Fwd: An Economy at Stall Speed - John Mauldin's Weekly E-Letter

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Missed Last Week's Article? Read It Here An Economy at Stall Speed By John Mauldin | July 29, 2011 In this issue: An Economy at Stall Speed Is There a Recession in Our Future? What I Told the Senators Escalating Eurozone Interbank Liquidity Crisis: Dollar-Euro Impact? Time for Friends, Fish, and Wine The GDP numbers for the second quarter came in, and there is no way to spin them as anything but ugly. And the revisions were worse. We simply have to take a few pages to look at them. And, as I noted last Monday in the Outside the Box, I met with some ten Senators Monday afternoon (as well as Congressmen in the morning), plus a lot of staff. Getting ten Senators in a room for 90-plus minutes is not so often done. I will report in this week's letter about our conversation and my impressions. But first, I was in Vancouver for a few days this week at the Agora conference. I had dinner with old friends Bill Bonner, Barry Ritholtz, David Tice, Frank Holmes, and Keith Fitzgerald. I had spoken that morning and my speech was well-received, getting a fair complement of laughs. I was somewhat on a roll. I mentioned that I think a lot of the better financial speakers are actually frustrated stand-up comics, and there was general agreement on that. I say that to set up the next item. This past April I spoke at my own investment conference in La Jolla (co-sponsored with Altegris Investments). It was a brand new speech, and I did something I have not done in years: I actually practiced it several times, as I did not want to embarrass myself, given the quality of the other speakers. I came off the stage feeling that I had given the worst speech of my career. The room was absolutely silent. I normally get a lot of laughs. I was getting no reaction at all. As I made my way to the rear of the room I was actually quite depressed. Then several people (people who cut me no slack) told me that it was the best speech they had ever heard me give. I was surprised and said, "But the audience was so quiet. How come?" "John, you just walked them through a scenario that was so compelling and so fraught with regard to our problematic future that it was very sobering. There really was nothing to laugh at." This from a man who has been very blunt with me and has heard me speak many times and tells me if I am off my game. I got the same comment a lot. I am now using a different speech, so we are going to make the one from our conference available online to all those who have signed up for my accredited investor letter. It is the last speech of the conference to be posted, so now every one is online – speeches by David Rosenberg, Martin Barnes, Neil Howe, Gary Shilling, and more, plus the panel sessions. A very powerful lineup it was. If you are an accredited investor (net worth of over $1.5 million), you can go to www.johnmauldin.com and click on The Mauldin Circle and fill out the form, and one of my worldwide partners will get in contact with you and give you access to the speech. And if you have not yet reached that status, you can still sign up, and my partner CMG, based in Philadelphia, will make sure you get access. These all are management firms that, like Altegris, have access to some of the best alternative investments and commodity funds I am aware of. Let them show you what adding some of the managers they represent can do for your portfolio. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) Please read the risk disclosures on the form and at the end of the letter carefully when you are thinking about alternative investments. And now to this week's letter. An Economy at Stall Speed There is no way to spin the GDP report that came out this morning as anything but very bad. It was just last May that the consensus was that second-quarter GDP would be 3.3%. That had been revised down to 2.7%, but the number came in at 1.3%. Normally, at this time in a recovery we are growing at close to 3 times that number, or 3.6%. (You can read the press release and see the data I write about at http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm.) Even worse, the first-quarter number was revised down from 1.9% to an anemic 0.36%. For new readers, note that the first estimate of a quarter's growth is just that, an estimate. There are three monthly revisions that follow, and after a few years it is revised yet again with the aid of hindsight. And the 4th quarter of 2010 was taken down from 3.1% to 2.35%! If you are looking for something (anything) that can explain the new number, then you could attribute a small portion to the effects from the Japan earthquake and tsunami, as "durable goods" from motor vehicles and parts reduced GDP by about .2%. And it gets worse. It seems that BEA went back and revised the numbers for the recession. Would it surprise you to learn that the recession was worse than we thought at the time? The peak-to-trough decline was 5.1% instead of 4.1%. That means that in real terms the economy has not yet recovered back to the pre-recession levels. David Rosenberg notes that in his research "going back to 1947 and never before have we seen this dynamic of the level of overall economic activity lower on the second birthday of the recovery than it was at the prior cycle peak. Typically two years into a recovery, real GDP is already 9.5% above the pre-recession high." Look at this chart from the St. Louis Fed. It is real Gross Domestic Product going back five years. This is just ugly. More on this later, as I made this point with the Senators (I wish I'd had this data when I was there!) Now, notice the direction of the revisions. Care to wager the over/under on where the revisions will go when the second quarter is revised? Dare we say it could go negative? Say it ain't so, Joe! I don't have time to cover it this week, but global growth is slowing. China's PMI came in at 48.9 in July. Korean exports are slowing. Joan McCullough notes: "Working from Q309, forward, read GDP as follows: "1.7, 3.8, 3.9, 3.8, 2.5, 2.3 … now here it comes: 0.4 … and then today's 1.3%. "I won't keep you in suspense any more. Here's my take: MOMENTUM IS BROKEN. A big, ol' monkey wrench, courtesy of input arising from the change in inventory and Imports. And once momentum stumbles, then H2 growth becomes a wild card, right?" Is There a Recession in Our Future? I mentioned a chart from Rich Yamarone, Chief Economist at Bloomberg (who I'm having dinner with next Tuesday in NYC). I previously wrote: "And the last chart is one I had not seen before, and is interesting. Rich notes that if year-over-year GDP growth dips below 2%, a recession always follows. It is now at 2.3%." Growth is clearly decelerating. Look at the growth numbers from the St. Louis Fed website for the last six quarters: 2009-10-01 13019.012 2010-01-01 13138.832 2010-04-01 13194.862 2010-07-01 13278.515 2010-10-01 13380.651 2011-01-01 13444.301 It will be very interesting to see, at the end of the month, what the numbers are for the second quarter. Another quarter like the first quarter and we should either be close to or actually dip below 2%. Oops. Today David Rosenberg updated that chart. This from Rosie: If Rich is right, then the next revisions will be down. And the growth in the second half is not going to be all that good for jobs and consumer spending. And this from Rosie as well: The economy is at stall speed, it is quite possible we'll see further downward revisions to the already anemic growth numbers, and Congress and the President are dithering over the debt ceiling. It will not take much to push us into an outright recession. We can go a few days, I think, with the latter problem, but not too long or the markets will throw up. I should note that the Congressmen and Senators I met with were a very wired-in bunch. Many of them are in the leadership. And they had no clue as to how the debt-ceiling snafu would play out. Lots of speculation, but no real idea. And they were worried. But enough on the GDP. Suffice it to say that the stock market drops about 40% on average in a recession. Just sayin'. What I Told the Senators It started when a friend gave Senator Dan Coats a copy of Endgame. He read it and underlined, highlighted, and scored it. The Senator Rob Portman took it off his hands and read it. They asked me to come to DC and meet a few Senators. You don't say no to such a request, but the only free day I had was Monday. I met with nine of them for about 90 minutes and Senator Cornyn (from Texas) privately beforehand for an hour. I offered him a copy of the book, but he said he was already reading it on the iPad he was carrying. I gave him one anyway. ;-) I met with several chiefs of staff before the meeting, and they decided I should not use the typical PowerPoint approach but just talk, and gave me advice on how to go about it. Evidently, Coats and Portman had worked the room, because nine guys showed up more or less on time. Two Democrats, six Republicans, and an independent (Lieberman). Jon Kyl was there, as well as Gang of Six member, Tom Coburn from Oklahoma. Also Corker, Lugar, Coats, Portman, and Mike Lee, the "Tea Party" senator from Utah, who took the most notes. But there were a lot of them taking notes. And asking questions, some rather pointed. Overall, I was very impressed with the level of knowledge in the room and the candor. I started by explaining what I meant by the debt supercycle and how deleveraging recessions are fundamentally different from business-cycle recessions, which is why we are not seeing a normal recovery. And it is happening all over the developed world. I think I surprised them by jumping to Europe first, noting that Europe appeared to be imploding even as we were meeting. I made the point that we could see a banking and credit crisis coming from Europe that might be worse than the subprime crisis. I noted that it was not just Greece, Ireland, and Portugal. Spain and Italy have their own share of problems, and the markets have taken their interest rates up by 1% in just the last month, just as a large rollover of debt is coming due. We'd better stay with this Europe thing for a few minutes. A few weeks back, I talked about Italy and said I thought their debt was longer-duration, and so they might not go critical quite so fast. I got this note from London partner Niels Jensen, pointing out to me how wrong I was: "Wrong! Italy average debt duration is in fact quite short, as illustrated in the chart below. Within Europe, only the UK has really long average debt duration (about 13 years). Most countries are averaging 5-7 years. Italy is no exception. Best, Niels." Then today I get this note from Bluemont Capital Advisors, written by Harald Malmgren, Global Economic Strategist, and Mark Stys, Chief Investment Officer. It is short but important, so I am going to quote it in full. Thanks, guys. Escalating Eurozone Interbank Liquidity Crisis: Dollar-Euro Impact? "Italian and Spanish interbank lending is freezing up. French Finance Ministry officials and banks have been in emergency meetings this week regarding Eurozone interbank market stress. IMF and EU officials are warning that France might also face downgrade if greater spending cuts are not made. Finance Ministry staff have been warned to be available 24/7 (irrespective of sacred August holidays!) as contagion may soon affect French banks and sovereign debt. "In spite of last week's Eurozone Summit agreement on Greece and EFSF 'flexibility', Italian and Spanish sovereign debt yields have resumed escalation this week. Moreover, the Italians had to cancel issuance of longer maturity debt as demand was insufficient. German Finance Minister Schauble damaged confidence Wednesday when he said the EFSF would not have a blank check to purchase Eurozone sovereign debt in the secondary market. "Eurozone banks' primary holding of capital is in the form of Eurozone sovereign debt. It is obvious that the EFSF is not large enough to handle crises on the scale of Italian and Spanish sovereign debt. Schauble's statement is interpreted as indicating precarious support within the German parliament for the recent Summit package for Greece and the EFSF, and that an increase in EFSF is unlikely. (Schauble is personally powerful within the CDU, so his statements most likely carry more political weight than Merkel's at present.) "Meanwhile, US money market funds have been withdrawing from Eurozone bank commercial paper, leaving Eurozone banks with a big gap in availability of short-term funding and a severe shortage of dollars. "In the background, the Fed has quietly advised the ECB and some other central banks that Congress has warned the Fed not to repeat the huge liquidity support to Europe and Asia that it provided in 2008. European officials believe the Fed would be less able to come to the rescue again with increased swap lines and direct loans to Eurozone banks, as it did post-Lehman. "Thus, in parallel with the US debt ceiling uncertainties, the Eurozone appears to be entering into renewed crisis of breakdown in interbank trust and escalating borrowing costs for Italy and Spain, and maybe even France. Whatever happens with the US debt ceiling, attention will soon turn back to Eurozone sovereign debt problems and threats to the viability of Eurozone banks from debt contagion. "It is increasingly possible that the ECB may not be able to function as lender of last resort on the scale required to cope with an interbank lending breakdown. It is also thus likely that the Eurozone will suffer a shortage of dollars for its interbank credit markets. Demand for dollars will likely escalate, while confidence in Eurozone financial institutions falls. This could force Eurozone banks to purchase dollars in the open market and drive the dollar higher." I made some similar points to the Senators about why the euro is going to parity – if it survives. Then I went into my "Japan is a bug in search of a windshield" spiel, pointing out that the yen will fall in half. All this to say is that the bond markets are going to get spooked sooner than we are prepared for. If the US does not show up with a credible deficit-reduction program by the end of 2013, we could see interest rates rising even in the face of a deflationary recession. If we do nothing, we become Greece. And the $4 trillion they are talking about? That is a down payment. We need $10-12 trillion in cuts over ten years, which I explained would put us into a slow-growth-at-best, Muddle Through economy with high unemployment and tough tax policies. I pointedly showed Senator Mike Lee why we could not cut spending too fast (as the Tea Party wants) – unless we want Depression 2.0 and 20% unemployment. It has to be my "glide-path" option. As I said, Lee was taking notes fast and furious. And asking the right questions. I like him. Lieberman was also engaged (I really do like him), and they were all very candid about the political problems they were facing. And it was a very sober group as we ended the meeting. But they all politely thanked me for coming and talking frankly. Even the Dems (I confess I think I know the name of one, but the website picture does not look like him, so I don't want to get it wrong. But he was impressive with his questions as well.) I could go on, but long-time readers know by now my Endgame scenario. I got a lot of promises that the Senators would read my book. Coats and Portman got extra copies to give out on the floor. I have to tell you, gentle reader, that leaving that meeting I was very sober as well. They made it clear that getting it done is going to be very hard, and it will take real commitment from men and women like them to get us through this. They all noted that their mail was running 100 to 1 against cutting Medicare. Every one of them. They know that they cannot close the deficit gap just with the elimination of the Bush tax cuts. And I think I convinced any who weren't already, that not getting the deficit under control means Depression 2.0 and a disaster. The debate in 2012-13 will be, how much Medicare do we want and how do we want to pay for it? Sadly, I think the only way is with a VAT (value-added tax), since less than 50% of citizens pay any income taxes now. Want to run on a program of taxing the "middle class?" Didn't think so. Want to run on a platform of cutting Medicare? That is not a winner either. We are at an impasse. We need a massive restructuring of our entire tax code to be more encouraging of creating jobs. But that is another story for another week. It is time to hit the send button. Well, just one brief commercial. If Senators are reading Endgame, maybe you should be! Get it at your local bookstore or Amazon.com. Time for Friends, Fish, and Wine While I will be in New York for a few days next week, I first head on Thursday morning for Grand Lake Streams, Maine. I will take a float plane in from Bangor with Nouriel Roubini and my son and a few others. This is I think year 6 for me to go fishing. Bloomberg is sending a TV crew. We fish, then eat the fish we catch for lunch, drink good wine, fish some more, have a gourmet dinner, drink more wine, and talk economics. The event is organized by David Kotok of Cumberland Advisors. The list of friends is so long. John Silvia (chief econ at Wells Fargo), Martin Barnes, Barry Ritholtz, Paul McCulley, Bill Dunkelberg (chief econ at the National Federation of Independent Businesses), some Fed econ types, hedge-fund managers – and this year there will be seven ladies. About 40 people in all. Seems the limit is the number of guides we can get. My son Trey has grown up with this crowd. It is our favorite time together of the year. NYC will be fun. Yahoo and Bloomberg. I meet with my publisher, Debra Englander from Wiley, about the next books under way. As noted, Rich Yamarone has an all-star cast lined up for dinner, and I get to be with Art Cashin. I will also get to hang out with Doug Kass and Vince Farrel. How fun. Mike West of Biotime will be at dinner Wednesday. I think he may be the most important man of our times. If anyone can figure out how to stop this aging thing, it will be him. What a great week! And you have a great week as well. Now let me close with a great line from Doug Casey, who sat next to me on the Whiskey Bar panel at the Agora Symposium, which had the crowd in stitches. Ritholtz was on a roll, too, and some of the rest of us got in a few good lines. Great fun! "The situation is hopeless, but it is not serious." Gentle reader, we get through this. Your really looking forward to next week analyst, John Mauldin John@FrontlineThoughts.com Copyright 2011 John Mauldin. All Rights Reserved.

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Thoughts From the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.JohnMauldin.com. Please write to johnmauldin@2000wave.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.JohnMauldin.com. To subscribe to John Mauldin's e-letter, please click here: http://www.frontlinethoughts.com/subscribe To change your email address, please click here: http://www.frontlinethoughts.com/change-address If you would ALSO like changes applied to the Mauldin Circle e-letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request to wave@frontlinethoughts.com. To unsubscribe, please refer to the bottom of the email. 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Fwd: Germany's Choice: Part 2 - Outside the Box Special Edition

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Subject: Germany's Choice: Part 2 - Outside the Box Special Edition
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Missed Last Week's Article? Read It Here Germany's Choice: Part 2 By STRATFOR | July 28, 2011 For today's special-edition OTB, let's turn our fiscal eye across the pond to all that's going haywire in Europe. But not the continent's banking crisis, per se. Today's piece takes a broad look at who's really running the show. I'll give you a hint: they've done it before, and it wasn't too long ago. The folks at STRATFOR (a global intelligence publication) have spent the better part of two years saying that Germany will run Europe. The newly redesigned EFSF (European Financial Security Facility) can be considered concrete evidence of such. From Berlin's point of view, the Eurozone is its sphere of influence, and its preservation is in Germany's national security interest. It's a new Europe, where Germany is not just the checkbook anymore, but holds some reins. I'm sure you'll find this piece as thought-provoking as I did. Investors are always talking about geopolitical risk (but you and I talked about it first here), and if you're looking for geopolitical analysis and forecasting, I highly recommend you check out STRATFOR. OTB readers can get a hefty discount on a STRATFOR subscription, plus a free copy of (warning: more self-promotion) my book Endgame. Your now craving schnitzel analyst, John Mauldin, Editor Outside the Box JohnMauldin@2000wave.com

Germany's Choice: Part 2 July 26, 2011 Related Link Germany's Choice Germany: Mitteleuropa Redux By Peter Zeihan and Marko Papic Seventeen months ago, STRATFOR described how the future of Europe was bound to the decision-making processes in Germany. Throughout the post-World War II era, other European countries treated Germany as a feeding trough, bleeding the country for resources (primarily financial) in order to smooth over the rougher portions of their systems. Considering the carnage wrought in World War II, most Europeans — and even many Germans — considered this perfectly reasonable right up to the current decade. Germany dutifully followed the orders of the others, most notably the French, and wrote check after check to underwrite European solidarity. However, with the end of the Cold War and German reunification, the Germans began to stand up for themselves once again. Europe's contemporary financial crisis can be as complicated as one wants to make it, but strip away all the talk of bonds, defaults and credit-default swaps and the core of the matter consists of these three points: Europe cannot function as a unified entity unless someone is in control. At present, Germany is the only country with a large enough economy and population to achieve that control. Being in control comes with a cost: It requires deep and ongoing financial support for the European Union's weaker members. What happened since STRATFOR published Germany's Choice was a debate within Germany about how central the European Union was to German interests and how much the Germans were willing to pay to keep it intact. With their July 22 approval of a new bailout mechanism — from which the Greeks immediately received another 109 billion euros ($155 billion) — the Germans made clear their answers to those questions, and with that decision, Europe enters a new era. The Origins of the Eurozone The foundations of the European Union were laid in the early post-World War II years, but the critical event happened in 1992 with the signing of the Maastricht Treaty on Monetary Union. In that treaty, the Europeans committed themselves to a common currency and monetary system while scrupulously maintaining national control of fiscal policy, finance and banking. They would share capital but not banks, interest rates but not tax policy. They would also share a currency but none of the political mechanisms required to manage an economy. One of the many inevitable consequences of this was that governments and investors alike assumed that Germany's support for the new common currency was total, that the Germans would back any government that participated fully in Maastricht. As a result, the ability of weaker eurozone members to borrow was drastically improved. In Greece in particular, the rate on government bonds dropped from an 18 percentage-point premium over German bonds to less than 1 percentage point in less than a decade. To put that into context, borrowers of $200,000 mortgages would see their monthly payments drop by $2,500. Faced with unprecedentedly low capital costs, parts of Europe that had not been economically dynamic in centuries — in some cases, millennia — sprang to life. Ireland, Greece, Iberia and southern Italy all experienced the strongest growth they had known in generations. But they were not borrowing money generated locally — they were not even borrowing against their own income potential. Such borrowing was not simply a government affair. Local banks that normally faced steep financing costs could now access capital as if they were headquartered in Frankfurt and servicing Germans. The cheap credit flooded every corner of the eurozone. It was a subprime mortgage frenzy on a multinational scale, and the party couldn't last forever. The 2008 global financial crisis forced a reckoning all over the world, and in the traditionally poorer parts of Europe the process unearthed the political-financial disconnects of Maastricht. The investment community has been driving the issue ever since. Once investors perceived that there was no direct link between the German government and Greek debt, they started to again think of Greece on its own merits. The rate charged for Greece to borrow started creeping up again, breaking 16 percent at its height. To extend the mortgage comparison, the Greek "house" now cost an extra $2,000 a month to maintain compared to the mid-2000s. A default was not just inevitable but imminent, and all eyes turned to the Germans. A Temporary Solution It is easy to see why the Germans did not simply immediately write a check. Doing that for the Greeks (and others) would have merely sent more money into the same system that generated the crisis in the first place. That said, the Germans couldn't simply let the Greeks sink. Despite its flaws, the system that currently manages Europe has granted Germany economic wealth of global reach without costing a single German life. Given the horrors of World War II, this was not something to be breezily discarded. No country in Europe has benefited more from the eurozone than Germany. For the German elite, the eurozone was an easy means of making Germany matter on a global stage without the sort of military revitalization that would have spawned panic across Europe and the former Soviet Union. And it also made the Germans rich. But this was not obvious to the average German voter. From this voter's point of view, Germany had already picked up the tab for Europe three times: first in paying for European institutions throughout the history of the union, second in paying for all of the costs of German reunification and third in accepting a mismatched deutschemark-euro conversion rate when the euro was launched while most other EU states hardwired in a currency advantage. To compensate for those sacrifices, the Germans have been forced to partially dismantle their much-loved welfare state while the Greeks (and others) have taken advantage of German credit to expand theirs. Germany's choice was not a pleasant one: Either let the structures of the past two generations fall apart and write off the possibility of Europe becoming a great power or salvage the eurozone by underwriting 2 trillion euros of debt issued by eurozone governments every year. Beset with such a weighty decision, the Germans dealt with the immediate Greek problem of early 2010 by dithering. Even the bailout fund known as the European Financial Security Facility (EFSF) was at best a temporary patch. The German leadership had to balance messages and plans while they decided what they really wanted. That meant reassuring the other eurozone states that Berlin still cared while assuaging investor fears and pandering to a large and angry anti-bailout constituency at home. With so many audiences to speak to, it is not at all surprising that Berlin chose a solution that was sub-optimal throughout the crisis. That sub-optimal solution is the EFSF, a bailout mechanism whose bonds enjoyed full government guarantees from the healthy eurozone states, most notably Germany. Because of those guarantees, the EFSF was able to raise funds on the bond market and then funnel that capital to the distressed states in exchange for austerity programs. Unlike previous EU institutions (which the Germans strongly influence), the EFSF takes its orders from the Germans. The mechanism is not enshrined in EU treaties; it is instead a private bank, the director of which is German. The EFSF worked as a patch but eventually proved insufficient. All the EFSF bailouts did was buy a little time until investors could do the math and realize that even with bailouts the distressed states would never be able to grow out of their mountains of debt. These states had engorged themselves on cheap credit so much during the euro's first decade that even 273 billion euros of bailouts was insufficient. This issue came to a boil over the past few weeks in Greece. Faced with the futility of yet another stopgap solution to the eurozone's financial woes, the Germans finally made a tough decision. The New EFSF The result was an EFSF redesign. Under the new system the distressed states can now access — with German permission — all the capital they need from the fund without having to go back repeatedly to the EU Council of Ministers. The maturity on all such EFSF credit has been increased from 7.5 years to as much as 40 years, while the cost of that credit has been slashed to whatever the market charges the EFSF itself to raise it (right now that's about 3.5 percent, far lower than what the peripheral — and even some not-so-peripheral — countries could access on the international bond markets). All outstanding debts, including the previous EFSF programs, can be reworked under the new rules. The EFSF has been granted the ability to participate directly in the bond market by buying the government debt of states that cannot find anyone else interested, or even act pre-emptively should future crises threaten, without needing to first negotiate a bailout program. The EFSF can even extend credit to states that were considering internal bailouts of their banking systems. It is a massive debt consolidation program for both private and public sectors. In order to get the money, distressed states merely have to do whatever Germany — the manager of the fund — wants. The decision-making occurs within the fund, not at the EU institutional level. In practical terms, these changes cause two major things to happen. First, they essentially remove any potential cap on the amount of money that the EFSF can raise, eliminating concerns that the fund is insufficiently stocked. Technically, the fund is still operating with a 440 billion-euro ceiling, but now that the Germans have fully committed themselves, that number is a mere technicality (it was German reticence before that kept the EFSF's funding limit so "low"). Second, all of the distressed states' outstanding bonds will be refinanced at lower rates over longer maturities, so there will no longer be very many "Greek" or "Portuguese" bonds. Under the EFSF all of this debt will in essence be a sort of "eurobond," a new class of bond in Europe upon which the weak states utterly depend and which the Germans utterly control. For states that experience problems, almost all of their financial existence will now be wrapped up in the EFSF structure. Accepting EFSF assistance means accepting a surrender of financial autonomy to the German commanders of the EFSF. For now, that means accepting German-designed austerity programs, but there is nothing that forces the Germans to limit their conditions to the purely financial/fiscal. For all practical purposes, the next chapter of history has now opened in Europe. Regardless of intentions, Germany has just experienced an important development in its ability to influence fellow EU member states — particularly those experiencing financial troubles. It can now easily usurp huge amounts of national sovereignty. Rather than constraining Germany's geopolitical potential, the European Union now enhances it; Germany is on the verge of once again becoming a great power. This hardly means that a regeneration of the Wehrmacht is imminent, but Germany's re-emergence does force a radical rethinking of the European and Eurasian architectures. Reactions to the New Europe Every state will react to this new world differently. The French are both thrilled and terrified — thrilled that the Germans have finally agreed to commit the resources required to make the European Union work and terrified that Berlin has found a way to do it that preserves German control of those resources. The French realize that they are losing control of Europe, and fast. France designed the European Union to explicitly contain German power so it could never be harmed again while harnessing that power to fuel a French rise to greatness. The French nightmare scenario of an unrestrained Germany is now possible. The British are feeling extremely thoughtful. They have always been the outsiders in the European Union, joining primarily so that they can put up obstacles from time to time. With the Germans now asserting financial control outside of EU structures, the all-important British veto is now largely useless. Just as the Germans are in need of a national debate about their role in the world, the British are in need of a national debate about their role in Europe. The Europe that was a cage for Germany is no more, which means that the United Kingdom is now a member of a different sort of organization that may or may not serve its purposes. The Russians are feeling opportunistic. They have always been distrustful of the European Union, since it, like NATO, is an organization formed in part to keep them out. In recent years the union has farmed out its foreign policy to whatever state was most affected by the issue in question, and in many cases these states has been former Soviet satellites in Central Europe, all of which have an ax to grind. With Germany rising to leadership, the Russians have just one decision-maker to deal with. Between Germany's need for natural gas and Russia's ample export capacity, a German-Russian partnership is blooming. It is not that the Russians are unconcerned about the possibilities of strong German power — the memories of the Great Patriotic War burn far too hot and bright for that — but now there is a belt of 12 countries between the two powers. The Russo-German bilateral relationship will not be perfect, but there is another chapter of history to be written before the Germans and Russians need to worry seriously about each other. Those 12 countries are trapped between rising German and consolidating Russian power. For all practical purposes, Belarus, Ukraine and Moldova have already been reintegrated into the Russian sphere. Estonia, Latvia, Lithuania, Poland, the Czech Republic, Slovakia, Hungary, Romania and Bulgaria are finding themselves under ever-stronger German influence but are fighting to retain their independence. As much as the nine distrust the Russians and Germans, however, they have no alternative at present. The obvious solution for these "Intermarium" states — as well as for the French — is sponsorship by the United States. But the Americans are distracted and contemplating a new period of isolationism, forcing the nine to consider other, less palatable, options. These include everything from a local Intermarium alliance that would be questionable at best to picking either the Russians or Germans and suing for terms. France's nightmare scenario is on the horizon, but for these nine states — which labored under the Soviet lash only 22 years ago — it is front and center.

Copyright 2011 John Mauldin. All Rights Reserved.

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Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.JohnMauldin.com. Please write to johnmauldin@2000wave.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.JohnMauldin.com. To subscribe to John Mauldin's e-letter, please click here: http://www.frontlinethoughts.com/subscribe To change your email address, please click here: http://www.frontlinethoughts.com/change-address If you would ALSO like changes applied to the Mauldin Circle e-letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request to wave@frontlinethoughts.com. To unsubscribe, please refer to the bottom of the email. 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Missed Last Week's Article? Read It Here Converging On The Horizon By Ed Easterling | July 26, 2011 This week's Outside the Box is with an old friend to long-time readers, Ed Easterling of Crestmont Research. Ed is usually on the bullish side, but his research of late points to a few warning signs that say some cycle convergences may be pointing to problems. And that coincides with my macro concerns. As usual, lots of charts and data, but easy to read and understand. And, for those with stock market investments, very thought-provoking and timely. I write this at 34,000 feet on the way back to Dallas. I met with a few Congressmen this morning and then ten Senators (!) this afternoon. It seems that some of them had read Endgame and rounded up a rather impressive group to come hear me speak for about 90 minutes. No Powerpoint, just off the cuff, with lots of very pointed questions, and they were taking notes (mostly). Some have been my long-time readers (go figure). It was bipartisan. Actually tripartisan, as independent Joe Lieberman was there, and asked some very hard questions. They cut me no slack and I gave no quarter. It was a very frank discussion. This is a group that is quite worried (I should say seriously worried) about our future, and they let me know there were more like them. On both sides of the aisle. It was actually somewhat encouraging, except that they are not optimistic. There was a sense of palpable concern that nothing might be done until we have a crisis, and so they realize the need to act. They are working to get their fellow Senators on board. Maybe there is hope. Without naming names, I was particularly impressed with the questions from a "Tea Party" Senator when I talked about the "glide-path option" and what going too fast would mean – as in a depression. I think he got it. We'll see. He took the most notes, although Portman (who ran OMB so has a serious resumé and credibility on budgets) was going through paper rather fast as well. They grilled me on the debt ceiling, and I gave it my best; but I think the debt ceiling is a temporary sideshow to the whole deficit issue. They truly were getting the "hitting the wall" if we don't get the deficit under control. I left a lot of books and was surprised that more than a few came with their own copies to have me sign. Senator Dan Coats set up the meeting, and Rob Portman helped round up the group. Getting that many Senators in a room is not easy. And a few of my heroes were in the room, too. It was a very humbling experience for your already humble analyst. As an aside, neither the Congressmen (some of whom are in the GOP leadership) nor any of the Senators have a clue as to how the debt-ceiling issue will work out. There were lots of guesses and speculation. One of the "Gang of Six" was there, and he had no idea what would happen. Small self-promotion: you should get Endgameand read it. If Senators are reading it and marking it up, maybe you should take a look. http://www.amazon.com/Endgame. Ok, we are landing, so it's time to hit the send button. More later. Your can't believe this life analyst, John Mauldin, Editor Outside the Box JohnMauldin@2000wave.com

Converging On The Horizon By Ed Easterling July 21, 2011 Copyright 2011, Crestmont Research ( www.CrestmontResearch.com) The end is near! Stock market history and earnings cycle history are converging. As a result, the market is likely to be down for the year 2011 or 2012. If not, then it will have been different this time. Crestmont's research focuses primarily on long-term secular stock market cycles and their fundamental drivers. Inside of the secular periods are short-term cyclical cycles, primarily driven by psychology, collective emotion, and reactions to current events. These short-term cycles are part of the market process to incorporate new information and to balance the pressures of buyers and sellers. In the long-run, the short-term cycles are reconciled back to the long-term fundamentals of value. The stock market remains in a secular bear market. Actually, it is still in the early stages of a secular bear based upon relatively high P/E valuations currently and a relatively low core inflation rate (the driver of P/E over time). Secular bear markets, albeit fairly flat periods for returns, experience violent interim swings—it's just the nature of market volatility. Although Crestmont's research does not explain or predict the short-term movements, it does recognize a fundamental nature and tendency that should be respected. For example, even if we can't explain why there tends to be short runs of positive years in the market, we should realize that risk increases as we approach the historical limits. Beware: there are two series of short-term trends that are converging on their limits. They portend increased risk for the stock market (…or new historical precedent). The first is the sequence of market gains and losses; the second is the earnings cycle. The goals of this discussion are (1) to dispel the notion that P/E is low today and (2) to highlight the risks of a market decline in 2011 or 2012. P/E TODAY Most reports and articles about stock market valuation contend that P/E is low and below average—supposedly, it is a harbinger for upcoming gains. This is the result of two major distortions. The first distortion is that the reported P/E is based upon unsustainable earnings (EPS). The second distortion results from comparing P/E to its historical average. On the first point, profit margins are near historical highs; it is unrealistic to expect that the trend will extend indefinitely into the future. For more details, see Beyond The Horizon: Redux 2011 at CrestmontResearch.com. Otherwise, here are the basics. The graphs virtually speak for themselves, yet a few notes are included as highlights. Figure 1. Pre-Tax Corporate Profits As % of GDP: Quarterly 1990–1Q2011 NOTE: Profit margins are returning to lofty levels, and this does not reflect the forecast by most analysts for even higher margins. Based upon the current forecast for public company earnings, the line in the graph should exceed 14% by 2012. Figure 2. The Analysts' Forecast: S&P's Outlook—Percentages NOTE: Historical annual changes and S&P's forecast for the percentage change in as-reported earnings per share (EPS) for 2011 and 2012. Figure 3. The Analysts' Forecast: S&P's Outlook—Dollars NOTE: The blue line is actual reported EPS; the red line extension is S&P's forecast. The orange and purple lines are baseline normalized EPS using Crestmont's & Shiller's methodologies (the latter one is adjusted as described in Probable Outcomes: Secular Stock Market Insights). Figure 4. Magnitude of EPS Over/Under Baseline Trend NOTE: This graph reflects the percentage variance of reported EPS over and under the baseline trend EPS based upon Crestmont's methodology. Current forecasts imply record profit margins. Figure 5. Duration of EPS Cycles NOTE: So if you are convinced that a reversion of profit margins is imminent, how soon could it happen? Past EPS cycles have lasted one to six years. Over the past six decades, there have been twelve up-cycles. Six lasted one or two years (2010 was year two for the current cycle). We're now in the second half of the game. As each upcoming year passes with an increase in EPS, the likelihood rises for the next decline in the market. Conclusion #1: Reported earnings are expected to decline over the next two years (or they are increasingly likely to disappoint current expectations). That will put pressure on the stock market. If history is a guide, and if the line in Figure 4 only slightly retreats below the baseline, the implication is a decline in reported EPS of almost 40%! Conclusion #2: The measures of P/E that are based upon reported EPS are currently distorted by the business cycle. Whereas current reports reflect forward P/Es near 13, a more rational measure for P/E based upon normalized baseline EPS is close to 20. P/E is not below average and is not ready to propel the market upward, it is well above average. But a high P/E does not necessarily mean that the stock market is "overvalued"… MISGUIDED AVERAGE The average yield from U.S. Treasury bonds over the past fifty years is almost 7%. Today, the yield is near 3.5%. Are Treasury bonds grossly overvalued? Before we can compare today's yield to the historical yield, it's important to assess the driver of bond yields—the inflation rate. Over the past fifty years, inflation averaged near 4%; today's reports reflect inflation at less than half of that rate. Since the inflation rate drives the yield of a bond, today's below-average inflation is causing bond yields to be below-average. Therefore, to assess relative valuation and the appropriate bond yield, we should compare it to the inflation rate. For example, when the inflation rate was below its average over the past fifty years, bond yields averaged under 6%. But when the inflation rate was above its average, bonds averaged over 8%. Likewise for the stock market. Inflation drives the P/E ratio. When the inflation rate has been below average, P/E has typically been in the upper teens. Higher inflation and deflation drive P/E into the lower teens (and with extreme inflation and deflation, P/E went well into single digits). As an analogy, consider the weather report for Chicago. Wouldn't you laugh if the weatherman boasted: "G-o-o-d morning and Happy New Year in the Windy City. Today's high will be near 50 degrees! It'll be a chilly one for sure on this first day of the year, since the long-term average high in Chicago is almost 60 degrees…" What, chilly at 50 on a January day in Chicago?! Yes, the average daily high in Chicago is 60 degrees, but not in January. Even weathermen, with their notorious imprecision, know to use a relevant average—one that is at least generally comparable. If bond market folks and weathermen know to use relevant benchmarks, then why do we let stock market analysts and writers lead us with a convoluted average? The reality is that today's relevant average for P/E is closer to 20 than to the recognized long-term average near 15. The inflation rate is relatively low and bond yields are relatively low; thus, P/E is appropriately above the long-term average that includes both low inflation rate and high inflation rate periods. As a result, the stock market currently is not overvalued, nor is it undervalued. Today's high normalized P/E corresponds to the relatively low inflation rate (the relatively high P/E also reflects current secular bear market conditions). Thus, the stock market is near fairly valued albeit at high levels (given the inflation rate at low levels) as well as in the early stages of a secular bear because valuations are high yet trending lower. Today's normalized P/E of 20 is within the range of fair value given the relatively low inflation rate. Most importantly, investors cannot rely upon the tailwind of an undervalued market, nor should they necessarily fear the headwinds of an overvalued market. So if the fundamental conditions do not overlay a directional bias, what's likely ahead of us in the near-term? IN-A-ROWS Although P/E is near fair value for the long-run, the stock market may be vulnerable in the short-run. Long-term secular stock market cycles are punctuated by short-term cyclical cycles. This leads to the second major point of this discussion—the current run in the market is nearing its typical limit. The market does not always go up in secular bull markets, nor does it constantly go down in secular bear markets. Instead, the market's fluctuations alternate between periods of gains and losses. This is the concept behind "in-a-rows." In-a-row reflects the number of periods in one direction before a reversing period in the other direction. For example, assume that the market goes up in years 1, 2, and 3. Then in years 4 and 5 the market declines. Years 6 through 9 are winners, then year 10 is a loser. In this example, we have a 3 in-a-row, followed by a 2, then a 4, and last a 1. The gain periods are 3 and 4 in-a-row and the loss periods are 1 and 2 in-a-row. There may not be cause and effect explanations for longer gain periods and shorter loss periods. Nonetheless, if we find that the pattern repeats over time, there is at least a propensity worth recognizing. If gains have always been 3's and 4's while losses were always 1's and 2's, then what should we expect for the future? We certainly can't and shouldn't bet the farm on a second year gain, yet we should recognize that the trend will match its historical limit in year 4…and it'll make history if year 5 is up. Before exploring the actual characteristics of the cyclical cycles inside secular periods, let's review the overall characteristics of secular bulls and bears. Using another weather analogy, secular bull markets are periods like spring. During the spring, daily high temperatures generally rise. Today's high is not always higher than yesterday, but the trend is upward. That's analogous to what the stock market experienced in the 1980s and'90s, a generally rising trend across the two decades. Secular bear markets are periods somewhat like winter. During much of winter, the daily highs fluctuate without a general trend. The general declines of fall have ended and the general increases of spring have yet to arrive. That's analogous to what the stock market experienced over the past decade and during most of the 1960s and the 1970s. Each type of secular period reflects different characteristics. During secular bull markets, when the trend is generally rising, the up-periods tend to last longer than the downs. Based upon annual data, the average cumulative gain during cyclical cycles in secular bull markets is 100% before the next down period, which averages a loss of just over -6%. As a result, the short-term cycles in secular bulls deliver net returns of 87% on average (the length and number of ups and downs vary, so the averages can't be used to calculate the net). During secular bear markets, when the market is generally flat and choppy, the duration of the up-periods and down-periods are somewhat similar. Further, although the average cumulative gain during cyclical cycles in secular bear markets is 42% and the average loss is -29%, the power of losses mutes the gains. As a result, the short term cycles in secular bears deliver net returns of 1% on average. Figure 6 reflects the frequency of in-a-rows for combined secular bulls and bears as well as the frequency for each type of market. To illustrate, 41% of the time across all years from 1901 to 2010, the market reversed course during the subsequent year (i.e., if it was up one year, then it was down the next or vice versa; thus, only one year in-a-row either direction before reversing direction). Figure 6. Cyclical Cycles Within Secular Stock Market Cycles Figure 7. Cyclical Cycles Within Secular Bull Markets During secular bulls, one-in-a-rows occurred half the time compared to approximately one-third of the time for secular bears. Secular bears, however, tend to have a profile that is more concentrated into shorter durations, while secular bulls tend to have longer runs. It may be surprising to see that secular bulls have so many one-in-a-rows, especially compared to secular bears. That is where the details are revealing. All declines in secular bull markets (nine of them) have lasted only one year. In contrast, the short-term bull runs generally stretch over five years (and one lasted nine years). After two or three years of gains, it's still reasonable to expect another year or more of gains (especially if the cumulative gains have been modest). Figure 8. Cyclical Cycles Within Secular Bear Markets In secular bear markets, the gains most often last two years—with the other in-a-rows split evenly between one and three years. The losses last a year about half the time, with declining frequency out to four years. So where are we now? The past two years were up, 19% and 11% respectively. Cumulatively, that's 32%. The historical average cumulative gain for cyclical cycles in secular bear markets is 42%. Therefore, after two consecutive up-years, if this year ends with gains, it'll add another mark to the three-in-a-row column. For 2012, assuming a gain this year, an up-year would make history. As for today's perspective, the Dow is near 12,500. When we add this year's gain to the cumulative gain last year, we're up 42% for this cyclical cycle (exactly the average of past up-year runs in secular bear markets). This is not a prediction that the market is reaching its top, but it is a reflection that this cycle has not only duration but also magnitude. CONVERGENCE TO CONCLUSION By the end of this year, the earnings cycle is likely to be well above its typical thresholds of duration (certainly into the second half of the game) and magnitude (well beyond the upper 10% threshold and at record levels). Although earnings could again rise in 2012 without making history (especially if there are shortfalls to the gains in 2011), the magnitude of excess margins portends a fairly significant decline when the earnings cycle reverts. In addition, the profile of cyclical cycles in the stock market may have also run its course. The market may sustain or extend its gains for 2011 by year-end, but another up-year in 2012 would make history. Not only is duration stretched, but also the magnitude of cumulative gains has now matched the historical average. In the longer-run, over this decade for example, the fundamental drivers of stock market returns will provide total nominal returns of 6% or less compounded annually. The current level of normalized valuation (P/E) provides dividend yields near 2%, earnings growth of less than 4%, and little room for P/E expansion. Should the inflation rate rise over the next few years, thereby increasing the nominal growth rate of earnings, the resulting decline in P/E will more than offset it. The probable outcomes for the stock market over this decade, using your assumptions and outlook for key variables, are the subject of recently-released Probable Outcomes: Secular Stock Market Insights ( www.ProbableOutcomes.com). In the shorter-run, the drivers of cyclical cycles will continue to provide investors with a dramatic spectacle. For those seeking investment success, their investment approach must change with the market environment. The approaches that work in secular bull markets fail in secular bears. Secular bear markets are more demanding. They require diversification, skill, and active portfolio management. With two major market factors converging on the horizon, is your portfolio positioned to resist the risks while still participating in the opportunities? Ed Easterling is the author of recently released Probable Outcomes: Secular Stock Market Insightsand award-winning Unexpected Returns: Understanding Secular Stock Market Cycles. Further, he is President of an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU's Cox School of Business where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students. Mr. Easterling publishes provocative research and graphical analyses on the financial markets at www.CrestmontResearch.com.

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Outside the Box is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.JohnMauldin.com. Please write to johnmauldin@2000wave.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.JohnMauldin.com. To subscribe to John Mauldin's e-letter, please click here: http://www.frontlinethoughts.com/subscribe To change your email address, please click here: http://www.frontlinethoughts.com/change-address If you would ALSO like changes applied to the Mauldin Circle e-letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request to wave@frontlinethoughts.com. To unsubscribe, please refer to the bottom of the email. Outside the Box and JohnMauldin.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin's other firms. John Mauldin is President of Business Marketing Group. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. 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Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. 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WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investorâs interest in alternative investments, and none is expected to develop. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273.

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