when you buy them. Actual defaults of cities or states are rare, but do happen. For high net worth income investors who want yield, municipal bonds can be a very good option, especially in today’s world as bond funds are being forced to sell good quality bonds at a discount. You can get 6% tax free at times on bonds which will only default in Armageddon. I mean Middle America, no debt issue states and cities which have their act together. But the bonds are beat down not because of their value, but because of people fleeing bond funds and the funds selling not what they want to sell, but what they can. That is rare opportunity for investors.

That being said, I would be very careful about what bonds I buy. While many savvy managers would disagree, I would not buy bonds from states with clear problems, like California or Illinois. They may turn out to be a great value, but for the small extra yield I am not sure it is worth the political risk they pose. If you put money into a fund, find out what they own before you invest. Do your homework or get a SPECIALIST to buy your bonds for you, not a broker who calls his desk to find something. There are bargains out there, some very real bargains, but you need to do your homework.

In your book Bull’s Eye Investing, you make a compelling argument backed up with years of statistics evidence regarding the relation of the S&P 500 P/E ratio and long term stock market performance. I have a 2 part question. Assuming an investor subscribes to applying the S&P 500 P/E ratio as a means to reallocate their equities portfolio based on high or low P/E ratios, which P/E ratio do you recognize as being the most effective in gauging the overall health and performance of the S&P 500? I see a number of different variations of P/E ratios from the one located at the S&P website to Robert Schiller’s 10-year P/E ratio. As a follow-up to my first question, how often does the actual P/E ratio that you recommend adjust (monthly, quarterly, annually) and at what interval should an investor use to gauge when to apply an asset reallocation into or out of equities?

Good questions. As to what P/E ratio to use, as you noted, there are several. I do like Shiller’s smoothed ratio, and Ed Easterling’s even better (www.crestmontresearch.com and his book Unexpected Returns). But none of them are any good for exact timing. There are numerous studies which show that long terms returns are HIGHLY correlated with the P/E ratios at the time you invest. These cycles are on average about 17 tears, as I discussed in the book and a lot of e-letters. The ratio and analysis are not useful for shorter term investors, but very useful for longer term investing. Basically, when ratios get down to the low teens, start buying. They may go lower, but your long term (ten year) returns will do just fine. When they start to get high, hedge, put in stops, etc. In between either stay long (secular bulls) or use an absolute return strategy (secular bears) depending on the starting point. I think we are still in a long term secular bear and that the next recession will start to give us a real potential entry point to become more aggressive equity wise.

So, while you may look each month, this is really more of a generational approach than trying to find the actual bottom or top, which only the lucky can do.

Since your declaration of a secular bear market in Bull's Eye Investing, what have you seen in the 6 years since? The first half of the the book is very interesting, taking your advice on getting the background before looking for opportunities. Do you still believe we are in a secular bear market? Do you believe there are still some years to go? And is the roller coaster since October 2008 still within your parameters? - Kris

Excellent question, Kris, and one I get a lot on the road. Secular bear markets are an average of about 17 years (anywhere from 13-20 years), as I was writing in 1999. We are 11 years into this one. As you read in Bull’s Eye, my view is that long term secular bull and bear markets should be seen in terms of valuations and not prices. Markets go from high valuations to low valuations and back to high. So far, at least, they do not seem to stop in the middle and turn around, as much as the perma-bulls would like you to believe. Within those very long cycles there are many “cyclical” bull and bear markets with very large price movements. These are wonderful trading opportunities. In a secular bull market (like 1982-99) you buy the dips and your bias is long. In secular bears, as I still believe we are in today, you trade the movements, and focus on absolute return strategies. In secular bulls, you really can make 10% compound real returns (after inflation) in stocks, as I outlined in chapters 5-6. Everyone is a genius. In secular bears, it is a lot tougher over the longer term. Sadly, you focus on about half that return and enjoy what you can get. It is more fixed income, dividends, yields, trading funds, hedge funds, etc. The most important thing to bear in mind in long term investing is the valuations of the stocks when you start investing. Start cheap and you win big. Start expensive and you get returns like we have had since 2000. All the wishing in the world will not change things. It just seems (as the research I wrote about in the book and have written since then) that these cycles are hard-wired into our human brain. Maybe someday we will get smarter. Until then, you must be an absolute return investor in secular bear markets, at least for now.

That being said, if you do your homework, there are always bull markets somewhere. Rifle shot stock picking becomes paramount if you want to play the stock market. You just need to be more nimble. In secular bears, you don’t have to dig a hole and crawl in and cover yourself. There are opportunities. You just have to be more realistic.

I know I keep sounding like a one note John when I tell people to talk with my partners around the world about absolute return strategies (www.mauldincircle.com), but that is just the times we are in. As I wrote back in 2002 and in Bull’s Eye, it typically takes about three recessions to really put in a valuation bottom. We have had two. There will be another. (There always is.) At that point, you may (will!) see me swing back to long biased funds and management styles, and probably too early, as I was too early in seeing the secular bear cycle in early 1999 (in my first book prior to Bull’s Eye). While I do not look forward to another recession, I really forward to being a bull once again. Markets go up and you (and everyone else, Kris) gets to be a genius.

As an aside, I re-read Bull’s Eye a few months ago just for fun. The first sic chapters and some of the middle are still very relevant. I nailed a few ideas here and there. In the back of my mind I have the idea of re-writing a second updated version of Bull’s Eye in 2013-14 when we get closer to the next cycle. And thanks for the kind words.

If European leaders were required to follow your advice on how to save the Euro, what are the first three things you would ask them to do, to help save the Euro? And do you think the Euro-USD foreign exchange rate will reach parity again?

Let’s take the last question first. I have been on record since 2002 that I thought the euro would go to $1.50 (it was $.88 at the time) and then all the way back to parity by the middle of the next decade. I think the euro has structural issues, but be warned that it is not a straight-line trip to parity. There will be a lot of volatility to this trade.

Saving the euro is the far, far tougher question. If their banks did not have so much sovereign debt from peripheral countries, you could simply restructure some of the debt, and let bondholders take a haircut. But doing so on a broad basis (Ireland, Greece, Portugal and some Eastern Europe debt) would so weaken the banks it would be another credit crisis. That would mean massive bailouts at a not inconsiderable cost to taxpayers somewhere.

There is no easy solution. Somebody somewhere is going to have to take a lot of pain, and it will be tough to get taxpayers in countries that have been responsible (or see themselves that way) to agree to share the pain for the sake of the euro. Germans rightly ask why should we cover Greece so they (hairdressers, writers, radio announcer, railroad workers) can retire at large pensions at 50? The Greeks are the world’s champion at not paying taxes. “Where is the shared pain in that?” And on and on.

Can the political types get it done? Maybe. But that is the point of last week’s letter. If Ireland decides to back off the bank debt, what is next? And in my humble opinion the Irish should.

The US “works” (if Illinois can be said to work) because the states must balance their budgets. European countries need to give up their right to run deficits (with some exceptions like project specific revenue bonds, roads, etc.) if they want to use a common currency. Using debt to finance current consumption leads to imbalances over time. Will they do that? The states and municipalities that have not acted responsibly are on their own. That should be the case with European countries if they want long term stability. The EU as it is set up now will not work. But it can (and if I was forced to bet will) be changed into something that will be viable, but not without a lot of pain and a much lower euro. And at that point we can start another cycle where the euro gains value.

The U.S. stock market is predicted by many to rise in double digit percentages in 2011. You and others speak about recession in Europe, vast numbers of unoccupied buildings and apartments in China, rising cost of food and other commodities, critical water shortages, oil and gasoline prices and debasing currencies. Where is the demand for U.S. goods and services going to come from if, indeed, the dollar rises in the face of the decreasing value of other currencies. Will the U.S. consumer be able to shoulder this, more or less, by him/herself to keep corporate profits climbing?

This is a very good question. I should do a whole letter on this but the short answer you have described a very big wall of worry that must be climbed. Remember, 80% of Americans have full-time jobs and another 10% have part-time jobs. That will improve over time, especially as we get our fiscal deficit under control and stop crowding out private funding.  We are getting better at exports of late. Asian economies are growing. The problems you describe in China are very real, but they are not just particular to China. Over time they will have to solve them.  And while Europe is likely to fall into recession, they will still be buying “stuff” from us. Their needs don’t just stop. Maybe they buy 10% less (pick a number). But it also means we get to buy cheaper things as well. I don’t think anyone would accuse me of being Pollyanna, but we do Muddle Through.

How do you respond to someone that argues that interest rates are rising because investors are confident the economic recovery is gaining credibility?

That’s a very good question, Richard.

First, I would be careful reading deep meaning into rising rates as an indicator of rising optimism. Consumer confidence and the 4 small business confidence indexes, while rising, are still at levels that are associated with recessions. Unemployment is functionally over 10% and not falling.

But the biggest reason is that rates are moving in lock-step all over the developed world. Consensus is that much of Europe will slide into recession in 2011 and yet rates are rising. Are we really optimistic about Japan which is still in deflation? If rates were just rising in the US I think we would have to give more credence to the possibility that rising rates are a bullish indicator. But we do not have tight money. Just the opposite. The theory (or at least the Keynesian one), as I wrote, is that rates should have gone down. Something is amiss and I am watching.