IF KARL ROVE SEEMED

like an obscure, shadowy figure operating behind the scenes during the first term of George W. Bush, that's clearly no longer the case. Everyone now knows the story of the slick political operator who turned a young, well-connected baseball executive into a two-term president.

Last week, an old acquaintance of the Texas political handler sent Rove an open letter titled "The Next Bush Recession." In the letter, John Mauldin, president of Millennium Wave Investments, an Arlington, Texas-based investment adviser, warns that a variety of indicators are signaling a dramatic recession two years down the road. And with the Fed almost out of bullets and no big federal tax cuts coming down the line, there will be no way to stop it, he says.

Mauldin, an avowed Texas Republican, tells Rove that if Bush wants to get his agenda through Congress, he'd better act quickly. Because once the economy goes into a tailspin, the mood for major policy changes in Congress will evaporate faster than John's Kerry's dreams of presidential glory last Wednesday morning.

SmartMoney.com recently spoke with Mauldin to find out why he thinks the economy is going to fall into recession and what investors should do to prepare for it.

SmartMoney.com: How do you know Karl Rove?

John Mauldin: I was active in Texas Republican-party politics. I worked on a number of campaigns and did fundraising. That was in the 1980s and 1990s. In terms of bumping around and meeting Rove, if you were active in party politics in statewide races in Texas, you were going to meet Karl. He was everywhere.

SM: Rove has become a pretty controversial figure.

JM: He was controversial in Texas, too. Karl is, and was, a pragmatist. As I wrote in my letter, he once told me that if you don't win the election, you don't get any of your agenda through. His first goal is to win the election. As far as those of us who might have been more ideologues, that was a frustrating thing, because we wanted to promote our agenda. Karl is more about winning elections.

SM: In your open letter to Rove, you argue that we may be heading for another recession in a few years. Why so?

JM: We're not seeing albeit last month's strong jobs numbers enough jobs being created to maintain equilibrium. You need close to 200,000 jobs just to maintain equilibrium. So unless we start seeing 350,000 jobs added back to back to back, there's going to be a problem. We're also starting to see inflation beginning to create a problem in producer costs. [Producers are] having to pay more to produce goods...and that's squeezing profits. Profits as a percentage of gross domestic product are busting out at a multidecade-high level, so there's not much higher that they can go. I don't think consumer debt is as big of an issue as some say it is, but the problem is that much of the recovery and the shallowness of the recent recession is [attributable to the fact that] people were willing to go into debt, more than [the fact that] their incomes were rising. We're reaching the point where consumers can't borrow much more than they already have.

SM: You also argue that the recession might be worse than the one we just struggled out of.

JM: That's because we won't have the ability to stimulate the economy as much. The Fed will have 3, 3 1/2 [percentage] points [of rate cuts to work with] if we're lucky. The government isn't going to be able to throw in much of anything. There also won't be much mortgage refinancing, and that was part of the reason for the shallowness of the last recession. We can argue with Fed policy on a lot of things, but the reality is that the stimulus, coupled with mortgage refinancing and three Bush tax cuts, did make a difference. It kept us out of a deep recession. Those tools just won't be available.

SM: You also say there's a risk of deflation. That might come as a surprise to some, especially considering that the Fed is hiking rates to hold the reins on inflation.

JM: Recessions are by definition deflationary. If the Fed can't get rates back up to 3 or 3 1/2%, so that when you hit that deflationary pocket there's some room between current rates and zero, there's going to be real problems. I think the Fed was fighting deflation in 1999. They were saying that they were worried about it. During the recession, people really got worried about deflation. We saw a year-over-year consumer price index of 1.1%. Year-over-year CPI right now is still under 3%. When prices start to fall again, we won't have the deflation-fighting tools that we had in 2001 and 2002.

SM: Another potential negative sign you point to is the potential for an inverted yield curve. Could you explain why that's bad signal for the economy?

JM: There was a Fed study in 1996 that took four indicators and analyzed how useful they were in predicting recessions. The only thing that really worked was an inverted yield curve. Every recession we've had since World War II has been preceded by an inverted yield curve. In October 2000, I said we're going to have a recession in 2001 and that the average stock market falls by 40% during a recession and so it was time to get out of stocks. That was when the NYSE was still at its all-time high. It didn't take a rocket scientist to know that we had an inverted yield curve and that it was time to get out.

Now, an inverted yield curve happens when long-term rates are lower than short-term rates. So a flattening or inverting yield curve means that people don't want to put money to work for the long term. They're not borrowing money for the long term, and there's excess capacity there, and that brings prices down. That's part of what that signal means. A flat or inverted yield curve doesn't force a recession, it tells us there are conditions in the market that are unsettling.

SM: Some economists argue that strong productivity should keep the economy chugging along. What do you think?

JM: Well, there's always a this-time-it's-different crowd. Rising productivity is not without its costs to the economy. That cost is fewer jobs. It has been the rising productivity that has helped slow down job growth. It has helped drive up profits, but those profits have been sitting in corporations' bank accounts. They basically haven't put it back into increasing capacity. We're not at full utilization now. The capital spending that's going on now is replacement spending, it's not new-capacity spending. It's true that the fact that this country is so productive and its economy is so flexible will keep us from going into a depression. The conditions in terms of debt and in terms of a number of different factors are eerily reminiscent of 1929 and 1930. But our economy and markets are far more flexible, and our capital situation is far more durable than it was back then. And we don't have a Fed that is entirely stupid.

SM: How can investors position themselves for a slumping market?

JM: They don't want to be in broad-based indexed mutual funds. They want to be in individual sectors or stocks that they like. This is a deep-value market. Seeking absolute returns is the single best strategy to focus on. My feeling is this: We're going to get to buy this market at a significant discount from where it is today, at least 20% to 30%. So I'm going to get to buy this market at a discount. In the meantime, my bond returns and my absolute returns might be small, but they're there. Preserve your capital, grow it in a prudent manner, so that when this opportunity comes around in the future, you've got your capital.