Climbing the Wall of Worry: So Bad It's Good

Climbing the Wall of Worry: So Bad It’s Good
With all of the market volatility, a few of our Clients have wondered “what is going on with the market?” The response: “It’s so bad it’s good”. While this sounds like something Yogi Berra would say, people genuinely seem to understand the sentiment immediately. The response sums up investing in general—it takes patience, fortitude, resolve, endurance, and the counterintuitive nerve to buy high quality assets when others are frightened. As we saw in the Fall of 2008 and the Spring of 2009, fear and uncertainty give us low prices. Low prices make us second guess our long term decisions, yet these are the points in time that maximize long term investment returns if they can be capitalized on well.

And a quick note in keeping with volatility: true to form, as this is written just weeks after the close of a terrible third quarter, the stock market has rallied over 10% from the values at the end of Q3 (i.e. the reports you will soon receive “as of” September 30, 2011 are in the rear view mirror).

When PIIGS Fly...
Speaking of Europe, we have entered a new period of fear and uncertainty, revolving around the Eurozone, and the PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Couldn’t they have called something less derogatory, like GIIPS, or SPIIGhetti, or SIPIG? A recent piece put out by Stratfor is called “Preparing for Greece’s failure”, and we think it is worth a Google search.

The gist of the analysis is that the Eurozone needs 2 Trillion Euro in place to backstop a Greek departure from the Eurozone. This backstop would be used to shore up the net tangible capital within the European banking system. Their conclusion: Greece won’t be jettisoned until there are at least 2 Trillion Euro in the system.

Just the other day, Angela Merkel of Germany reassured markets that they are working to shore up the banking system, “just in case”. It is anybody’s guess which way the Eurozone issues will go, though there is a fork in the road. As Yogi Berra would say: just take it.

The first avenue in the fork is a really brutal painful abandonment of the Euro as currency, which essentially splits Europe into “northern” and “southern”. What happens in this scenario? The SPIIGhettis split away, revert to their old currencies, and then massively devalue their currencies, wiping away their debts but also wiping out their citizens’ savings. Southern Europe would be on sale, and the Northern bloc of Europe would then swoop in with their strong currencies and buy up Southern Europe. Northern Europe would become economically pinched as their exports become less competitive, and the Southern bloc becomes more competitive. This is ugly, painful and drawn out, and represents a “cliff” event that would create massive uncertainty, and is likely far too abrupt approach for investors, businesses, consumers, and governments to be able to react to with any facility.

The second avenue is more likely, wherein the Northern bloc essentially dictates the terms (at the last minute of each mini-crisis as it the whole thing unfolds) in order to keep the Euro alive. This will also be drawn out, but ultimately less painful. Part of the solution set is essentially the formation of a “real” European Central Government (ECG), not just a European Central Bank, which still has no real teeth. An ECG would obtain buy-in from all parties, and then would be authorized to issue massive quantities of Eurobonds, and also the ability to turn on the printing presses with full authority. This is the most politically viable option, and entails the Europeans performing a more formalized version of Quantitative Easing, but with a couple of Michelin stars thrown in. In short, the less painful path is for them to join the US in the “race to the bottom” in global currencies—print their way out. The second avenue is the “slow bleeding” approach that may allow investors, businesses, consumers, and governments a more gradual solution with plenty of time for all stakeholders to adjust.

Synopsis of last four years, as told to an alien that just landed on Earth:
“A housing bubble fueled by cheap money led to unproductive asset creation and resulted in massive securitization of these assets, which ultimately collapsed and threatened the global banking system. And now we’re paying for it.”


The result of the housing bubble left us with nothing but debt and empty real estate; the result of the internet bubble was an actual “new backbone” that continues to grow and innovate. The challenge for the US economy, and the rest of the globe, is figuring out what to do to be productive and innovative. In the United States, one day people will wake up and say “do we really need 5 million more houses?”, or should we re-direct our resources to something that can pay dividends, like our much-trumpeted idea of pursuing energy non-dependence for the US. Pursuing such an agenda would create millions of new jobs, create a new and innovative energy grid, would pursue all forms of energy creation, and the US could then export this knowledge as “services” to other nations.

Market Environment
This is an environment for short maturity bonds, floating rate funds, high dividend paying companies, and select growth companies. The Bull case is that eventually most of the problems hanging over the markets will be solved (i.e. Eurozone), we will eventually have a rising yield environment, and the nearly $2 Trillion that is sitting in “safe” bond funds will need to find a new home as yields rise and long-bond returns suffer. Stocks have always outpaced inflation over long periods of time, and based upon their current earnings power, this fact may once again be recognized, even if it takes some pain to finally realize it. During this “period of solutions” it is possible that our creditors will demand much higher rates of interest, while also fleeing to gold, silver, and oil as reserve assets. The last time we had a bout of high inflation was in the early 70’s, when we went off the gold standard and had an oil embargo. Gold, commodities, and oil did exceptionally well in that environment. The question is whether any rising yield environment will be gradual in nature, or a shock to the system. A gradually rising rate environment, and frankly any environment that allows companies and consumers time to adjust, is associated historically by rising stock prices and higher aggregate demand. A shock-reset in rates could hurt in the short term but still yield a brighter future with more certainty. For now, the Wall of Worry continues to grind higher. In fact, since 9/30/11, the market has climbed about 14%, though extreme volatility appears here to stay.

Valuations:
We continue to favor stocks that look like bonds and bonds that look like stocks. We prefer to buy the earnings streams of dividend-paying high quality companies at valuations that compensate us for risk. In other words, we are looking to buy an earnings stream for ½ to ¾ of the valuation placed on the broader market, and that pays 3-4% in dividends. This is twice the yield of the S&P 500 with ½ to ¾ of the price risk. It’s also much better than a Treasury security, which currently faces equity-type risk in the face of a rising yield environment. With the high grade corporate bond index paying 4-5% yields, it becomes clear that if we can find great companies with similar or higher payout attributes, we are buying stocks that resemble bonds. Additionally, if a fortress company takes a big dip in price due to the whims of the stock market, the reality is that most fortress companies have dividend policies that do not change so rapidly, unless there is a huge fundamental problem at the company (i.e. financial companies post 2008 that were/are scrambling to stay alive). A large health care company, an oil company, and a spirits distributor (as examples) are unlikely to have this problem.

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%). To put it bluntly, we do not trust the government numbers, the Fed, or the Treasury. Rule #1 in bond investing is: get paid, and get your money back at maturity. When we ask the question “Whom do I trust to pay me back?” increasingly the only reliable payers are corporations and sovereign nations that can actually pay their debts (think of resource rich countries like Canada, Norway, and Australia). Corporate debt levels can be measured in a finite number; whereas, government debt levels can be measured in wheelbarrows full of worthless paper.

Government Solutions to Economic Problems
When the government spends more than it takes in through taxes, and creates enormous debts over time, it has several options to “balance the accounts”. It can (1) slash spending, (2) increase revenue by raising taxes, or (3) stiff its creditors.

Many long-term studies show that the U.S. government, regardless of high marginal income tax rates of 80%, or low marginal rates of 25%, only collects about 20% in tax revenues from its citizens. This is a historical fact. The problem is that our government currently spends 25%. Easy math, right? Revenue (20%) – Expenses (25%) = -5%. So the government spends 25% more than it takes in.

Warren Buffett has become famous, again, lately for proposing the “Buffett Rule”, which the Obama Administration and some in Congress seem to like. It would tax those Americans now making more than $1 Million on their W-2 at a higher rate, assuming they don’t end up employing additional tax professionals to get their W-2 under $1 Million.

This is a lot better than going after those formerly-labeled “rich” $250k W-2-ers, and certainly plays better to a certain somebody’s populist base, but…let’s just assume that Mr. Buffett is correct. There were 7.8 Millionaires in the US for the 2009 tax year. Tax them all at the rates being proposed, and the estimates are new “revenue” of $450 Billion per year in tax receipts. The argument is that “well, that millionaire is just hoarding that extra $150,000 so he might as well give it to the government in the form of taxes”. The major problem is this: even using the Buffett Rule, the US is still in the hole to the tune of $1.5 Trillion! And what if half of these people are not “hoarders” but instead want to create new companies, innovate, and create new jobs? That’s $225 Billion that would have been put to productive use and toward job creation. And assuming the millionaires know how to run a business, those jobs would be sustainable, a far cry from “shovel ready” projects that end once the project ends.

MV=PQ
This brings us back to the old Milton Friedman formula yet again: MV=PQ. Money Supply x Velocity of Money = Price Level x Quantity. The only piece herein not working (yet) is Velocity of Money, or “V”. Here’s what’s been happening with V. The banks are sitting on the cash given to them by Fed repurchasing programs to help recapitalize the banks post-2008. There is currently not sufficient borrowing demand for the funds, and the demand that is being met is being lent to those who already have sufficient assets. What we have right now is: too many dollars not-yet chasing too few goods. To have a true “reignition” in the economy a few things must occur: government should rein in spending in a responsible manner in order maintain its credit-worthiness and to defend its citizens, government should initiate incentives to spur business and consumer investment and spending, and importantly government must remove and/or simplify a regulatory environment that is currently counter to the efforts to spur business and consumer activity.

We will also hold forth the intellectual integrity that this could be an incorrect view, and that the counter, Gary Schilling’s deflationary view, is possible. In this view, Europe implodes, destroys global aggregate demand, which distorts the pricing environment downward, which hurts revenues, profits, lowering tax receipts and shrinking all forms of output. The debt has yet to be repaid, and there is less revenue to pay for it, and we go into a sustained Global Depression. However possible this is, we have pointed out since the end of 2008, Google the terms “deflation speech Bernanke 2002” and you will find the equivalent of Knut Rockne’s playbook before the game. Google this if interested. In this speech, when Bernanke was a Fed Governor, he discusses that “inflation is always preferable to deflation”. In other words, increase the money supply, increase the balance sheet, and print out of it (i.e. inflate/debase the currency). Europe has been messaging that they are going to ride the Bernanke Express on this one, so the world “eventually” will have the USA and Eurozone debasing their respective trading bloc currencies, which is the least painful alternative to a failed Euro. And this is why China is so upset with US policy, because the US will pay back its Treasury obligations in increasingly worthless currency, or a “soft default”.

There are three well-known ways to protect yourself from inflation: own energy, own agriculture, and own sound money. We can buy equity in companies that specialize in energy assets or in agricultural assets. We are actively seeking out “trophy assets” that are well-run businesses that are difficult/impossible to replicate, many of which pay dividends, and many of which are necessary for the proper functioning of society. Sound money just means buying gold and silver, and of course there are several ways to do this. Regarding the metals, we have intellectually backed into this position over the last three years, and do not yet see a compelling reason to back away. Whenever a sovereign nation becomes so indebted it can never hope to repay, it inflates (i.e. it prints money, which debases the currency). Remember: inflation and currency debasement share a common truth—a reduction in purchasing power.

Race to the Bottom
Globally we are in a “race to the bottom” in currencies. Central banks that print money are debasing their own currencies, some to remain competitive in terms of exports. But if everyone is debasing and printing money, the relative pain doesn’t look so bad, does it? The truth is that paper currencies, unless backed by real assets and reserves (think gold and oil), are simply fiat and ultimately worthless. When comparing a currency’s purchasing power with the purchasing power of metals or really any commodity, it is clear that the purchasing power of the fiat currencies has dropped dramatically, while the purchasing power of gold or silver has only risen. So what are good alternatives? When we look at this from our perch, the clear alternative is to invest in strong franchise companies that have real, productive assets, pay solid dividends, are growing, and can grow in a rising price environment and that we think can outpace debasement/inflation.

Commodity Price Swings: Why so Crazy?
Commodity prices over the last two months have see-sawed all over the place, beginning with the August lows (of 8/8/11) and have been back and forth amidst all the fear emanating from Europe, as well as from a slowing Chinese growth rate. If the emerging markets’ growth slows, the thinking goes, then demand for commodities will falter. The European fears of a Greek default, or Greece expulsion from the Euro, have also led to fears of a massive slowdown, which would affect the U.S. economy as well—this is the Global Depression/deflation worry (Gary Schilling view). Commodity company stock prices have reflected this worry, and copper in particular broke down, but has rallied back in the last few weeks.

Fixed Income Commentary
Corporate bonds, particularly high yield, look relatively attractive. We are also finding interesting foreign bond issues (mostly sovereign) for new money that look more attractive than US paper in terms of their ability to pay.

Treasury securities with longer maturities should be avoided at all costs in what we expect to be a rising rate environment. The Fed can control short-term rates, but the market dictates long rates.

Municipal Bonds
CA Municipals (and really any/all municipals) are starting to look interesting again.

New Arrows in Our Quiver
In the last few months, in anticipation of potential Client needs, we have added two new suppliers of research and product offerings that could become part of an investment solution for Clients: Goldman Sachs Asset Management and DFA (Dimensional Fund Advisors). Goldman Sachs is probably a well-known name to you in terms of their research, and they have some interesting alternative product offerings as well. DFA may not be well-known to you— it is a 30 year old firm that specializes in “active indexing” solutions. ACC Investment Management, Inc., an independent, fee-only Registered Investment Advisory firm, now has access to these additional platforms.

Thank you for your continued business and referrals
Please know that we are here to answer your questions, to go over your portfolio positioning in the context of your retirement plans, and to provide a sense of perspective in this market. Investing is a long term endeavor. We hope you enjoy reading our independent Quarterly Commentary as much as we enjoy writing it! Though risks remain, patience will be rewarded.

A.Charles Cattano
ACC INVESTMENT MANAGEMENT, INC.
1325 Howard Avenue PMB #433
Burlingame, CA 94010
ccattano@accimi.net 650-344-1600 www.accimi.net