Fwd: The End of QE2? - John Mauldin's Weekly E-Letter

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The End of QE2? By John Mauldin | March 18, 2011
In this issue: New York Times Bestseller The End of QE2? Producer Prices Up 35-40% in the Last Six Months What Happens When We Come to the End of QE2? London, Malta, Milan, Zurich, Salt Lake, and New York
What happens when the Fed is finished with QE2? I have been letting that filter into my thinking lately as I look at the economic landscape and the data we have seen the past few weeks. Correlation is not causation, as I often say, but all we can do is look back at what happened last time and speculate about the future. A very dangerous occupation, but your fearless analyst will plunge on ahead into the jungle of a very hazy future. You come with me at your own risk! New York Times Bestseller Quickly, a big Mauldin thanks to those who already bought my book, Endgame, as it made the New York Times bestseller list yesterday, earlier than I thought it would. That would be my 4th, and that and my kids are about my only small claims to fame. I have ruthlessly promoted the book to you, and so this week I resist my inner promotional demon and simply provide a link to http://www.amazon.com/exec/obidos/ASIN/1118004574/frontlinethou-20 where you can read the reviews and buy the book if you have not, or get it in your local stores. At the end of the letter, I note that I will be at a book launch party in London Monday evening, and would love to have you stop by. Details below. And now to this week's letter. The End of QE2? The Fed committed to buying $600 billion of Treasuries between the beginning of QE2 in November and the end of June. June is 3 months away. What will happen when that buying goes away? The hope when QE2 kicked off was that it would be enough to get the economy rolling, so that further stimulus would not be deemed necessary. We'll survey how that is working out, with a quick look at some recent data, and then we go back and see what happened the last time the Fed stopped quantitative easing. First, the guy on the street is getting squeezed. Real US consumer spending slowed in January and looks like it did only marginally better in February. The Fed argues that inflation is mild, as they prefer to look at "core" inflation (inflation without considering food and energy). If you look at it that way, they are right. And in normal times, I can kind of see why we strip out energy and food, as they are very volatile price points and can move a lot from month to month. But that argument gets a lot weaker when your main policy, that of significant quantitative easing, is perhaps CAUSING the rise in food and energy (as well as weakening the dollar)! If the Fed policy is at least contributing to the cause of total inflation, arguing that food and energy don't count doesn't hold water. Let's look at the following chart from economy.com. In particular, notice the rise in the last three months since the beginning of QE2. Inflation is running at over 5% on an annualized basis. Companies like Kimberly (diapers, etc.), Colgate, P&G, and others all announced 5-7% price increases this week. These are companies that provide staples we all buy. Those prices matter. Even Wal-Mart will have to pass those increases on. To say that food and energy don't matter misses the point. These items have real economic impact. As my friend David Rosenberg wrote this morning: "In February, there was no inflation at all in average weekly wage-based earnings but there was 0.5% inflation in consumer prices, meaning that real work-related income was crushed 0.5% and has now deflated in each of the past four months and in five of the past six months, during which it has contracted at a 2.3% annual rate. Once the effects of fiscal stimuli wear off, this negative income trend will show through in a much more visible slowing in real consumer spending that we doubt the markets have fully discounted. So far, what has happened in equities has been treated as a financial event – just wait until the economic event follows suit. And it's not only fiscal stimulus that is soon to subside. We still have that 86% correlation over the past two years between movements in the Fed balance sheet and the direction of the S&P 500 – this too will come home to roost before long, whether or not we end up seeing a resolution to the crises in Japan, Libya or Bahrain." He goes on to give us this chart: How's that QE2 thingy working for you, Mr./Ms. Average Worker? Prices up, income down? And remember, most workers got the equivalent of a 2% pay hike with the temporary boost in Social Security, which goes away at the end of the year (and without which the economy and consumer spending would be even worse!). Maybe that's why New York Fed Chief William Dudley got heckled this week. (Courtesy of the Agora 5 Minute Forecast:) "Dudley – a 21-year vet of Goldman Sachs – stepped out of his bubble to explain Fed policy to real people in Queens. "It might not have been the first time Dudley attempted to gain the trust of the hoi polloi, but we're pretty sure it'll be the last. The details here were reported widely. We divined the scene from a Reuters report. "First Dudley swore up and down that inflation was no problem. 'When was the last time, sir,' came a reply from the audience, 'that you went grocery shopping?'" "Dudley boldly proceeded to explain the concept of 'core CPI' – the cost-of-living measure designed for people who don't eat or consume energy. Heh, we know firsthand how well that goes over… "Then in a brilliant stroke, he pointed to Apple's shiny new iPad 2 to illustrate his point. 'Today you can buy an iPad 2 that costs the same as an iPad 1 that is twice as powerful,' he gamely explained. 'You have to look at the prices of all things.' "'I can't eat an iPad,' someone yelled from the crowd." Ouch. (For the record, I do go to the grocery store and Wal-Mart and Home Depot, as well as other less frugal venues.) And core inflation may soon be under pressure. There were two articles yesterday, one from Yahoo and the other on Bloomberg. Both related to rising pressure on rental costs. (My recent lease renewal increase was significantly above core CPI!) (From http://realestate.yahoo.com/promo/rents-could-rise-10-in-some-cities.html) "Already, rental vacancy rates have dipped below the 10% mark, where they had been lodged for most of the past three years. 'The demand for rental housing has already started to increase,' said Peggy Alford, president of Rent.com… By 2012, she predicts the vacancy rate will hover at a mere 5%. And with fewer units on the market, prices will explode." Look at this graph showing their projections: Here's what to pay attention to. Notice that since 2002 (or thereabouts) rental costs have been flat, and down of late (inflation-adjusted). If Rent.com projections are anywhere close, we could see a rise in rents of 15% by the end of 2012. Let's remember that 23% of the CPI and 40% of core CPI is Owner Equivalent Rent. If they are right, that adds about 3% to total CPI and 6% to core CPI! Will the Fed be telling us to focus on core inflation in 12-18 months? And those prices will start to show up steadily. "This is a sharp change from the recession, when many Americans couldn't afford to live on their own. More than 1.2 million young adults moved back in with their parents from 2005 to 2010, said Lesley Deutch of John Burns Real Estate Consulting. Many others doubled up together. "As a result, landlords had to reduce prices and offer big incentives to snag renters. Now that the recession is easing, many of these young people are ready to find new digs, mostly as renters, not owners. Plus, the foreclosure crisis continues unabated, and the millions losing their homes are looking for new places to live." Producer Prices Up 35-40% in the Last Six Months Then let's look at business. The Producer Price Index was out this week, and it was way up – 1.6% for the month, or an annualized 20%+. Even if you look at the last year, it was up a real 5.8%. That is inflation in the pipeline. Look at this chart from economy.com. Notice the trend since QE2 was announced in August and implemented in November. I won't bore you with the details, but for those interested, go to www.bloomberg.com and search for "Japan supply issues" and further on "semiconductors." It is clear that, at least for a while, prices of electronics and tools are going to rise as one company after another is shutting its production lines down in Japan. Auto manufacturing plants in the US will have to close soon, as critical parts from Japan are not going to be forthcoming. Flat screen TVs? The iPad 2 I keep trying to find? All sorts of companies are going to get their costs squeezed even further. Remember, the above PPI numbers are from before the Japanese earthquake and tsunami and nuclear disaster. (I was in Tokyo less than two weeks ago. I can't imagine the stress and anguish going on there. The scope of the disaster is just shattering. I encourage my readers to go to http://american.redcross.org and donate directly to their Japanese fund or the charity of your choice. A few details from Japan, though, gleaned from here and there. Sony alone makes 10% of the world's laptop batteries. Japan is responsible for 30% of global flash memory, 20% of semi-conductors, and 40% of electronic components. The point is that the Fed has created real pressure in the price pipeline, primarily on basic commodities and energy. "Crude" goods, which is basically materials before there is any value added, are up 28% from a year ago and pushing an annualized 35-40% for the last six months. Those costs are filtering in to final finished products. And when you add in the supply-related problems from the recent disaster? It is not a pretty picture for profits. Let's go back and look at a graph from friend Vitaliy Katsenelson, from a few weeks ago. It points out that corporate profits are back close to all-time highs as a percentage of GDP. As the brilliant Jeremy Grantham says, and I am paraphrasing, corporate profits are among the most mean-reverting of all statistics. And this makes sense unless capitalism is broke. High profits entice competitors to come in and take market share by selling for less. If corporate profits went back (mean-reverted) to their longer-term average, P/E ratios would be close to 24 at today's prices. Corporations have some room to absorb some price increases, but at the expense of the bottom line. What Happens When We Come to the End of QE2? We have only one instance where the Fed cut back on quantitative easing, and that was last year. It is a data set of one, but it is all we have. So, let's look at what happened. As noted by several sources (but I am looking at Rosie's list right now), the Fed let its balance sheet contract by some 12% from late April to late August. Quoting: "Now over that interval ... "The S&P 500 sagged from 1,217 to 1,064…. The S&P 600 small caps fell from 394 to 330…. The best performing equity sectors were telecom services, utilities, consumer staples, and health care. In other words — the defensives. The worst performers were financials, tech, energy, and consumer discretionary…. Baa spreads widened +56bps from 237bps to 296bps… CRB futures dropped from 279 to 267…. Oil went from $84.30 a barrel to $75.20…. The VIX index jumped from 16.6 to 24.5…. The trade-weighted dollar index (major currencies) firmed to 76.5 from 75.5…. Gold was the commodity that bucked the trend as it acted as a refuge at a time of intensifying economic and financial uncertainty — to $1,235 an ounce from $1,140 and even with a more stable-to-strong U.S. dollar too…. The yield on the 10-year U.S. Treasury note plunged to 2.66% from 3.84%…" What will happen this time around? Is the economy strong enough to grow on its own without stimulus, or strong enough that the Fed will be reluctant to continue with QE3? My friends at Macroeconomic Advisors have reduced their first-quarter GDP projection to 2.5%. Morgan Stanley has dropped theirs from 4.5% less than six weeks ago to 2.9% today. That is a huge drop in a short time for a forecasting model. Forecasts at other economic shops are being slashed as well. States and local governments, as I have continuously noted, are cutting more than 1% of GDP from their budgets as I write. That translates into real-world pressure on the GDP (even if it'stemporary, which I believe it to be, we live in the present). I am not ready to use the "R" word, but Muddle Through could show up with a true vengeance this summer, with higher inflation and slower growth. I lived through the '70s, and frankly, I would just as soon not go see that movie again. The danger here is that the Fed (Bernanke) watches the economy slow and decides we need another round of quantitative easing. I have resisted that idea but, as I have noted, sometimes we need to think about the unthinkable. And thus, I come to the end of the letter with a brief note on a very worrisome conversation I had yesterday with Martin Barnes, editor of the esteemed Bank Credit Analyst. Martin is one of the people I call when I want to know what the Fed might do. I guess I was looking for assurance that the Fed would not do QE3. I did not get it. "Look, John" (insert Scottish brogue as I paraphrase), "if the Fed sees the economy rolling over into recession they will put their mandate for employment ahead of their mandate for stable prices." "But that would mean higher inflation in the face of a slow economy." "And?" he shot back. "That would just be the price of trying to increase employment, in their minds." "But at some point you have to bring out your inner Volker!" I intoned. "What about the future?" The conversation continued, but I never got my warm and fuzzy assurances. For the record, another round of QE, unless there is a true liquidity crisis (and the last QE did not qualify!), would be a disaster, at least from the cheap seats where I sit. There are all sorts of inflationary and stagflationary consequences, none of which I like. Brief plug: This April, at my Strategic Investment Conference, the first two questions that each speaker will get at the end of their presentation will be, first, "What will happen when QE2 goes away?" and second, "Under what conditions will the Fed launch QE3?" I will pose them to Martin Barnes, Marc Faber, Niall Ferguson, Louis-Vincent Gave, Paul McCulley, David Rosenberg, and Gary Shilling – and John Paulson has agreed to speak as well! They will be joined by Neil Howe (The Fourth Turning, and demographics guru) and George Friedman of Stratfor, as well as your humble analyst and Altegris partner Jon Sundt. I mean, really, is there a conference anywhere this year that has a line-up that powerful? The conference is April 28-30 in La Jolla. It is filling up fast. You can register at https://hedge-fund-conference.com/2011/invitation.aspx?ref=mauldin. Sadly, it is for accredited investors only, but I will report back to you the answers from the speakers to those questions. London, Malta, Milan, Zurich, Salt Lake, and New York I am off to London tomorrow. I will be guest hosting Squawk Box on CNBC London at 7 AM (gasp!), then do various meetings, and that night will be with co-author Jonathan Tepper for our book-launch party at the Mint Hotels - Tower of London Hotel, 7 Pepys Street, City of London. If you can, RSVP to endgame@variantperception.com so we can have some idea of how many are coming. I know, last minute and all, but that's my life! The next day I fly to Malta for board meetings, then on to Milan for a public presentation, then on to Zug and Zurich, before heading back. The next weekend I am off to Salt Lake for CMG partner Steve Blumenthal's 50th birthday bash, then to NYC on Sunday for three days of media and meetings. I will update you with the media schedule next Friday, but right now I know I am on Fast Money for the first time on Monday the 4th. That should be interesting. I am a little slower than those guys, but maybe they can slow down for the old man. The Japanese disaster has gotten to me more than most similar tragedies. Maybe it is because I was there less than a week before the earthquake. Maybe it is the thought of all those elderly people who have lost everything, with no place to go back to, and enduring horrible weather conditions. I have had letters from readers who have friends there, and the stories they relate show a nation that has energy problems, with gas rationing, and that means that trucks have a hard time delivering food. Empty shelves are the norm, and reports of people running out of food keep coming to me. For whatever reason, it has me thinking about how fragile life is, how short our time is, and how I need to focus on the important things, like family and friends. I do enjoy the business and my work (maybe too much!), but I need to make sure there is balance, as do we all. The Japanese are a resilient people and will rebound, but they could use our help. Again, think about giving to the Red Cross or your own favorite charity. And let's pray that they can figure this nuclear thing out soon. Your getting on yet another airplane analyst, John Mauldin John@FrontlineThoughts.com Copyright 2011 John Mauldin. All Rights Reserved
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Fwd: Game Changer - John Mauldin's Outside the Box E-Letter

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From: John Mauldin and InvestorsInsight <wave@frontlinethoughts.com>
Date: Tue, Mar 15, 2011 at 12:18 AM
Subject: Game Changer - John Mauldin's Outside the Box E-Letter
To: jmiller2000@gmail.com

	Contact John Mauldin Print Version Download PDF Volume 7 - Issue 11 March 14, 2011 Game Changer By Ed Easterling This week we look at another except from Ed Easterling's gonzo book on stock market return projections, called Probable Outcomes. This section is entitled "Game Changer," and it is that and more. (Again, thanks to Ed for letting us read his work!) "Game Changer" is a thought-provoking, somewhat detailed analysis, with two major surprises. The first is that GDP growth was well below average last decade (a trend that could continue this decade); and second, slowing growth has a substantial negative effect on valuations (P/E ratios). This ties well into my own Endgame and suggests implications about slower growth, etc. (similar to what I project from work of my own). Slower growth drives P/Es lower (even without higher inflation, or deflation) and could drop the market by a third or so relative to "normal" cycles. Ed and I talk about this a lot, and agree that readers must understand Endgame to appreciate how significant "Game Changer" can be. Probable Outcomes complements Endgame with specific implications for investors and policy makers who look to the stock market for returns over this decade. Just another quick plug for Endgame from a review on Amazon: "Endgame: 'The final stages of an extended process...' The aptly chosen title for Mauldin's new book reflects the vision that he started sharing over a decade ago when he foresaw the Muddle Through Economy (he repeatedly warned about Muddle Through in his free weekly newsletter at Thoughts from the Frontline and in his best-selling books). "In Endgame, Mauldin and Tepper detail the history of events that layered increasing debts on an underperforming economy. Their analysis is not limited to the U.S., but rather walks around the world highlighting a global issue. Mauldin again demonstrates his laudable ability to synthesize vast amounts of information into relevant nuggets. The first half of Endgame lays the foundation brick-by-brick, including a look at the basics of economics and recent research to understand the situation. The second half of the book proceeds country by country laying out the common and unique problems that they confront. It exposes a world of vulnerability, but not one that is hopelessly destined. Mauldin and Tepper are optimists, and present a call to action that can result in a successful endgame. "Once again, as another decade starts, Mauldin assembles a plethora of data and charts to deliver information that investors, policy makers, and involved citizens need to better understand and act upon. From the classic principles of Minsky to the modern groundbreaking research of Reinhart and Rogoff, Mauldin explains clearly the credible scenario that the burdens from mountains of debt create another decade or longer of Muddle Through as a process rather than an event. Passage through the vestibule of the endgame requires restitution in the forms of deflation, inflation, volatility, and slow economic growth. Despite the headwinds, endgame need not be game-over – which appears to be Mauldin's personal game plan for his new book. He includes writings to his children that their future can be much brighter than the current period that we confront. Knowledge is power and you'll find both in Endgame." You can get the book at Amazon or Barnes & Noble. And enjoy "Game Changer"! Your writing away analyst, John Mauldin, Editor Outside the Box Game Changer An Excerpt from Probable Outcomes: Secular Stock Market Insights By Ed Easterling Copyright 2010, Crestmont Research Well-recognized and published statistics tell us that the long-term return from the stock market has been 10%. The reality is that the 10% average reflects the combination of periods with above-average returns and those with below-average returns. These periods, however, are not random sets of over and under. Rather, the stock market experiences these periods based upon fundamental conditions in the economy and the financial markets. Further, the conditions are recognizable, and therefore stock market returns are relatively predictable over extended periods of time. These periods are known as secular stock market cycles. The term "secular" is derived from a Latin word that means an era, age, or extended period. Actually, an original Latin variation of the word has been closer to hand than most people realize. On the back of the American one-dollar bill is the Great Seal of the United States. One part of the seal is the circle on the left-hand side bearing a pyramid topped with an eye. Look closely under the pyramid: there is a banner with the phrase "novus ordo seclorum." In 1782, Charles Thomson, a Founding Father of the United States, and secretary of the Continental Congress, worked as the principal designer of the Great Seal. There is extensive symbolism included in the seal. When Thomson proposed the seal to Congress, he described the meaning of novus ordo seclorum as "the beginning of the new American Era." When the word "secular" is used to describe stock market cycles, it expresses that the cycle is an extended period with something in common throughout. Secular bull markets are extended periods that cumulatively deliver above-average returns. These periods are driven by generally rising multiples of valuation as measured by the price/earnings ratio (P/E). Secular bear markets are the opposite: extended periods with cumulative below-average returns driven by a generally declining P/E for the market. Thus the secular aspect of these periods relates to the generally rising or falling trend in P/E over an extended period of time. P/E is the price of the market divided by the earnings of the market. Investors and analysts often apply to individual stocks the same formula used for the market. This valuation multiple essentially represents the number of years' worth of earnings that investors will pay for the investment. During certain conditions, typically when the inflation rate is low and interest rates are low, investors are willing to pay higher prices measured as a multiple of earnings for the market and for stocks in general. When inflation and interest rates are high, or when deflation (negative inflation) occurs, investors are driven to pay lower prices and multiples for the market. Probable Outcomes goes deeper into the financial reason for those decisions. At this point, it is important to remember that the stock market moves through periods of above- and below-average returns—known as secular stock market cycles. The secular cycles are graphically visualized in figure 2.1, reflecting the secular bull market periods (green bars) and secular bear market periods (red bars). The blue line below the bars reflects the cycle of the P/E ratio that drives the green-bar and red-bar periods. Figure 2.1 Secular Stock Markets Explained Link: Secular Stock Markets Explained The most significant aspects to note in this chart include the variability in time over which secular cycles occur. Some cycles were relatively short, while others lasted close to two decades. This graph also begins to gives us a sense that returns come in spurts rather than a more consistent uphill grind around an average that some people incorrectly believe is normal. In particular, note the blue line on the lower part of figure 2.1, reflecting P/E and its cycle over more than a century. The historical range within which P/E has cycled has been relatively consistent: generally with lows that were near 8 and highs in the low to mid-20s (except, of course, the late 1990s bubble). The historical average has been near 15, depending upon the method and time period used. Foremost, keep in mind two key points. The range of the P/E cycle, as established by the highs and lows, is largely determined by the real growth rate of earnings. The relative position of P/E within the range is what has been determined by the level of inflation and its trend. Pop Quiz Before venturing further into the discussion about the P/E cycle, pause a moment for a pop quiz to highlight the previous point about the effect of economic growth on P/E. There is new information that could actually make it different this time! Beyond the insights from the question and its answer, this will start the journey toward the potential scenarios for the economy over this decade and the implications for stock market returns. Over the past century in the United States, real economic growth before inflation has averaged near 3% per year. Over the decades of the 1970s, 1980s, and 1990s, the compounded average annual growth rate was 3.2%, 3.0%, and 3.2% respectively. So during the decade of the 2000s (2000–2009), when consumers were loading up their credit cards, homeowners were said to be using home equity like an ATM, unemployment averaged 5.5% and fell below 4% at times, and leverage was being added to leverage, what was the compounded annual growth rate before inflation rounded to the nearest percent? The first choice, 4%, is the most logical response. It reflects the perception that much of the consumption and leverage artificially accelerated economic growth. People that choose 4% expect that the factors in the question boosted economic growth above the historical and recent average growth rate. Following such a strong period of economic growth, most people answering "A" expect a period of below-average growth over the 2010s to make up for the excesses of the prior decade. They expect that periods during which growth was fueled by debt will be followed by offsetting moderation as the vestiges of leverage and excess consumption are addressed. The second choice, 3%, is the contrarian response. It reflects a belief that this time was not different. Though some of the factors included in the question may have impacted economic growth, people who choose 3% either don't believe that those factors had much effect, or presume that there may have been similarly unique factors during prior decades. Nonetheless, economic growth of 3% has endured for more than one hundred years and has been very consistent in recent decades. Some people in this group believe that 3% is likely for this decade, while others have begun to adopt the notion of a New Normal with slowing growth due to recent trends in demographics, government policy, taxes, etc. The third choice, 2%, is the correct response, despite being least selected. Many investors are surprised that the decade of the 2000s experienced compounded annual growth of only 1.9%. Some economists say that it was a decade sandwiched by two recessions, while others blame it on the severe recession of 2008 and the related financial crisis. Yet excluding the recession of 2008 from the decade, the growth rate for the first eight years of the 2000s was still only 2.6%. Further, cumulative economic growth throughout the decade of the 2000s did not exceed 2.7%. It would have required an unusual surge—near 4.5% annually—in the final two years for the full decade to reach the historical average annual growth rate of near 3%. This sets the stage for a dilemma. Will the decade of the 2010s restore the long-term average by growing at 4%, thereby defying the predominant belief of a slow-growth decade? Was the prior decade of the 2000s an anomaly, with future economic growth simply returning again to its long-term trend of 3%? Did something change ten years ago, and has economic growth downshifted to a level near 2%, or as some might contend, could the rate be even lower due to the economic, financial, and/or policy headwinds in front of us? All three scenarios are plausible, which makes economic growth Major Uncertainty #1. The answer to the dilemma has very significant implications for stock market returns over this decade and longer. Game Changer Probable Outcomes explores the possibility that future real economic growth, excluding inflation, may have downshifted from its historical trend of 3%. This major issue has not often been considered. In the past century, real economic growth has increased at slightly more than 3% annually. As a result of the relationship between earnings and the economy, EPS has increased at near 3% in real terms. Therefore the range of the past P/E cycles has been driven by real growth near 3%. That level of growth has been considered a standard assumption. The recent decade and other factors are now challenging that assumption for the future. One effect of slower economic and earnings growth is a lower level of earnings in the future. For example, over ten years, $1.00 compounds to $1.34 at 3%, but only to $1.22 at 2%. The difference is about 9.3% less EPS for the stock market under the slower growth scenario. Many analysts would consider that level of variance a minor forecasting error for EPS over a decade. Whether the stock market is 9% higher or lower in a decade is generally small change in the context of overall returns. But the implication of slower growth is far more significant than simply the ending level of earnings. Slower growth is a game changer. There are three ways to assess its effect, all of which provide similar results. First, an extremely long-term model of earnings growth, dividend payouts, and present value can be constructed to assess the impact of changes in growth on P/E. Second, the academic formulas can be used to derive the effects on P/E based upon perpetual dividend growth. Third, the impact on P/E can be evaluated through the components of stock market return. Since all three approaches reflect comparable results, the more pragmatic third approach will be used to explore the implications. Before examining the details, consider the significance of the issue. If the future growth rate of earnings decreases by 1% (i.e., near the reduction that would be expected if economic growth decreases by 1%), the historical average for P/E would decline from 15.5 to 11.5—representing a 26% decline in the stock market beyond the 9% shortfall from lower earnings growth. More dramatic, the typical peak in P/E falls from the low to mid-20s to the mid-teens; the adverse impact of slower growth increases at higher levels of P/E. As previously discussed, inflation causes P/E to decrease because investors demand more return to compensate for higher inflation. Unlike the inflation rate, the growth rate of earnings does not necessarily change the return level that investors expect. They will still expect returns that are commensurate with the stock market and the expected inflation rate, but they will look to replace the contribution of slower earnings growth with another source of return. To illustrate, assuming that a change in the growth rate does not change the inflation rate, the yields on government bonds can be expected to remain the same. Absent a change in credit quality from slower growth, the risk premium within corporate bond yields would not change. Likewise, the expected return from stock market investments can be expected to remain unchanged due to the growth rate. When slower growth reduces the contribution of earnings growth to total return, another source of return is therefore needed to fill the shortfall. Stock market investors will not be willing to take equity risk without appropriate equity returns. If bond yields do not change, they will not compromise stock market returns. In this situation, stock market investors will step away until the price of the market declines to again provide appropriate returns. This is the function of markets—finding the price that provides a fair return. This discussion relates to the effect from changes in the growth rate of earnings. To isolate that factor, several assumptions are needed, basically providing that the relevant relationships remain the same. First, based upon the previous economics discussion, a downshift in economic growth drives slower earnings growth. Second, long-term profit margins remain similar under both growth scenarios, thus the slowing of earnings growth is consistent with the downshift in economic growth. Third, the inflation rate remains constant across both scenarios for growth. Fourth, the expected return for stocks and bonds as well as the related equity risk premium for stocks does not change across both scenarios for growth. In other words, the relevant relationships remain the same. Of the three components of stock market returns, two are available as sources of return, and the third one represents the way in which returns occur. The first source of return, EPS growth, is defined in this example as either providing 3% or 2% toward to the total return. As a result, the second source of return, dividend yield, will need to increase to compensate for lower earnings growth in the second scenario. Herein is the role of the third source of stock market returns: changes in P/E. The dividend yield rises as P/E declines and vice versa. For the stock market to be positioned to provide equity-level returns, investors will look for the lower price that enables the dividend yield to rise sufficiently to offset the loss of earnings growth. The required decline in P/E varies based upon the starting level of P/E. If P/E starts relatively high, then a higher decline is required to provide the required dividend yield increase. For example, if EPS growth drops by 1%, then the change in P/E required to increase the dividend yield by 1% is 7 points from 22 to 15, 4 points from 15.5 to 11.5, and 2 points from 10 to 8. This shift in P/E relates only to the change in earnings growth. P/E would then be further affected by changes in the inflation rate. There will likely be, and needs to be, much debate about the accuracy of the estimates presented above, and about nuances that could add decimal points to the factors, or adjust the effects based upon further scenario assumptions. However, whether using long-term models, academic formulas, or the component-based method, all three approaches provide similar results. It is therefore important to recognize that slower growth will have a significant impact on P/E at all levels of the inflation rate. As the discussion evolves into implications and probable outcomes over this decade, slower economic and earnings growth will have a direct effect on the P/E range. In closing, P/E is a measurement tool for market valuation. The level of P/E, driven by the principles of present value, reflects the price at which the stock market can deliver sufficient returns to compensate for inflation and risk. P/E is driven lower when conditions of inflation change the outlook for required returns. In addition, P/E declines when deflation changes the outlook for the level of future earnings. Of particular note, slower long-term economic and earnings growth reduces future cash flows and drive P/E lower. Conditions of solid long-term earnings growth and low inflation therefore provide the best conditions for a high P/E. In an environment where economic growth and the inflation rate are major uncertainties, an accurate and valid measure of P/E is more relevant and needed than ever before. Rainbows Investors are confronting the reality of the current secular bear market. It is both the consequence of the previous secular bull market and the precursor to the next secular bull. The duration of the current secular bear period is uncertain. Should inflation or deflation overcome the economic environment in the near term, this secular bear could end sooner. That reality, however, would cause significant losses to stock market portfolios. If inflation or deflation slowly creeps into the economy, over the next decade for example, then this secular bear will have been one of the longer ones. However, if this decade repeats the relatively low inflation of the past decade, then the secular bear should remain in hibernation. Beyond the inflation rate, economic growth also will have an impact on the future of this secular bear. Following last decade's below-average economic growth, this decade could generate above-average growth to offset the recent shortfall. The result would be a solid boost to earnings in this decade. Economic growth, however, also could have downshifted during the last decade to a lower level for the foreseeable future. The result would be a significantly lower range of P/Es, but not necessarily a progression through the secular bear market. The economic growth rate can shift P/E upward or downward, but only inflation or deflation can end a secular bear market. Whether this secular bear cycle ends in five years, ten years, or beyond, the result will be the start of the next secular bull market, which will bring an extended period of above-average returns. Spring finally will have sprung. This longer-term view of secular stock market cycles is the reason to look out across this secular bear to the next secular bull. The operative word is "across" this secular bear and not "past" it. "Across" recognizes the reality of the risks and opportunities presented by secular bear markets. "Past" is the ostrich-like approach of ignoring reality with blind hope for an unrealistic outcome. "Across" is enabling, while "past" is disabling. For investors who are accumulating for the future, secular bear markets are times to build savings for later investment. This is done not only through contributions but also through prudent investing with an absolute return approach to investment returns. The absolute return approach uses the dual strategy of risk management and investment selection. Investment portfolios should be diversified across a range of investments that are diligently selected and actively managed, especially ones that control risk and enhance return. In particular, investors should not avoid the stock market or bond market. Instead, their objective should be to seek in both markets investments that incorporate elements of skill to enhance returns. Secular bear markets are not periods during which to avoid investing; they are periods that demand an adjustment to investment strategy. For investors who are more dependent on their current assets, including pension funds and retirees, investment strategy should be paired with early recognition. The principles of absolute return investing are important for preserving capital and generating much-needed returns. But potentially more important than managing the investment portfolio, pension funds and retirees would be well served in this environment to manage their assumptions and expectations. Earlier recognition of secular bear market conditions enables potentially painful adjustments to be smaller. Delaying action until crisis has onset generally brings greater adverse consequences. It is not prudent to hope for the next secular bull market to arrive sooner as a way to address shortfalls. The longer expectations take to adjust, the greater the gap to fill with an increasingly short time to fill it. John F. Mauldin johnmauldin@investorsinsight.com You are currently subscribed as jmiller2000@gmail.com. To unsubscribe, go here. Reproductions. If you would like to reproduce any of John Mauldin's E-Letters or commentary, you must include the source of your quote and the following email address: JohnMauldin@InvestorsInsight.com. Please write to Reproductions@InvestorsInsight.com and inform us of any reproductions including where and when the copy will be reproduced. Note: 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. 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