Economicus Terra Incognita
By John Mauldin
“The most reliable way to forecast the future is to try to understand the present.”
John Naisbitt
“We really can’t forecast all that well, and yet we pretend that we can, but we really can’t.”
– Alan Greenspan
Welcome to 2016. Tradition dictates that you spend the first few weeks or so reading forecasts for the coming year. I can say with certainty that most of them will be wrong. A smaller number may hit the target. Unfortunately, no one knows which forecasts will fall into which category. 
For the last 16 years my first letter of the year has also been a forecast issue, and I will continue to go with that tradition – but with one major caveat. I do not base my forecasts on mathematical models or some finely honed methodology, but on my sense of where the economic world stands today and where I think it might likely be in the near future.
Actually, I’m going to spend the first few pages demonstrating that the mathematical models used to forecast GDP and all sorts of interesting economic events are basically nonsense.
For me, forecasting the year ahead is somewhat like being an explorer who comes to the top of a high new mountain pass along with a group of his friends and looks far out in the distance and sees another mountain pass, shrouded in clouds but offering the promise that it’s possible to continue the journey. It is clear to him that they should all forge ahead to find a way to that next mountain pass, but between his location and his destination lie all manner of unknown geographical features, not to mention the prospect of unfriendly natives who may want to contest their passage.
So today, as we crest the mountain pass of a new year, I will look off in the distance and tell you what I see. Let me be clear, though, that I’m not coming back from the future and telling you what it’s like; I am merely hoping to get our general direction right. Some years the path ahead seems remarkably straightforward and clear of obstructions. I can tell you right now that this year the challenges seem particularly fog-shrouded. But what’s an explorer to do but to press ahead?
Before we begin, I want to suggest you mark out time in 2016 to attend my Strategic Investment Conference. This year we’ve moved the event to Dallas. The dates are May 24-27.
I’m proud to say that SIC probably has more repeat attendees than any conference I know. This fact speaks to the care with which my conference team organizes the event and the quality of our speakers. A side effect is that the bar is raised a little each year. Somehow I have to deliver a better-than-ever program year after year – and somehow we’ve always done it.
My goal in designing the agenda is to give you a mixture of old favorites as well as new perspectives. Our confirmed speakers so far (in no particular order) are George Friedman, Mark Yusko, Pippa Malmgren, Charles Gave, Lacy Hunt, Anatole Kaletsky, David Rosenberg, David Zervos, Gary Shilling, Louis Gave, and Neil Howe. We will be confirming several others within the next few weeks. You probably know at least some of those names. If not, you should. Just this initial group is quite a brain trust.
This year I’ve juggled the schedule to give us more time for informal networking opportunities. SIC attracts an impressive group of attendees, and every year I hear from people who made invaluable business contacts at the conference. We are going to be using an app for the conference that, among other cool options, will help you network and find people whose ideas and information will enhance your own life.
Note that this extra “networking” feature is completely optional. (We are still accepting sponsors, too, if your company would like to reach several hundred high-powered investors and money managers from around the world.)
For more information, you can visit the SIC 2016 website. Register by Jan. 31 and you’ll save $500 off the walk-up rate.
Two notes before we start. At the beginning of the letter I am going to launch a few nukes on the banality of making predictions based on models. That is at least the first half of the letter. If you want only my musings on events to look for in the coming year, skip down about halfway.
Second, and VERY IMPORTANT. At least to me. This is the typically the most forwarded letter of the year. If you are reading me for the first time, this letter is free – you can subscribe at by simply entering your email address. And you can get free emails from a brilliant group of writers and analysts who are far smarter than I am, if you choose. The whole team at Mauldin Economics looks forward to serving you.
Now, let’s jump in!
Wall Street Takes the Heat for You
“What will the stock market do this year?” It seems like a simple question. You might wish for a simple answer to it, and think that people who watch stocks for a living should know that answer. Not so. The evidence shows they are no more accurate than anyone else is.
Morgan Housel of The Motley Fool skewered Wall Street’s annual forecasting record in a story last February. He measured the Street’s strategists against what he calls the Blind Forecaster. This mythical person simply assumes the S&P 500 will rise 9% every year, in line with its long-term average.
The chart below show’s Wall Street’s consensus S&P 500 forecast versus the actual performance of the S&P 500 for the years 2000–2014.
The first thing I noticed is that the experts’ collective wisdom (the blue bars) forecasted 15 consecutive positive years. The forecasts differ only in the magnitude of each year’s expected gain.
As we all know (some of us painfully so), such consistent gains didn’t happen. The new century began with three consecutive losing years, then five winning years, and then the 2008 catastrophic loss.
The remarkable thing here is that forecasters seemed to pay zero attention to recent experience. Upon finishing a bad year, they forecasted a recovery. Upon finishing a good year, they forecasted more of the same. The only common element is that they always thought the market would go up next year.
Housel calculates that the strategists’ forecasts were off by an average 14.7 percentage points per year. His Blind Forecaster, who simply assumed 9% gains every year, was off by an average 14.1 percentage points per year. Thus the Blind Forecaster beat the experts even if you exclude 2008 as an unforeseeable “black swan” year.
This data raises plenty of questions, starting with, “Why do investors listen to forecasters who are so consistently wrong?” I have a guess, but let’s first look at Morgan Housel’s answer. (I should note that Morgan is my favorite writer at The Fool.)
The first question is easy. I think there’s a burning desire to think of finance as a science like physics or engineering.
We want to think it can be measured cleanly, with precision, in ways that make sense. If you think finance is like physics, you assume there are smart people out there who can read the data, crunch the numbers, and tell us exactly where the S&P 500 will be on Dec. 31, just as a physicist can tell us exactly how bright the moon will be on the last day of the year.
But finance isn't like physics. Or, to borrow an analogy from investor Dean Williams, it's not like classical physics, which analyzes the world in clean, predictable, measurable ways. It's more like quantum physics, which tells us that – at the particle level – the world works in messy, disorderly ways, and you can't measure anything precisely because the act of measuring something will affect the thing you're trying to measure (Heisenberg's uncertainty principle). The belief that finance is something precise and measurable is why we listen to strategists. And I don't think that will ever go away.
Finance is much closer to something like sociology. It's barely a science, and driven by irrational, uninformed, emotional, vengeful, gullible, and hormonal human brains.
For the most part, I agree with Morgan. Investors want to believe that certainty is possible, that crunching the right numbers or listening to the right guru will reveal what lies ahead.
The idea that markets are inherently messy and disorderly frightens them. It’s much more comforting to think that someone out there has a crystal ball that you just haven’t found yet.
I’ll add a twist to Morgan’s answer. I think what many investors really want is a scapegoat.
The only thing worse than being wrong is being wrong with no one to blame but yourself.
Forecasters keep their jobs despite their manifest cluelessness because they are willing to be the fall guy. Present company excepted, of course.
There used to be a saying among portfolio managers: “No one ever gets fired for owning IBM.” It was the bluest blue chip, one that everyone agreed would always bounce back from any weakness. If IBM made you have a bad year, the boss would understand.
Wall Street strategists serve a similar purpose. If, say, Goldman Sachs forecasts a good year, and it turns out not so good, you will be well-armed for the inevitable discussion with your spouse, investment committee, or board of directors: “I was just following the experts.”
Compare that to the alternative. How does that discussion turn out if you build your own forecasting model and it delivers dismal results?  The story probably ends with you sleeping in the doghouse and/or polishing your resumé.
In the short run, hiring a scapegoat, er, forecaster, seems the path of least resistance.
That’s why so many people choose it. But in the long run, that path leads you nowhere that you want to go. You will be in fine company as you underperform, but underperform you will.
People also look to forecasts that reward their confirmation bias, reinforcing and validating their understandings of markets and investment strategy. Sadly, I must confess that I much prefer to hear a forecast or read analysis that confirms my own biases. Which is one reason I make sure to read the analyses of those who don’t agree with me.
I typically ignore – for good reason, as we will see below – forecasts based on mathematical models. I much prefer the assessments of those who analyze the future in terms of trends and general economic forces, giving us their own sense of direction about the interplay of the complex drivers of the economy. But that’s just me.
Fed Says Fed Forecasts Fail
All right, so if forecasting the stock market is harder than it looks, how about forecasting the economy? Surely the Federal Reserve has a good handle on future growth prospects.
If that’s what you think, prepare to be disappointed.
We can’t say the Fed doesn’t try. In 2007 the Federal Open Market Committee (FOMC) started releasing GDP growth projections four times a year. They do this in the same report where we see the much-discussed interest-rate “dot plots.” It is called the “Summary of Economic Projections,” or SEP.
A 2015 study by Kevin J. Lansing and Benjamin Pyle of the San Francisco Federal Reserve Bank found the FOMC was persistently too optimistic about future US economic growth. They concluded:
Over the past seven years, many growth forecasts, including the SEP’s central tendency midpoint, have been too optimistic. In particular, the SEP midpoint forecast
(1) did not anticipate the Great Recession that started in December 2007,
(2) underestimated the severity of the downturn once it began, and
(3) consistently overpredicted the speed of the recovery that started in June 2009.
So, it isn’t just Wall Street that wears rose-colored glasses – they are fashionable at the Fed, too. Lansing and Pyle provide helpful charts to illustrate the FOMC’s overconfidence.
This first one covers the years 2008–2010.
The colored lines show you how the forecast for each year evolved from the time the FOMC members initially made it. Note how they stubbornly held to their 2008 positive growth forecast even as the financial crisis unfolded, then didn’t revise their 2009 forecasts down until 2009 was underway – and then revised them too low. However, they did make a pretty good initial guess for 2010, and they stuck with it.
The next chart shows FOMC forecasts for 2011–2013.
We see a different picture in this chart. As of October 2009, FOMC members expected 2011 and 2012 would both bring 4% or better GDP growth. Neither year ended anywhere near those targets. Their initial 2013 forecast was near 4% as well. They reduced it as the expected recovery failed to materialize, but as in 2009, they actually guessed too low.
One problem here is that GDP itself is a political construction. Forecasting the future is hard enough when you actually understand what you are forecasting. What happens when the yardstick itself keeps changing shape? You get meaningless forecasts. But this doesn’t stop the Fed from trying.
CBO: We’re Less Wrong Than They Are
If the Fed can’t accurately forecast the economy, can anyone? Surely someone in the federal government has better answers.
The Congressional Budget Office issues forecasts much as the Federal Reserve does. And like the Fed, the CBO grades itself. You can see for yourself in “CBO’s Economic Forecasting Record: 2015 Update.”
Read that document, and you will find the CBO readily admitting that its forecasts bear little resemblance to reality. Their main defense, or maybe I should say excuse, is that the executive branch and private forecasters are even worse.
I’m not kidding. The CBO report includes the following chart. I removed other categories they measure so we can look specifically at their GDP estimates. I should also point out that they cooked the books a little by averaging two-year forecasts to make themselves look better. But even so…
The bars compare the degree of error in forecasts by the CBO, the Office of Management and Budget (OMB), and the private Blue Chip economic forecast consensus. A reading of zero would mean the average forecasts matched reality. A negative number would mean they were too pessimistic. A positive number – which is what we see for all three entities – means they were all overly optimistic on GDP growth.
So, what we see is that the OMB – whose director is a political appointee – was more optimistic than the Blue Chip consensus, which in turn was more optimistic than the CBO, which was more optimistic than reality.
It is also worth noting how the CBO views the future. Their latest economic outlook update, published last August, features this chart.
The forecasts for GDP growth, unemployment, inflation, and interest rates all flatline after 2016. As of now, the CBO’s official position is that the US economy will remain stable with no recession until at least 2025.
If you find this particular prognostication hard to believe, you aren’t the only one.
Nevertheless, this is what the government agency with the best forecasting record says we should expect.
I’ll go out on a limb here and say that the CBO is wrong. I am 100% certain we will have a recession before 2025. We can debate when it will start, what will cause it, and how long it will last, but not whether it will happen.
Economists Are (Still) Clueless
I wrote these next few paragraphs three years ago, but what I said then is still true today.
In November of 2008, as stock markets crashed around the world, the Queen of England visited the London School of Economics to open the New Academic Building. While she was there, she listened in on academic lectures. The Queen, who studiously avoids controversy and almost never lets people know what she's actually thinking, finally asked a simple question about the financial crisis: "How come nobody could foresee it?" No one could answer her.
If you've suspected all along that economists are useless at the job of forecasting, you would be right. Dozens of studies show that economists are completely incapable of forecasting recessions. But forget forecasting. What's worse is that they fail miserably even at understanding where the economy is today. In one of the broadest studies of whether economists can predict recessions and financial crises, Prakash Loungani of the International Monetary Fund wrote very starkly, "The record of failure to predict recessions is virtually unblemished." He found this to be true not only for official organizations like the IMF, the World Bank, and government agencies but for private forecasters as well. They're all terrible. Loungani concluded that the "inability to predict recessions is a ubiquitous feature of growth forecasts."
Most economists were not even able to recognize recessions once they had already started.
In plain English, economists don't have a clue about the future.
If you think the Fed or government agencies know what is going on with the economy, you're mistaken. Government economists are about as useful as a screen door on a submarine. Their mistakes and failures are so spectacular you couldn't make them up if you tried. Yet now, in a post-crisis world, we trust the same people to know where the economy is, where it is going, and how to manage monetary policy.”
Central banks tell us that they know when to raise or lower rates, when to resort to quantitative easing, when to end the current policies of financial repression, and when to shrink the bloated monetary base. However, given their record at forecasting, how will they know? The Federal Reserve not only failed to predict the recessions of 1990, 2001, and 2007; it also didn't even recognize them after they had already begun. Financial crises frequently happen because central banks cut interest rates too late or hike rates too soon.
The central banks tell us their policies are data-dependent, but then they use that data to create models that are patently wrong time and time again. Trusting central bankers now, whether in the US, Europe, or elsewhere, is a dicey wager, given their track record.
Unfortunately, the problem is not that economists are simply bad at what they do; it's that they're really, really bad. They're so bad that their performance can’t even be a matter of chance.
The reason is that they base their models on flawed economic theories that can only represent at most a pale shadow of the true economy. They assume they can use what are called dynamic equilibrium models to describe and forecast the economy. In order to create such models they have to make assumptions – and when they do, they assume away the real world.
It is not so much that the models I am criticizing are useless – they can offer economic insights in limited ways – but they cannot be (successfully) used to predict the economy or stock markets with anything close to certainty. They are simply not complex enough – and they cannot be made complex enough – to accurately describe the nonlinear natural system that is the economy.
Such models can at best give you insights into certain conditions that are limited by the assumptions you have to make in order to create the models. If you’re using your models properly, you understand their deep limitations. I freely admit to using models to gather as many insights as I can (especially about relative valuations), but I certainly don’t rely on them to actually predict the future. You should never use a model without understanding in a deep and all-encompassing way that past performance is not indicative of future results.
I’m concerned that, in the coming years, looking at historical data for guidance about the future will be more misleading than simply guessing would be. The times aren’t just changing; the very underlying economic conditions that produced past performance will no longer pertain. We are truly on economicus terra incognita. (Okay I made that one up, but you get the idea.)
If I were a young and mathematically gifted economist, I think I would explore the use of complexity theory to model the economy, based not on Keynesian nonsense or the hubristic assumption that an economy can ever be in a state of equilibrium (it can’t), but using Claude Shannon’s information theory instead as a better way to demonstrate how economics works in the real world (an idea brilliantly suggested by George Gilder in Knowledge and Power).
QE 4
So now that we’ve established that forecasting is worthless, let me make a forecast.
When we next have a recession in the US, the Federal Reserve will give us QE 4. They are going to base their monetary policy on the data they have at the time, even though all their own research says that the last round of QE really didn’t do anything.
They will once again push us into a world of financial repression malinvestment because they will feel the need to “do something,” and about the only thing they will be able to come up with is more quantitative easing. Which will force the world into yet another mutually destructive round of competitive currency devaluations. The image that springs to mind is that of a circular firing squad, with the participants being the world’s major central banks, some of which actually do have bazookas. As usual, the investors of the world will be caught in no-man’s land. (I hear the old tune by Martha and the Va ndellas starting to play in the back of my brain: “Nowhere to run to, baby, nowhere to hide….)
There is a significant part of me that now feels, or perhaps fears is the better word, that the Fed will embark upon an experiment with negative interest rates in the world’s reserve currency. One of the ideas that I want to explore at my conference this year is what the consequences would be of negative interest rates in the US and how we should deal with them. We will have a number of European financial experts in attendance, and I will pose the question to them. I am more interested in this prospect as a practical matter than as a theoretical one. If you are managing a client’s money in anything that looks like income ETFs or mutual funds, how would you deal with this? There are a number of different types of funds that are actually required to hold their excess assets and cash reserves in short-term Treasurys. Will regulators really make funds hold reserves in assets that force clients into negative returns? Seriously?
Why Forecasting Next Year Is a Crap Shoot
By this point it should be clear that even the brightest economic and financial minds struggle to make accurate forecasts. Should we ignore them all?
No. I think the real problem is timing.
I think it is possible to observe events and trends and then to make informed projections about the future. A few people can even do it with reasonable accuracy, at least in their own areas of expertise. The problem lies in correlating what you know is coming with the particular calendar year in which it will occur.
For instance, note what I said above. I made a recession forecast within a 10-year period. I feel very confident we will have a recession between 2016 and 2025. I can’t tell you exactly what year it will occur, although I will expose the extent of my hubris by actually trying to narrow that range down in just a few paragraphs.
I can readily forecast within a 10-year window because economic trends rarely change overnight. The events that drive national and global economic cycles take time to unfold. Even if we completely ignore present circumstances, we know it would be unprecedented for the US economy to go 10 years without at least a mild recession.
I’ll readily admit that some people are pretty good at forecasting short-term market movements. Most of them are professional traders. They’re also the first to tell you that they don’t bet the house on their forecasts. They know how easy it is to be wrong – and how costly.
My own talents are at the other end of the scale. I can look out 5–10 years and tell you in broad terms what I think will happen, but the next year is a crapshoot. I make annual forecasts mainly because so many people want to know what I think. If that’s you, please note that I reserve the right to change my mind tomorrow.
Another Muddle-Through Year
So with all that as prelude, let’s get on with my 2016 forecast. I talked about it in a CNBC appearance last month. Click on the picture of the old guy for a quick summary; then I’ll give you some additional detail.
I don’t know exactly how this happened, but I have become widely known in financial circles as “the Muddle-Through Guy.” I began using the term in 2002, when I was forecasting that we would be lucky to do more than 2% for the entire decade. It turns out I was an optimist – we did only 1.9%. Likewise, I think we will be lucky to average 2% in the US in 2016.
In general, recent data has been trending down (with the obvious exception of the employment numbers). I am concerned that the US will be much closer to 1% growth than 2% for 2016. I know plenty of folks who expect the US to go into recession this year. They may be right, but if so that downturn will be due to some kind of external shock. But at a 1% growth rate, which is close to economic stall speed, it wouldn’t take much of an external shock. I can see three real possibilities that we will need to keep an eye on.
  1. The first is Europe. Longtime readers know that my base forecast is that the euro survives, but only if the eurozone nations mutualize their national debts. The euro is not an economic currency; it is a political currency. And it will take the political solution of creating a fiscal union to maintain it. Given the level of debt of most of the major members of the eurozone, a fiscal union can occur only if every country – read Germany – agrees to mutualize debts,.
Up until recently I believed that you could get a majority of eurozone voters to go along with the pro-euro elite politicians’ extraordinary intentions to actually mutualize debts under the balance sheet of the European Central Bank (or another organization that would be created in the midst of crisis).
I now think that a political solution is at serious risk because of the immigration crisis. You can almost feel whatever sense of political unity existed in Europe disintegrating right in front of us. The recent tragic events in France and Germany are exacerbating the problem. I think getting a majority of voters to go along with the idea of giving up national sovereignty over their own budgets (which is what a fiscal union and the mutualization of debt would require) is becoming increasingly unlikely. As more and more people begin to demand that their countries control their own borders, the entire Schengen agreement is in jeopardy. And without that agreement, the next national debt crisis (beyond that of Greece – Italy? France? Spain?) will call into question the unity of Europe.
As country after country in Europe begins to close its borders, the flow of refugees will not slow but will actually increase. If you are in a failed state in the Middle East or North Africa and you think the doors to Europe are closing, you’re going to go now rather than wait. The refugees will find ways into Europe through those countries that don’t have the resources to control their borders (think Greece). Europe’s ad hoc approach to border control simply won’t work. It will only serve to demonstrate the true impotence and incompetence of Brussels and EU bureaucracy. And it will provide political fodder to nationalist groups that are beginning to hold sway in a number of major European countries.
No matter what you think of economic austerity in Europe, that concept is going to come increasingly under political fire and will be discarded. European borders are becoming less transparent, and Europe is increasingly economically vulnerable. A recession in Europe will cause a recession in a US economy stuck at stall speed.
  1. I am flying over China (from Hong Kong) as I write this paragraph. I have just been a speaker at a conference sponsored by Bank of America Merrill Lynch, with some 60 major investment representatives sitting around a large table, for a very wide-open conversation. There were multiple hundreds of billions of dollars of funds represented around that table. Now perhaps it was influenced by two days of significant losses in the Chinese stock market, but the overall mood was decidedly bearish. Only a few people were actually talking hard landing, but the large majority of Chinese growth projections were decidedly lower than government forecasts.
Further, there seemed to be general agreement that the renminbi is headed down. I was particularly impressed by the Merrill Lynch Chinese analyst from Shanghai who pointed out that if the wealthiest 3% of Chinese moved just 7% of their money offshore, we would be talking close to $1.5 trillion. Money is literally flying out of China, in a variety of legal and questionable ways.
The Chinese government has been manipulating its currency higher for many years. That is now getting ready to change. Andy Xie, a well-regarded China analyst who sat next to me during my presentation, would not rule out a 30–40% devaluation over time. Admittedly, his is one of the more bearish forecasts, but few in the room were arguing that the renminbi would get stronger. Andy in particular was bearish about China over the next two years, though he remains an undaunted China optimist over the longer term. He truly believes China will rule the world within a few decades. In what was a very multicultural room (as you would expect in Hong Kong trading and investment society), it was interesting to watch the crowd’s reaction to Andy’s sentiments.
China’s slowing down more than forecasts anticipate – or, God forbid, a hard landing – would definitely deliver a shock to a still-weak US economy. We will have to pay close attention to China this year.
  1. While everybody thinks of the Middle East in terms of geopolitics and military conflicts, the economic consequences of low oil prices will have far more problematic effects on the stock markets of the world. We are talking about sovereign wealth funds holding multiple trillions of dollars having to liquidate a portion of their assets in order to maintain their governments. These vehicles were created as the ultimate rainy day fund, and it is raining hard right now. My personal view is that we will see oil in the $20s before we see it back in the $50s. By a kind of perverse logic, the cure for low prices is low prices. It won’t happen overnight, but oil will reverse. In the meantime, low oil prices mean that sovereign wealth funds have to liquidate.
But let’s examine that concept for a moment. Many sovereign wealth funds are invested in very long-term and illiquid projects. Rightly so – that is what you should be doing with that sort of money. But that means when you have to liquidate, you sell what you can, not what you want. And that means funds will be selling liquid stocks and bonds. By the hundreds of billions of dollars’ worth. That is a lot of selling pressure, much of it in dollars and much of it in the US.
Unfortunately, this will happen just as more people realize the US stock market is priced for a correction. The earnings expectations of many companies are far too optimistic, and they are running out of financial engineering tools to hide it. We have gone much too long without an extended correction. I believe we could see a 15–20% downturn if key companies miss their forecasts.
While multiple crises blanketing the entire Eurasian continent suggest that dollars will be flowing into the United States, the sovereign wealth fund need for liquidation will require the reverse. I defy anyone relying on anything other than an educated guess to tell me which will be the greater force. (Do Japanese pension funds continue to liquidate JGBs and buy US and European stocks? In what size? Do they wait for the markets to settle out? Inquiring minds want to know.)
Here is the real question: Can the US have a recession without an inverted yield curve? This is an ongoing debate I am having with several prominent economists. I would say yes. Although we have not seen a recession without an inverted yield curve since World War II, I think we are now in different times, with different underlying conditions, as noted above.
Zervos and Rosenberg would argue that the Fed will continue to raise rates until we get the potential for an inverted yield curve, albeit at a lower rate than we have ever seen. I am doubtful that the Fed will raise rates more than two or three times this year. We are going to enter the next recessionary period with interest rates the lowest they have ever been. I defy you to perform an historical analysis that sheds light on future conditions under those circumstances. Which is why I’m concerned about the Fed giving us negative interest rates.
I’m actually far more concerned about a real bear market in stocks creating the conditions for a recession. Any of the three potential shocks I listed above could create a bear market and a US recession. Attention must be paid.
Jim Grant, who spoke at the same private conference in Hong Kong that I did, said he was worried that the US is already slipping into recession. I am certainly not ready to agree with that analysis, but I am not confident enough to disagree with my friend Doug Kass, who expects that the US will enter recession before the end of the year.
My base case at the moment is that we will not, but we will continually teeter on the brink. For all intents and purposes, the result may feel like a recession. Which suggests to me that the data the Fed looks at will keep them from raising rates the four times they currently predict. I still think we will once again see 0% interest rates before we see 2% rates or maybe even 1% rates – depending (I say with a dollop of sarcasm) on the data.
Dangerous World
Looking beyond China and Europe, Latin America is a wild card. The strain of lower resource demand from China is beginning to show. Argentina has a new president, and Brazil may get rid of its current administration. I think we will see some dramatic swings in Latin American stock, bond, and currency valuations this year. Venezuela is on the edge of collapse.
Pulling all the evidence together into a strategy, my own plan is to avoid directional market exposure as much as possible. We should see plenty of volatility, and staying on the right side of it will be very difficult. I think certain targeted technologies will do well – mainly those that enhance productivity. Human workers will keep losing ground to artificial intelligence algorithms – a phenomenon that will continue to spread both vertically and horizontally in 2016.
I intend to direct more of my own assets into the private credit opportunities I mentioned two weeks ago. Thank you, by the way, to the many readers who wrote to me about the opportunities you’ve seen. A lot is happening below the radar, with very promising results so far. I’ll share more with you as the year unfolds and legal restrictions permit.
Bottom line for 2016: Don’t tie your fortune to a rising market – and I mean any kind of market anywhere on the globe. This is a time to think strategically, stay hedged and diversified, and avoid big directional bets. I think active and hedged management will be the place to be in the coming period. To quote the motto of House Stark in Game of Thrones, winter is coming.
In summary, while I understand the argument that Zervos and Rosenberg make about our not entering a recession until there is an inverted yield curve, I do not believe it.
In the past it is been easy to predict a recession because every recession since World War II was preceded by an inverted yield curve. With short-term rates artificially low, we no longer have that indicator. The US economy is close to stall speed, and a negative nudge could push us into recession, inverted yield curve or not.
The average stock market retreat in a recession is around 40%. If the Fed takes us back to zero rates and, gods forbid, possibly even negative rates, I think we will see the long bond at 2% and the 10-year below 1%. Think Japan. It’s counterintuitive in the extreme, but the world is going to be turned upside down. You are going to get a shot at the lowest mortgage rates of your life. This year? Next year? If such intricate timing makes a difference to you, you need to rethink your portfolio balance. Seriously.
Next week I will look at the forecasts that others have made and comment on them.
Back from Hong Kong
I normally put a personal note here, but the letter is already overly long, and I need to hit the send button to get this to my intrepid editors, who will be working on Sunday.
I want to thank my hosts at Bank of America Merrill Lynch in Hong Kong for being most gracious. I believe I learned a great deal more at their conference than whatever small morsels of knowledge I dished out. The dinner conversations were sparkling.
I’m looking forward to some biotech startup finding a fix for jet lag, because I do enjoy getting outside the confines of my home and absorbing the knowledge and wisdom of those from other backgrounds.
Even with what is a rather sober forecast issue, I remain an unrepentant optimist about the future. You have a great week and even better new year! I look forward to exploring Economicus Terra Incognita together with you. It will be an adventure!
Your fellow explorer analyst,

John Mauldin

Issues 2016

Doug Nolan

January 8 – CNBC (Ritika Shah): “Billionaire investor Mark Cuban is ‘doing nothing’ about the market sell-off. In his latest note to his ‘dusters’—a term for users of the Cyber Dust app that he advises and funds—Cuban revealed his investment strategy. ‘While all the selling seems to be based on China and the price of oil, I really don’t know what the long term implications for our stock market is,’ he wrote… ‘So I follow the number one rule of investing. When you don’t know what to do. Do nothing.’”
It’s being called the worst start for global securities markets ever. The Shanghai Composite was down a quick 10% this week. Japan’s Nikkei sank 7.0%. Hong Kong’s financial index dropped 8.7%. Germany’s (investor “darling”) DAX equities index was slammed for 8.3%. Here at home, the S&P fell a relatively moderate 6.0%. Biotechs sank 10%. Gloomily, the financials (banks and broker/dealers) were down almost double-digits. The small caps were hit for 8%. The Nasdaq100 fell 7%. “FANG” was defanged.

Credit spreads widened across the board. With “money” flowing out of bond funds, even top-tier bonds are now feeling the effects. Investment-grade spreads widened this week to a three-year high. It was another tough week for high-risk corporate debt.

Currency markets commenced the year in disarray. The yen jumped 2.7% against the dollar, surpassing August tumult-period highs. Borrowing in cheap yen to finance leveraged holdings in higher-yielding currencies was a fiasco. The Australian and New Zealand dollars were down almost 5%. Some key EM currencies were under intense pressure. The Mexican peso fell 3.9%, the South African rand 4.8%, the Russian ruble 3.1%, the Turkish lira 3.6%, the Chilean peso 2.9%, the Colombian peso 2.9%, the Singapore dollar 2.4% and the Malaysian ringgit 2.3%. China’s yuan declined 1.6% against the dollar.

WTI crude was down 10.5% to a new 12-year low. After sinking 26% in 2015, the Goldman Sachs Commodities Index fell 5.2% to begin 2016. Ten-year Treasury yields declined a modest 13 bps, with fixed-income this week offering little protection against major losses throughout global risk markets. Benefiting from safe haven status, bullion surged 4.1%. Conversely, copper sank 5.3% to an almost seven-year low.

It was an ominous beginning to what is poised to be a most tumultuous year. Market participants are quickly coming to appreciate that China does in fact matter. Few understand why. Most – from billionaires to fund managers to retail investors – will “Do Nothing.” This has worked just fine in the past – repeatedly. Not understanding and not doing anything will be detriments going forward.

Analysts will point to Friday’s surge in non-farm payrolls as evidence of the underlying health of the U.S. economy. There’s a strong consensus that U.S. markets have been greatly overreacting to risks posed by China and the global slowdown. Popular sentiment was captured well in a Friday headline: “Market meltdown can be read as giant ‘buy’ signal”

Back in 2000, I titled a presentation (and CBB) “How Could Irving Fisher Have Been So Wrong?” From Wikipedia: “The stock market crash of 1929 and the subsequent Great Depression cost Fisher much of his personal wealth and academic reputation. He famously predicted, three days before the crash, ‘Stock prices have reached what looks like a permanently high plateau.’ Irving Fisher stated on October 21 that the market was ‘only shaking out of the lunatic fringe’ and went on to explain why he felt the prices still had not caught up with their real value and should go much higher.”

Fisher, one of America’s most accomplished economists, was in 1929 operating with a deeply flawed analytical framework. And for years leading up to the crash the optimists had been repeatedly emboldened, as a booming stock market confirmed their view of the world. Fisher and the world were then completely blindsided. Their views of how the economy, the securities markets, policymaking and Credit interacted were completely erroneous. I expect some resolution of competing analytical frameworks to be a key Issue 2016.

Today’s conventional view holds that the underlying fundamentals supporting the U.S. economy are healthy. In general, markets are driven by fundamentals. Finance is sound. China, commodities and a downshift in global growth are temporary setbacks ensuring ongoing ultra-loose monetary policies. U.S. markets will soon look beyond negatives, as focus returns to long-term favorable prospects for growth, corporate profits and inflation.

An opposing analytical framework, one to which I subscribe, is focused foremost on finance – in particular the system of securities-based Credit and securities that over the past thirty years rose to world dominance. Regrettably, this “system” is deeply flawed and today acutely unstable. In short, global “money” and Credit are structurally unsound. In general, and especially late in this era, market-based finance drives economies. Unprecedented central bank monetization and market manipulation have inflated securities markets along with underlying fundamentals (corporate cash flows/profits, incomes, household perceived wealth and GDP).

Why is China today so critical to global markets – including those in the U.S.? The bulls argue that a Chinese slowdown will have minimal impact on U.S. corporate profits. The harsh reality is that Chinese financial and economic crisis has the potential to push an already fragile global financial “system” over the edge. From the perspective of my analytical framework, the historic “global government finance Bubble” is faltering and will not survive a China bust.

As they say, “bull markets create genius” (unless you’re an analyst of Credit and Bubbles). And there’s also a reason they’re called “virtuous cycles” – though there’s nothing virtuous about Bubbles. But they sure look good and feel good – and inspire over-confidence (along with dreams and inflated ambitions). Things just seem to go right during booms. And it wasn’t long ago that the conventional view held that Brazil, after all these years, finally got it right. Brazilian politicians, central bankers, businessmen – and the nation’s economy – were held in high regard. Talk today is of corruption, inflation, depression, impeachment and mayhem. The Bubble burst and genius was in short order transformed to gross Incompetence.

For years (decades), China was perceived to be doing all the right things. Their system of disciplined meritocracy ensured the best and brightest were in command of one of the greatest economic miracles (and enterprising and hard-working populations) the world has ever known. Today, history’s most spectacular Bubble is bursting. Genius has so rapidly morphed into Incompetence. When Bubbles burst – and confidence turns to angst – it’s as if suddenly nothing can go right. Dwarfing even the Japanese experience, it’s astounding how decades of accomplishment have been sabotaged by seven years of runaway Bubble excess.

This is not Mexico 1995, Thailand 1997, Russia 1998, nor even Europe 2012. Approaching $35 TN (from ~$8TN in 2008), the Chinese banking system over recent years has ballooned to almost double the size of that of the U.S. In terms of economic output, China rivals the U.S. As a global hub for manufacturing, they have few rivals. And if global financial and economic ramifications were not troubling enough, there is an alarming geopolitical component to the unfolding China bust. The Chinese boom has tremendously inflated perceived wealth right along with expectations. The Chinese people do not have a ballot box. Beijing will blame foreigners, especially the U.S. and Japan. China is a most critical Issue 2016 – and fight off the calls to downplay its maladies and significance.

A Friday headline from the Financial Times: “China steps up capital controls to stem outflows - Queues form outside Shenzhen banks as regulator orders them to limit clients’ dollar buying”

China policymakers today face a dire circumstance. Chinese international reserves dropped a record $108 billion in December to $3.33 Trillion (down almost $700bn in 12 months). The year ago $4.0 TN (and growing) reserve war chest was viewed as sufficient to placate growing international concerns for the soundness of China’s economy and the underlying finance underpinning the boom. Massive reserve holdings surely bolstered Beijing’s own confidence that ample resources were available to ensure system stability, as they moved forward with economic reform and structural adjustment.

Now, as the bursting Bubble phase gathers momentum, China’s reserves provide a crumbling foundation for confidence – internationally as well as domestically. Chinese officials might now seek to orchestrate a major currency devaluation and system reflation (comparable to past moves by the U.S., Japan and Europe). But they will face the traditional EM problem of flagging confidence – in their currency, in their banking and financial systems, in their economic structure and in policymaking. They risk further inciting destabilizing outflows – and the more aggressive Chinese fiscal and monetary stimulus the more precarious the “capital” flight issue will become.

It was always my view that there was an unappreciated downside to the inflating Chinese reserve position. There was evidence and anecdotes of enormous “capital” flight out of China (corrupt “money” as well as the affluent seeking safety). Yet these outflows were overwhelmed by massive “investment” inflows. I long suspected that huge – potentially unprecedented - “hot money” flows were being attracted by China’s high yields (i.e. corporate bonds and “shadow banking” instruments).

I believe we’re now seeing a highly destabilizing scenario unfold, where faltering financial and economic Bubbles spur de-leveraging and flight out of Chinese financial assets. At the same time, Chinese companies that issued huge amount of dollar-denominated debt are these days scurrying to accumulate dollars. Moreover, Chinese households – having accumulated Trillions of deposits and other financial claims – would today prefer to diversify some of their newfound wealth out of the depreciating yuan.

Do Chinese officials continue to expend national wealth (international reserves) to accommodate flight out of China (at top dollar)? Not many months ago Putin decided it was not in Russia’s interest to rapidly burn through the nation’s international reserve holdings.

January 7 – Under the Reuters’ headline, “Sources: China wants quick, sharp currency decline.” “China’s central bank is under increasing pressure from policy advisers to let the yuan currency fall quickly and sharply, by as much as 10-15%, as its recent gradual softening is thought to be doing more harm than good. The People's Bank of China (PBOC) has spent billions of dollars buying yuan over recent months to defend the exchange rate, but has failed to stabilize market sentiment... That gradual, managed depreciation makes the yuan a one-way bet for investors who see the currency weaken even as the central bank intervenes to prop it up. Policy insiders are now calling for a quick and sharp yuan depreciation, backed by tighter capital controls to curb speculation and the flight of money out of the country.”
Especially late in 2015, unusual anomalies throughout the interest-rate swaps derivative marketplace attracted some attention. Strange pricing relationships were generally dismissed as a consequence of extraordinary corporate debt issuance and related hedging coupled with atypically large EM central bank Treasury liquidations.

I’ll throw out some thoughts: In general, I expect so-called “price anomalies” and dislocation to be an Issue 2016 for derivatives and securities markets generally. The course of China’s currency regime shift could easily turn disorderly, spurring dislocation and illiquidity in various markets. At the same time, markets could dislocate as various currency “carry trades” unravel – certainly including what I suspect is massive embedded leverage in the yen “carry trade.” The probabilities are also substantial that EM markets could dislocate on the fear of unmanageable dollar-denominated debt. A system-wide de-leveraging episode is possible. I would argue that there has never been such a risky global backdrop with a confluence of major market fault lines.

My analysis has focused on the proliferation of leveraged strategies, speculative excess and the Crowded Trade phenomenon. For seven years now, the Fed and global central banks have inflated global securities markets with Trillions of new “money.” This “money” - along with central bank manipulation and liquidity backstops – over time effectively destroyed the normal functioning of the marketplace. Excesses were allowed to grow and become deeply embedded. 
And, importantly, the aberrant market backdrop worked to the disadvantage of active management relative to the indexes. Last year saw further exodus from active (to passive) management work generally to exacerbate the travails of active fund management, especially for more sophisticated “long/short,” “quant” and “risk parity” strategies.

The upshot has been, in the face of a faltering global Bubble, “money” continuing to rush into the “market” through index ETFs and similar products. According to Blackrock, $347 billion flowed into ETFs globally in 2015 to surpass $3.0 TN. Almost matching 2014’s $246 billion, another $228 billion made its way to U.S. ETFs last year. 
This is “money” speculating on the market, in contrast to investing in a savvy manager, a sound investment strategy or in company/industry fundamentals. Chiefly, it’s one historic bet on the conventional bullish view and faith in the ongoing genius of central bankers. This “hot money” and is now at high-risk for a destabilizing rush to the exits.

I have serious issues with the underlying structure of U.S. and global financial markets that I expect to emerge in 2016. The biggest losses since the financial crisis come with bullishness and complacency deeply entrenched. It is not easy at this point to envisage the buyers who will let the ETF crowd unwind their bullish positions. It’s not obvious how markets remain liquid in the event that the leveraged speculative community is hit with large redemptions. And I have no idea how confidence in the multi-hundreds of Trillions derivatives marketplace holds when the markets begin to seize up.

And it again comes back to competing analytical frameworks. China doesn’t look all too problematic from the perspective that views the U.S. economy as healthy; U.S. finance as sound; that corporate profits and GDP will continue their long-term upward trends; and that the astute Federal Reserve has things well under control. But from the perspective of seven years of the most egregious monetary inflation in history – the “Terminal Phase” of an unprecedented multi-decade global Credit Bubble - fueling the biggest global securities Bubble in history, with history’s greatest worldwide speculative excess and most precarious economic maladjustment and imbalances ever – well, China provides a dangerous Bubble-piercing catalyst.

I expect 2016 to see some resolution to the unprecedented divergence between inflated global securities markets and deflating fundamental prospects. Portending acute economic vulnerability, faltering markets will see a tightening of financial conditions and vanishing perceived wealth. Confidence will wane – confidence in the markets, in the economy and in policymaking. It will surely make for a wild election cycle. It will also ensure a high-risk geopolitical backdrop. I expect less rate “normalization” and more QE.

Drawing from my “Core vs. Periphery” analytical framework: De-risking/de-leveraging at the “Periphery” is problematic with the potential for expanding risk aversion to exert contagion effects toward the “Core.” I’ll posit that de-risking/de-leveraging at the “Core” pushes a fragile system right back to financial crisis. As such, the first week of 2016 supports the view of a vulnerable “Core.” U.S. stocks have succumbed to “risk off.” Attention now turns to a critical Issue 2016: The soundness of U.S. and global corporate Credit.

Over recent Bubble years, incredible quantities of “money” have flowed freely into U.S. Credit. Central bank policies have ensured epic mispricing throughout U.S. and global fixed income and derivatives markets. Buyers of U.S. securities and derivatives have been willing to tolerate skinny little returns on the view that the Fed ensured minimal risk. The Fed and global central bankers readily nurtured the perception of low risk throughout global securities and derivative markets – the “Moneyness of Risk Assets.”

There’s always a vulnerability associated with money – and “Moneyness”: crises of confidence are inherently highly destabilizing. There’s a shock when holders of perceived risk-free “money”/securities/derivatives come to realize their previous misperception. As confidence in both economic fundamentals and central banking wanes, I expect already problematic fund outflows to accelerate. A tightening of financial conditions portends Credit problems way beyond energy and mining. I hope I am much too dire. Acute systemic risk on a global basis is The Big Issue 2016.

Chaos and Violence

How New Year's Eve in Cologne Has Changed Germany

Photo Gallery: Germany's Night of Horror
New Year's Eve in Cologne rapidly descended into a chaotic free-for-all involving sexual assault and theft, most of it apparently committed by foreigners. It has launched a bitter debate over immigration and refugees in Germany -- one that could change the country. By SPIEGEL Staff

A lot happened on New Year's Eve in Cologne, much of it contradictory, much of it real, much of it imagined. Some was happenstance, some was exaggerated and much of it was horrifying.

In its entirety, the events of Cologne on New Year's Eve and in the days that followed adhered to a script that many had feared would come true even before it actually did. The fears of both immigration supporters and virulent xenophobes came true. The fears of Pegida people and refugee helpers; the fears of unknown women and of Chancellor Angela Merkel. Even Donald Trump, the brash Republican presidential candidate in the US, felt it necessary to comment.

Germany, he trumpeted, "is going through massive attacks to its people by the migrants allowed to enter the country."

For some, the events finally bring to light what they have always been saying: that too many foreigners in the country bring too many problems along with them. For the others, that which happened is what they have been afraid of from the very beginning: that ugly images of ugly behavior by migrants would endanger what has been a generally positive mood in Germany with respect to the refugees.

As inexact and unclear as the facts from Cologne may be, they carry a clear message: Difficult days are ahead. And they beg a couple of clear questions: Is Germany really sure that it can handle the influx of refugees? And: Does Germany really have the courage and the desire to become the country in Europe with the greatest number of immigrants?

The first week of 2016 was a hectic one. Tempers flared and hysteria spread. It should be noted that an attack would have triggered similar national emotions, or the murder of a child in a park or any other crime that touched on our deepest fears and serviced our long-held stereotypes -- any crime in which a foreigner was involved. On New Year's Eve in Cologne, it was -- according to numerous witness reports -- drunk young men from North Africa who formed gangs to go after defenseless individuals. They humiliated and robbed -- and they sexually assaulted women.

Their behavior, and the subsequent discussion of their behavior in the halls of political power in Berlin, in the media and on the Internet, could easily trigger a radical shift in Germany's refugee and immigration policies. The pressure built up by the images and stories from Cologne make it virtually impossible to continue on as before. That, too, is a paradox: The pressure would be no less intense even if not a single one of the refugees and migrants who arrived in 2015 were among the perpetrators.

Powerless in the Face of Chaos and Crime

Refugees, asylum seekers, migrants, foreigners, friendly or evil, new or long-time residents: It doesn't matter. It seems as though the time has come for a broad debate over Germany's future -- and Merkel's mantra "We can do it," is no longer enough to suppress it.

New Year's Eve marks a shift because it crystallized a widespread unease with state inaction.

The happenings on the square between the Cologne Cathedral and the main train station was as symbolic as they were real: symbolic of the state's powerlessness in the face of chaos and crime.

Two months after the attacks in Paris, one can have one's doubts as to whether Cologne represents a "completely new dimension of violence," as has been repeated by both police officials and politicians. What is clear, however, is that the police were unprepared and that they failed. The officers on site were reduced by the circumstances they faced to playing a pitiable role.

Some of the reactions coming from politicians this week were also a bit pathetic. Instead of offering a vision for how national and state politicians intend to integrate hundreds of thousands of foreigners or for how the state intends to finance and organize this new immigration society, many political leaders preferred to merely repeat tired demands for harsh judiciary action and other self-evident legal responses.

The chancellor too joined the legions of phrasemongers and, as has been her wont since last summer, did not have much to offer aside from her fundamental confidence. It is a political path that won't take her very far anymore. It has felt this week as though voters, if they don't feel like their concerns are being taken seriously by Merkel's conservatives or her Social Democratic coalition partners, will search for answers from other, more radical groups. As such, Cologne will be a test for Berlin.

But this hectic, fervid and, at times, hysteric, week has also been about much more: Namely it has been about all of the issues that the right-wing populist party Alternative for Germany (AfD) and the xenophobic movement Pegida have been shouting about for months. It was about Merkel's refugee policies and the upper limit for refugees demanded by her conservative Bavarian allies. Added to that was the perpetual problem of violence against women. It was about the integration of foreigners, the danger of a societal split over the refugee question and a shift to the right in Germany. But it was also about the quality of the work done by the police and about a state being unequal to the task facing it.

It is a lot to think about. The role of the "lying press" can't be forgotten either. And yet, it still isn't entirely clear what actually happened on New Year's Eve in Cologne.

'Largely Peaceful'

On Thursday, it was said that 16 suspects had been identified and that some 200 complaints, most of them from women saying they had been victims of sexual assault, had been received. But how did the events unfold?

At 8:57 a.m. on the morning of January 1, the Cologne police department's press department released a statement under the heading: "Festive Atmosphere -- Celebrations Largely Peaceful." But that isn't how Cologne police officer Hermann Wohlfahrt had experienced the previous evening.

Wohlfahrt has been a police officer for almost 20 years and has seen a lot: hooligan battles and melees between neo-Nazis and anarchists, for example. When speaking with SPIEGEL about New Year's Eve, he asked that his real name not be used. Wohlfahrt is a pseudonym.

His street shift began at 10 p.m. and he had been assigned the area around the cathedral and some of the main streets nearby. Some 80 riot police from the 14th Company were on duty that night, which was twice as many as had been patrolling the streets the previous year -- an increase that was largely due to fears of terrorist attacks. The Cologne police station had requested the full complement of 124 riot police, but the state police headquarters denied the request.

In the preparatory meeting at 9 p.m., just prior to his deployment, Wohlfahrt learned that there was an unexpected situation at the main train station. In a statement issued later, the police summarized the situation as: "400 to 500 apparently intoxicated persons engaging in conspicuously aggressive behavior. The majority are male and they are firing off firecrackers and rockets in an uncontrolled manner." In an internal report from Jan. 2, these men were surprisingly quickly, and without any confirmation whatsoever, described as "refugees."

Shortly before 11 p.m., the police began speaking of more than 1,000 people, mostly men and mostly of "North African or Arab origin."

At the taxi stand on the square, two young women climbed into Lucia Keller's vehicle and asked her to take them to Breslauer Square, located on the other side of the train station. Keller had been waiting for a fare for an hour and didn't know what was going on in the area, so she asked the two women why they didn't just walk through the train station to the other side. "We don't want to go through there," was the response. They had already seen what was going on inside.

Hermann Wohlfahrt arrived in front of the train station at around 10:50 p.m. His estimate for the number of men in the square in front of the station and on the stairs leading up to the cathedral is between 1,000 and 1,500. He watched as some of them aimed fireworks at others.

And he was surprised that the men seemed completely unimpressed by the police presence.

A Policewoman Under Attack

Wohlfahrt doesn't know where the men were from. He recalls that some of them kept shouting the French phrase "Pas de problème!", which means "no problem," and then continued lighting off their fireworks. "We had no effect on the atmosphere whatsoever," Wohlfahrt says.

Colleagues of his reported seeing two Moroccans trying to take a mobile phone from an Iranian refugee, but it is impossible to confirm that story. It is neither clear that the attackers were from Morocco nor that their victim was from Iran, much less a refugee from Iran.

Wohlfahrt first heard reports of sexual assaults over his police radio. He also heard that a female colleague had become a victim of violence. She had been together with two other officers dressed in civilian clothes in order to track down pickpockets and petty thieves when she was surrounded and indecently touched while others tried to steal her bag. From a police report, Wohlfahrt later learned that, because of the "complexity of the situation as a whole," the "deployment of uniformed officers" to protect the policewoman "had not been possible."

By a quarter past 11, all officers belonging to the 14th Company had arrived at the main train station and began clearing the square shortly thereafter, with federal police officers blocking the entrances and exits to the main train station. The operation lasted 40 minutes, whereupon parts of the 14th Company were ordered to deploy to other parts of the Cologne city center.

Around 40 officers remained behind at the cathedral and they watched as the area once again began to fill with people.

The police established two corridors: One on the narrow area between the top of the stairs and the cathedral, and the other at the entrance to the train station. Several people asked police for an escort, including, as the police report makes clear, many who themselves had "immigration backgrounds."

One of them stopped Hermann Wohlfahrt not long after midnight and asked him if such events are typical for New Year's celebrations in Germany.

It took four days before an officer with the federal police force put into writing what, from Wohlfahrt's perspective, really happened that night. The author makes it clear that the escalation that took place prior to the clearing of the square was caused by "persons with migration backgrounds." Later on in the "deployment report," it says that an identification of the perpetrators "was unfortunately not possible."

'Serious Injuries or Even Deaths'

His report reads like the protocol of a massacre. "Upon arrival," it begins, "we were informed of the conditions in and around the station by agitated citizens with crying and shocked children." Many "upset passersby" ran to the arriving police to tell them about fights, thefts and sexual attacks against women.

Regarding the situation on the square in front of the train station: "Women, accompanied or not, had to run a literal 'gauntlet' of heavily intoxicated masses of men of a kind that is impossible to describe." There were fears that "the situation we were confronted with (chaos) could have led to serious injuries or even to deaths."

The report mentions deliberate attempts to provoke the police. One example is of someone who "tore up a residency permit with a smile on his face, saying: 'You can't touch me. I'll just go back tomorrow and get a new one.'" Another example mentioned in the report was an unidentified man saying: "I'm a Syrian! You have to treat me kindly! Ms. Merkel invited me."

By morning, the riot police unit had banned 10 people from the square, taken 11 people into custody and arrested four others. There were 32 criminal complaints and the documents of 71 people were checked. The report indicates that the "majority" of those people whose documents were controlled were only able to produce "a registration document as an asylum seeker" issued by the Federal Office for Migration and Refugees. The "number of persons from the North Africa/Arab region," the report notes, was "very surprising" to the officers.

The public, though, was initially left in the dark. An early indication that sexual predators had been on the prowl between the train station and the cathedral appeared around 1 p.m. on New Year's Day on the Facebook page of a group called Nett-Werk Köln.

There are around 140,000 members of the group and the postings are usually rather run-of-the-mill. It is a local platform for Cologne residents looking for a party space or a cheap car repair shop, for people who have lost their phone or who have picked up a stray cat. The site is operated on a volunteer basis by Phil Daub and a few others. The 47-year-old Daub worked as a moderator in the 1990s for the music broadcaster Viva. Today, he does voice-overs for advertisements and is a voice for the broadcaster Sat.1.

The New Germany?

The Jan. 1 entry on Nett-Werk Köln spoke of "horrific scenes in the Cologne train station."

The author wrote of "crying women after multiple sexual attacks in the crowd." He wrote that he had been in the middle of the throng "hand-in-hand with my girlfriend, which unfortunately didn't prevent her from being repeatedly grabbed under her dress." The author combined his narration with a mention of his own efforts on behalf of the refugees who have poured into the country in the last year. "Is it for this that I donated half of the contents of my wardrobe? Is this the new Cologne? Is this the new Germany?"

The entry posted on New Year's Day can no longer be found on the Nett-Werk site. One of the group's administrators thought it was the work of a troll and immediately deleted it.

But the short text was nevertheless quickly shared. It was taken over by the kind of people who decorate their Facebook pages with the German flag, demand the resignation of Chancellor Merkel or who are firmly rooted in the right-wing extremist scene.

The tone on Nett-Werk Köln has also become much coarser since the New Year -- so course, in fact, that Daub felt it necessary to post a long contribution on Wednesday distancing himself from the content of his own forum. "The fact is," Daub wrote, "that Nett-Werk is currently a battlefield of verbal violence, mutual accusations of guilt, calls for vigilante justice, insults, abuse, incitement and racism."

The Facebook site of public broadcaster ZDF has also become a kind of battlefield. There is talk of the "lying press," conspiracy and state-control. "We are being overwhelmed with hate and anger," says Elmar Theveßen, ZDF's deputy editor-in-chief. "The mistrust that we are being confronted with is worrisome."

Something did, in fact, go wrong at ZDF. Initially, the most important news story of the new year went uncovered by the public broadcaster. Other media had already reported on the events in Cologne over the weekend, including the Cologne tabloid Express, the website of the Munich-based paper Süddeutsche Zeitung and the German news agency DPA. Following the press conference given by Cologne police on Monday afternoon, SPIEGEL ONLINE jumped on the story, as did private broadcaster RTL and Germany's other public broadcaster ARD. But ZDF remained silent.

Calming the Doubters

On Tuesday, the station issued a public apology for the lack of coverage. "It was a lapse in judgement that the 7 p.m. evening news show didn't at least mention the incident," Theveßen wrote on Facebook. Such an open admission of error by a senior manager at a public station in Germany is rare, but Theveßen's act of repentance did little to calm the doubters.

All established media have been confronted with the same phenomenon. In Germany, there is a stable minority that is convinced that the country's broadcasters, newspapers and magazines are controlled by dark powers and have agreed to suppress bad news about foreigners so as not to endanger the political project of welcoming refugees.

More than 2,000 users have thus far commented on Theveßens post, with most of the missives of a horrifying nature -- a collection of conspiracy theories characteristic of the far-right. One user named Johannes Normann, formerly a regional leader for AfD, wrote: "Does 'our' news have to be first cleared by our trans-Atlantic 'friends'? After all, they 'ordered' the 'Islamic mass-immigration.'"

Another user, Julien F. Weikinnes, wrote: "What would have happened if 100 Pegida followers had raped 300 Muslims? There would probably have been a breaking news alert and a live story from the Cologne train station."

Those, of course, are just the voices of individuals. Yet according to a survey conducted by Allensbach, 41 percent of Germans believe that critical voices are suppressed when it comes to the refugee issue. On the right wing of the political spectrum, that belief has become a certainty.

Aroused Right Wing

Right-wing populists and extremists are positively celebrating what happened in Cologne as confirmation of their long-held beliefs about foreigners and their allies with the "lying press."

Whether PI-News (PI stands for "Politically Incorrect") or Pegida, whether AfD or the neo-Nazi party NPD, whether the right-wing party ProNRW or the newly converted far-right snobs: All of those who wrote about Cologne reveled in the incident.

"Templer" wrote in PI-News: "The crazy chancellor has allowed millions of male, sexually starved, asocial illegals from the Middle East and Africa to come to Germany. Blond German women are, according to the Koran, 'prey-women' who can be abused according to your whims or enslaved."

"Eurabier" wrote, likewise in PI-News: "The lefty-green lying press … would have liked to have kept this group rape under wraps."

"eule54" wrote in PI-News: "All of it was predictable from Merkel's niggers, gypsies and Arabs, who she waved in illegally."

"Hans-Werner Link" wrote in Facebook: "Where were the girls screaming welcome this time? Those whores would certainly have loved to have their crotches or tits grabbed by countless hands."

"Stephan Tautz" wrote in Facebook: "Put them on a ship and sink them in the Atlantic."

There are even worse entries than these ones. But there are also missives with similar messages, yet delivered in a more genteel manner. Thomas Schmidt, in a blog belonging to the new right-wing magazine Sezession, writes of an "ongoing population exchange." On the website of the magazine Blaue Narzisse, also a right-wing publication, Felix Menzel writes of the need to "throw out non-integrated foreigners, cease paying social benefits to new arrivals and open asylum centers in North Africa and the Middle East."

And of course Björn Höcke of the AfD shouldn't be ignored. On Facebook, he wrote: "The events at the Cologne train station on New Year's Eve gave our country a taste of the looming collapse of culture and civilization. Hundreds of women were victims of a group of 1,000 (!) North African young men."

No matter how often such nonsense is repeated, it doesn't make it any more true. Yet the inaccurate, exaggerated numbers have found their way into the global press.

Constellation and Magnitude

Who should one ask to better understand what happened in Cologne? Wilhelm Heitmeyer is one of Germany's best known social researchers. For almost 20 years, he has led the Institute for Interdisciplinary Research on Conflict and Violence at the University of Bielefeld. His focus is on violence and brutalization, forces that drive society apart.

The fact that women were physically attacked, Heitmeyer says, is nothing new. "That has always happened. What's new is the constellation and the magnitude."

He says that the interaction of several factors is likely what made the large number of attacks possible. "The police could have handled 20 men. It follows, then, that there must have been a critical mass of perpetrators with the same idea in mind," he says. He notes that normal New Year's Eve happenings also played a role. "On New Year's, many people tend to collect in small spaces, it is loud and screams can easily be misinterpreted. In addition, large crowds make it more difficult to identify individual perpetrators."

Heitmeyer believes it is incorrect to speak of organized crime, as German Justice Minister Heiko Maas did this week. "Organized crime has a stable structure with targeted and obscured courses of events. But in Cologne, we are looking at the absence of structure. I assume that the perpetrators coordinated using modern communication devices and social networks. We are familiar with that from violence-prone football fans."

Because words can generate reality, Heitmeyer warns against speaking of sexual attacks. "That trivializes the phenomenon," he says. "It's about violence. And violence is a demonstration of power -- in this instance, women's right to self-determination, in order to express their inequality."

The search for the perpetrators initially led the Cologne investigators to a criminal milieu, one that has plagued Cologne for years, especially in nightlife districts or around the train station. It's typically groups of young pickpockets who use perfidious tricks to snatch wallets, phones and other valuables off unsuspecting pedestrians. The perpetrators dance up to their victims in a pretend celebratory mood, rub up against them and rob them. Those who try to defend themselves are insulted, threatened or even hurt.

No Deterrent Effect

In Cologne alone, more than 11,000 people have been robbed in this way in the last three years.

According to police, all of the perpetrators have been male and in the majority of cases, they have come from North African countries such as Morocco and Algeria. The authorities are also investigating groups of men from central Africa and Kosovo. One person involved in these investigations has said most of the men have been in Germany for quite some time but only have a "tolerated" immigrant status, meaning officials could not confirm their country of origin due to missing travel documents. This milieu has little to do with the refugees who have arrived in Germany recently after fleeing places like Syria, Iraq or Afghanistan.

The perpetrators -- among whom are also some Germans -- tend to be between 16 and 25 years old and they usually operate in small groups. On any given day in Cologne, there are about 20 of them on the streets. Conviction rates are low, and when they are made, the result is usually just a fine. Thus far, such penalties have not had a deterrent effect.

But all that may now change -- now that the criminals have moved on from mere thefts and threats. New Year's Eve may have marked a dramatic turning point. Sexual assaults were perpetrated en masse in several cities, as if coordinated by some invisible hand. Two of the alleged attacks in Cologne ended in rape. These are serious offenses that can hardly be mentioned in the same sentence as the tricks of the pickpockets.

In one rather explosive development, however, authorities in Cologne were able to locate some of the mobile phones that were stolen on New Year's Eve. In a number of cases, the trail has led to refugee shelters or their immediate neighborhood.

The stories of Lara, Jeanette and Paul, three university students from Bonn, paint a vivid picture of what so many women experienced on New Year's Eve. The trio had traveled to Cologne with two other female friends because the parties there are simply better than they are in Bonn. They arrived at the square in front of the train station just as the police were clearing it. They didn't know what was going on -- all they saw was police officers in helmets pushing people back. They continued on to the banks of the Rhine River, a vantage point from which they could view the fireworks, when Jeanette realized that her money, ID and entry ticket for that night's club had been stolen.

Just the Beginning

At midnight, they shared a bottle of cheap champagne out of plastic cups and then headed back to the central train station. In front of the stairs leading from the cathedral down to the train station, they had to squeeze past a large group of men. They locked hands, letting Jeanette take the lead because she knew judo. Paul tried to provide some cover for the girls. At one point, Lara cried out: "Someone just grabbed my crotch!" That was just the beginning.

Hands seemed to come from every direction to grab the women's bodies. They always went for between the legs. Paul's attempts to protect the women were futile. Providing cover for one left another to fend for herself. "It was one hand after another," Jeanette says. She was able to throw one attacker "really violently to the side" with a judo grip.

None of the three students can say for sure who attacked them. They are, however, all in agreement that all of the men surrounding them were speaking the same language, and that it sounded a lot like Arabic.

What Lara, Jeanette and Paul experienced in Cologne wasn't unique to that city. Police reports indicate that a large group of men also gathered along the famous street in Hamburg's St. Pauli district known as Grosse Freiheit, most of whom were probably of North African descent.

These men committed a series of "property thefts with sexual components."

In Stuttgart, a 20-year-old Iraqi has been in custody since the morning of Jan. 1 for allegedly groping two women at the city's Schlossplatz square. Police in Frankfurt am Main have reported similar incidents.

Jeanette and Lara, the two students from Bonn, went to the police six days after New Year's to file complaints for sexual assault. "We want this to be documented," Lara says. It makes them furious to read in the newspaper that what happened in Cologne came from the pickpocket milieu. The way Lara sees it: "We were systematically sexually harassed."

By the time Jeanette, Lara and Paul boarded the delayed train that would take them back to Bonn on New Year's, it was 2 a.m. During the ride, they met a young Syrian who told them about his flight from Damascus through Lebanon and Turkey and eventually by boat to Greece. From there, he continued on foot through the Balkans and on to Germany. Afterwards, they told him about their night in Cologne. He was horrified, they say.

'War in the Middle of Cologne'

Society should be grateful for witnesses such as Jeanette, Lara and Paul: people who experience horrible things, but who still refrain from resorting to prejudice.

Cologne's central train station isn't far from the tower where the office of one of Germany's leading feminists, Alice Schwarzer, is located. It is from there that she broadcasts her commentaries on current events out into the world. When it comes to the sexual assaults on New Year's Eve in Cologne, Schwarzer speaks of "war" and "terror."

"Young men of Arab or North African descent are playing war in the middle of Cologne," she writes, describing a "gang-bang party and 1,000 men who were acting as if they were at Tahrir Square in Cairo, dreaming of being heroes like their brothers in the civil wars of North Africa and the Middle East." They are a product, Schwarzer says, of misplaced tolerance in this country.

Schwarzer is speaking the language of all the people who see the events of New Year's Eve as proof that sexual violence is an imported problem -- a result of failed immigration. Young German feminists see it differently.

They argue that sexual violence is not a migrant phenomenon at all, but a long-standing, societal problem. Young feminists like Anne Wizorek criticize that Schwarzer -- along with many others -- is using the New Year's violence to fuel racist sentiment. They also criticize that broad swathes of society are acting as though there wasn't any sexual violence in Germany before the refugees arrived.

Every year during Oktoberfest, for instance, there are a number of sexual assaults, even rapes.

Men grab women inappropriately at clubs across the country. At public viewing sites, where people gather to watch soccer, or Karneval, the boundaries between playful flirting and malicious badgering are quick to blur. Nearly 60 percent of German women say they have been sexually harassed, according to a 2004 study. Sixty percent! It's impossible that such a staggering number of women were only harassed by men from North Africa.

Young feminists are being asked why they haven't been showing their outrage over the latest attacks as strongly as they did three years ago with the hashtag "#aufschrei," German for "outcry." At the time, a politician with the FDP party named Rainer Brüderle made a lewd comment to a female journalist and set off a wave of criticism on Twitter. Is it because many of the attackers this time around were migrants? Is that what they call political correctness?

Empty Words

When emotions are running high, nuanced opinions tend to be drowned out by the hysteria. A black-and-white view of the world takes hold and politicians promise swift, conclusive "solutions," as if such a thing were possible.

In this environment, reports of everyday sexism are hardly even registered in the public sphere because they don't match some people's perception of everyday life. But in some areas, everyday life has been in such disarray for such a long time that many speeches about the need for a strong integration policy sound like empty words.

Ercan Yasaroglu, a social worker from Berlin, was appalled when he heard about the attacks in Cologne. He was furious and dismayed, but he wasn't surprised. "What happened in Cologne has been happening here in Berlin for a year, but on a smaller scale," he says.

Yasaroglu works in the Kreuzberg district of Berlin. In recent months, he has seen how, time and again, women are verbally harassed, then groped, then robbed. "This is not some sudden loss of inhibition, but calculated action by criminals." Thieves intentionally distract women with sexual assaults, he says, and many of those responsible are from countries in North Africa.

Some of them have had their applications for asylum rejected, leaving them with a "tolerated" immigration status and a miserable life.

From his office at Kottbusser Tor in the heart of Kreuzberg, Yasaroglu gazes out at snowy streets. He has lived here since fleeing Turkey 30 years ago. To him, Kreuzberg seemed like a German melting pot of sorts, a place where people from around the world can live together more or less peacefully.

But the atmosphere has changed in the last year or two. It's gotten rougher, more hostile.

A dozen gangs, roughly 10 to 15 people in size, have divided the neighborhood up amongst themselves and are increasingly terrorizing residents and tourists. The number of registered drug-related crimes has increased by 90 percent in the last year, the number of pickpocket thefts by 30 percent. Numerous business owners in the area complained in a letter to the city government of the new level of aggressiveness at Kottbusser Tor. The square is dominated by criminals.

What's the best way to deal with such problems? A year ago, Yasaroglu wrote a letter to Berlin politicians requesting they make integration work a higher priority. But he also asked for a greater police presence in Kreuzberg. "If we can't -- or don't want to -- integrate these people, then we need to at least monitor them."

'Tough Response by the State'

Integration, integration policy, repression, immigration policy, caps on immigration: The events in Cologne have profoundly changed the dynamics of Berlin politics. Chancellor Merkel and her confidants fear that it will only get more difficult to enforce their current refugee policy.

Merkel doesn't usually comment on events until she has the full story. The fact that she has already responded to the violence in Cologne by saying that it deserved a "tough response by the state" shows how seriously she takes the matter.

Her fears are shared at the highest levels of her governing coalition. The parliamentary group leader of her Christian Democratic party, Volker Kauder, says he is concerned that what happened in Cologne will inflame already negative attitudes toward refugees. Kauder says the hate mail he receives has gotten more aggressive since New Year's.

Many members of German parliament report having similar experiences as Kauder. Gunther Krichbaum, chairman of the Committee on the Affairs of the European Union and a supporter of Merkel's refugee policy, says: "Cologne has the quality of changing the entire debate over refugees."

In fact, that's already happening. Merkel is suddenly calling for a "tough response," Interior Minister Thomas de Maizière says it must be easier in the future to deport delinquent asylum seekers. Justice Minister Heiko Maas, who is otherwise rather reserved, has said it may be possible to deport offenders.

Top Christian Democratic and Social Democratic leaders have until now avoided using such sharp language. But they are worried that right-wing movements like Pegida or populist parties like the AfD could become even more popular if the federal government is seen as being too soft on foreigners who commit crimes.

The Christian Democrat's new party line can be found in the so-called "Mainz Declaration," which the party's federal-level leadership intends to adopt this weekend. In the case of offenses like the one in Cologne, the declaration foresees "potential perpetrators being immediately ordered into custody" if there is sufficient suspicion against them. In the case of violence against police officers and other emergency personnel, a new designation will be created that will come with "significantly higher prison sentences." And anyone who is sentenced to imprisonment without parole will forego his or her right to being classified as a refugee or asylum seeker.

Running Out of Patience

The leader of the Social Democrats, Sigmar Gabriel, presented his party's new stance on the issue during a breakfast with other Social Democratic cabinet members at the Economy Ministry on Wednesday. "The time for understanding is over," he said. "Something must now be done -- otherwise the people won't understand us at all anymore." Parliamentary group leader Thomas Oppermann tweeted after the meeting in a manner that would usually be ascribed to members of the right-wing AfD: "No pardon for sex attackers. Investigate, arrest, punish harshly. And deport them if possible. To protect the victims and the refugees."

Even Merkel's style of communication has changed.

In a speech at the annual convention of the Christian Social Union (CSU), the Bavarian sister party of Merkel's Christian Democrats, she stressed several times that the number of refugees must be reduced. "I sometimes hear people say that I like the fact that so many refugees are coming to Germany," she said. "That's absolute nonsense." It was the first time party members had heard Merkel talk about refugees in that tone.

The chancellor still doesn't want to deviate from her political path. She has rejected demands from Horst Seehofer, the head of the CSU, for an upper limit of 200,000 refugees per year. Merkel is concerned that, were Germany to begin turning people back at its borders, the Schengen system of border-free travel in Europe would collapse. She hopes to be able to reduce the number of refugees using other methods. She is depending on Europe, with the help of Turkey, being able to secure its external border and hoping to establish a system whereby a predetermined number of refugees are distributed fairly among all EU member states. "I would ask that I am given the time to try these things out," she said at the CSU's annual convention this week.

But she is demanding a patience that many politicians and German citizens are running out of. And Merkel knows it. "Those who were already afraid see Cologne as confirmation," says a Merkel confidant. "And those who are fundamentally open to refugees are now saying: It can't go on like this."

What should be done? An attempt at complete honesty would be a good start. Germans are not children who need to be protected from the truth for well-intended reasons. And part of the truth is the fact that politicians like to talk about integration but have not yet given any indication that they understand the magnitude of the challenge facing them. Another part of the truth is this: German society is becoming increasingly divided.

By Maik Baumgärtner, Markus Brauck, Jürgen Dahlkamp, Jörg Diehl, Ullrich Fichtner, Jan Friedmann, Matthias Geyer, Hubert Gude, Horand Knaup, Alexander Kühn, Dialika Neufeld, Ralf Neukirch, Ann-Kathrin Nezik, Miriam Olbrisch, Maximilian Popp, Gordon Repinski, Sven Röbel, Barbara Schmid, Fidelius Schmid, Andreas Ulrich and Antje Windmann