End of Q3 2010 Commentary

Market Snapshot
We experienced a roller coaster, with a small correction in August, followed by what turned out to be one of the best September’s on record. Earnings have been good, though we have much mixed data, and are stuck in a “jobless recovery”. The government tells us that the recession ended last July, but Warren Buffett disagrees. Hmmm? The government also likes to tells us that prices are under control, but when we look at the CPI we are supposed to look at it “ex-food, ex-fuel”… On the optimistic side, much of the September rally has been attributed to a likely changing of the guard in Washington DC. A recent poll shows that 85% of the population is “angry” with the economy—never good for the incumbents. This is from Phil Gramm:



Let’s just hope that prescriptions by any political “new guard” don’t precipitate any major policy missteps. Investors have continued to pile into equities, with cash coming off the sidelines from money market funds, as well as a robust outflow of funds from the Bond markets into Equities. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products.

As an example of our risk-adjusted approach to equities, we have favored purchases in oil and oil drillers; for example, such companies trade at just over 9 times earnings, which is about half of the broader stock market multiple of 15-20 times earnings. We feel that such an example plays well on a bottom-up company analysis, on a top-down global macro analysis, on a global demand basis, on a currency basis (if the dollar weakens), and on a “black swan event” basis (Middle East instability). Further, if the economy weakens, oil prices are likely to stay in a $65-85 range; if the economy continues to expand, the range could reach $100 again. Here in early October in fact, oil has reached $80/barrel, and the Obama Administration just removed the moratorium on oil drillers in the Gulf—all positives for this sector.

Buy Stocks that Look Like Bonds and Bonds that Look Like Stocks
What do we mean by this? Simply, for new money purchases we are actively screening for equity valuations trading for 7-12x earnings, with dividend yields between 3-6% as an added bonus if we can get it. By buying the earnings stream of a high quality company at these valuations, we are much more certain in our investment thesis in terms of risk. In other words, we are looking to buy an earnings stream for ½ to ¾ of the valuation placed on the broader market, which only yields 1.5-2%. So any stock that pays 3-4% at a minimum is yielding twice as much as the S&P 500 with ½ to ¾ of the price risk. With the high grade corporate bond index paying between 4-5% yields, it becomes clear that if we can find great companies with even higher payout attributes, we are buying stocks that resemble bonds.

To flip the equation, in the bond market we are looking for high grade corporate bonds (4-5%) and “vanilla flavored” high yield bonds (7-8%). Why? Because we don’t trust the government, to put it bluntly. This mindless money-printing should lead all investors to ask the question: who do I trust more to pay me back? Warren Buffett or the USA? Increasingly the answer is corporate America, since we can easily examine a corporate balance sheet and determine the percentage of the company that is financed by debt. In a word, debt at the corporate level is a finite number; whereas government debt is dangerously in the other direction. Considering that the 10-year Treasury pays only 2.5%, and in the context of our view that inflation will eventually come home to roost, any holders of Treasury securities will lose badly to inflation or erosion of capital.



Often it takes time for the market to capture the intrinsic value of securities. While there are those who “believe” in the EMH (Efficient Market Hypothesis), we note that it is extremely important to realize that an “efficient” market doesn’t mean the market is always “rational”; in fact the inverse is true. “Efficiency” means that the market will efficiently produce a price, matching a buyer with a seller. “Efficient” pricing led to extremely high short-term valuations in 1999/2000, and extremely low short-term valuations in March 2009—but was it rational long term?

Inflation Is Still A Monetary Phenomenon!
Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. MV=PQ is the equation, and it essentially breaks down into a simple explanation such as “the more money is printed or created by the government, the higher the price level (prices) will be”. In other words, inflation. There has been discussion that increasing inflation will reduce unemployment; however Milton Friedman’s work in 1968 explained why any gain in employment would be temporary—it would last only so long as people underestimated the rate of inflation!

Looking at the Fed’s rather aggressively attempts at reflation, there is some concern now that the Fed may not be sparking the “good” inflation that is caused by strong demand and reduced slack in the economy, but rather the “bad” inflation that behaves more like a tax hike. The Fed is hoping that the wealth effect produced by a rising stock market will offset the concerns. The Fed’s policies produce asset classes that are re-flated due to a commensurate newfound liquidity creation of dollars and Treasuries via debt monetization (i.e. using one credit card to pay off another). The Fed has signaled that it again may resort to Quantitative Easing (being called QE2). This should keep a lid on mortgage rates (for now), but at what future cost to the economy is anyone’s guess…


Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by this measure the Fed seems to be succeeding.

In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises. In such an environment, it is important to remember “why we invest”, which is to outpace inflation. If the stock market goes up 30% but oil and other commodities go up 60%, you will have wanted more exposure to those sectors within the market.

In a long-term inflationary environment, we expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, beginning in the second half of this decade (which is another way of saying that we would expect inflation to be largely a global phenomenon). Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle.

In short, nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. We do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, precious metals and TIPS. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where we would expect the opportunities to emerge. The recent TIPS auction produced a negative yield for the first time ever… bolstering the case for inflation over deflation.

History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and the opportunity.

Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a weaker environment it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings. Additionally, the recent news that China’s Yuan is floating higher adds to the demand for commodities.

Currencies
Increasingly we are hearing about a troubled dollar, but the truth is that there is a global “race to the bottom” in currencies. Governments are printing money to inflate their way out of the global meltdown. And while some politicians are trying to put new tooth into the old Smoot-Hawley Tariff Act of the 1930’s (you probably think we’re joking, but we are not), the truth is that we are in an Economic War of Protectionism which is going at full throttle—countries with cheaper currencies are hoping to benefit growth of exports in order to grow their top line GDP numbers. But at what cost? It’s all an illusion to make it appear that things are better; the reality is that many countries are beginning to discuss a global currency alternative, or IMU (International Monetary Unit)—by the way this was a long time prediction by Nobel-prize winning economist Robert Mundell, who also predicted the rise of the Euro, says of the very unstable relationship between the euro-dollar rate “[this is a] terrible things for the world economy. We’ve never been in this unstable position in the entire currency history of 3,000 years”… what could transpire in the future that leads us to the IMU? An important question to contemplate, and one to which the price of gold may be sending us an answer.

Gold
Irving Fisher, economist of the 1920’s whose ideas were overshadowed by John Meynard Keynes, is the original proponent of a strong dollar backed by commodities.

If the Fed would have listened to gold (or the nominal GDP model) over the past 15 years, the US would probably not be in the mess it is in today. Gold prices fell from $400 per ounce to $255 an ounce between 1996 and 1999. This signaled deflation, but the Fed chose to ignore the signal and raised interest rates anyway in 1998 and 1999. Deflation, recession and a stock market crash were the result.

In the wake of the stock market crash, the Fed started cutting rates because it feared deflation. Gold started to rise and by late 2003 it was back above $400/oz. But the Fed held rates at 1% anyway, which created a housing bubble. When that bubble burst, the Fed started cutting rates again and gold prices have now moved to more than $1300/oz. At this point, one would think the Fed would pause before pumping even more money into the system and targeting higher inflation.

But it isn’t. The Fed continues to hold interest rates at zero, proposes another round of “quantitative easing” and plans to target 2% inflation. All because it won’t listen to gold and it’s unable to see that banks are afraid to use the money the Fed is pumping in because, down the road, the Fed will be forced to take it out or face serious inflation.

That’s what gold is saying. By signaling that it won’t quit anytime soon, the Fed is trying to force banks to change their behavior. If it works, look out for inflation to reach multiples of 2% in the years ahead. The Fed hasn’t been successful yet, when it ignores gold and commodity prices.

Mortgages
If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Recently the 30 year fixed mortgage dipped to about a 60-year low. It’s still cheap money, and it should be considered a very temporary “gift” from the Fed. The Fed is re-upping its bet of Quantitative Easing (buying mortgage backed securities on the yield curve to artificially keep mortgage rates low). Take advantage of this now, especially if you currently hold an adjustable rate mortgage. This gift, if you decide not to take advantage of it, will self-destruct within 24 months…

Fixed Income Commentary
Corporate bonds, both investment grade and high yield, look relatively attractive. In fact high grade corporate bonds are now trading on a near-equal basis with Treasury securities, meaning that sovereign debt is trading on credit-worthiness and balance sheet strength (instead of on ability to tax). As far as we know, this has never occurred before in history. Well, after all, who would you trust more to pay back a loan right now? Warren Buffett or the U.S. government? We’d choose Buffett.

Treasury securities with longer maturities should be avoided at all costs in this environment. TIPS offer some inflation protection, though recent auctions have produced negative real yields since investors are becomingly increasingly convinced that inflation is coming.

CA Municipal Bonds
The CA political atmosphere is heating up, with lots of talk; hopefully the “winners” can actually deliver on their rhetoric in terms of fixing the state’s woeful financial condition. The problems are big, but as a great politician once said: “the answers aren’t easy, but they are simple.” Please make your vote heard on November 2, unless you have already changed your legal residency to Nevada.