Crossing the Rubicon

Crossing the Rubicon   

The European Union’s agreement to continue to backstop Greece in the last quarter was significant: it signals that the Eurozone will continue its stabilization efforts. The two largest economies in the EU, France and Germany, simply have too much to lose by not holding the Euro together.

2012 is an election year in the US, and we sense policy changes in the air whether the current Administration remains, or is replaced.  Either way, we think more certainty is coming, regardless of the current uncertain state of affairs.  Investors and the market are tired of the uncertainties created by excessive cheap money policies and general government intervention.  As Europe eventually stabilizes, and as the election unfolds, we will experience increased certainty and more clarity from a fiscal, tax, and investment perspective. We try not to be political in these recaps, though we need to put election scenarios on the table since they directly affect market and business sentiment. 

If Romney wins the Presidency, we foresee an attempt to slow government spending (AKA the Ryan Plan) in conjunction with more certainty in tax and investment policy, and an earnest attempt to repeal the Affordable Care Act (ACA) if Republicans can garner 51 votes in the Senate.  51 votes is a simple majority requirement to repeal the ACA since it was passed as a “reconciliation” bill.  Then perhaps a bipartisan effort can generate a giant “do-over” that includes some of the obvious advantages that exist now, but with more market-based mechanisms in it.  Additionally, in a Romney campaign/victory, he would need to address the fiscal “tax cliff” that ends 12/31/12, and would attempt to pass legislation retroactive to 1/1/2013; however, much economic carnage will have been experienced by 12/31/12 despite these efforts.  On 1/1/2013 the top federal rate on personal income will increase to 39.6% from 35% (a 13.14% increase), with an additional 0.9% increase in payroll tax for Medicare.  The highest federal rate on dividends will increase to 43.4% from 15% (189% higher!), and the tax rate on capital gains will increase to 23.8% from 15% (“only” 58.6% higher).

If Obama wins the Presidency again, in what is undoubtedly a referendum election, we foresee additional thrust in fulfilling his agenda of “Hope and Change”; in other words, he would take a re-election as a mandate for more of the same. Yet if Obama wins re-election, we view it as less likely that his party will hold either the Senate or the House, thus any effort to repeal the ACA in this scenario will ultimately fail unless both the Senate and House can muster 2/3 supermajority votes to over-ride a certain Presidential veto of a repeal effort.  ACA would almost certainly stand.  We head over the “tax cliff” 12/31/12 and there will be no effort to address this. 

Whoever wins, there will be more certainty.  However, in our opinion the United States is at a giant fork in the road—thus the decision to cross the Rubicon, or not.  Voters must make the decision which direction the country goes— there is no going back.  As Julius Caesar might tell us, “the die has been cast”…but the way it is cast is up to us. 

Julius Caesar, Crossing the Rubicon

Valuations

Against this macro-economic backdrop, common stocks are reasonably valued, while bonds are historically expensive as fear trumps optimism. Valuations between common stocks and fixed-income securities have not changed materially since our last commentary. 10 year yields on US Treasuries touched a low of about 1.45% and have since inched up to approximately 1.60%.

US Stocks are now more attractive than earlier on a valuation basis. S&P 500 earnings estimates suggest that stocks are selling for roughly 13-14X this year’s expected earnings. Stocks are also providing dividend yields of 2.1% which is more than 0.5% greater than the yield on 10-year Treasuries. International stock prices have fallen further and we are seeing interesting opportunities in foreign equities.

We still believe equities are attractive investments, but do not see any near-term catalysts for rising prices. As discussed, economic growth is lackluster and the world is still deleveraging, which suggests limited potential for expansion until more demand emerges.

Risk Adjusted Values:    We continue to favor stocks that look like bonds and bonds that look like stocks.  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 find 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 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.  

What is Earnings Yield (E/P) Ratio?

Simply put, Earnings Yield is the inverse of the Price/Earnings ratio.  If the P/E ratio of the S&P 500 is 15.5 (current), the E/P is 6.4%.  This is also a good proxy for what the stock market might give us in terms of return, which is consistent with the CAPM (Capital Asset Pricing Model), which typically maintains an Equity Risk Premium of 4 points over Treasury yields.  We think the “goal posts” of Equity Returns are somewhere in the range of 6-9%, which is consistent with the long term averages of the S&P 500, which is 9.9% over 80 years of data.  So the question is:  what will it take to get the E/P Ratio higher?  Higher earnings in a sideways market works (and we have been sideways for 10 years), or lower prices.  If the “animal spirits” are rekindled through pursuit of the appropriate economic, tax, investment, and fiscal policies, the stock market could experience a surge due to increased optimism and investment.  An expanding P/E multiple (higher prices relative to earnings) would then bring prices up, in other words the confidence in the future increases the price an investor is willing to place on the future earnings stream of a company.

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”. The first known instance of inflation occurred in Rome (back to that Julius Caesar theme), when all coins in the realm were brought in, the edges were shaved off, and more coins were made out of the shaved edgings; all new (smaller) coins were re-cast with the same previous denomination.  In other words, inflation (debasement of the currency’s purchasing power). Fed Chairman Ben Bernanke has been expanding the Fed’s balance sheet in a similar fashion.

Last quarter I had the good fortune to be invited to the Hoover Institution in celebration of Milton Friedman’s 100^th birthday.  It was a fantastic gathering of brainpower.  The truly amazing aspect of Milton Friedman is that his body of work did not limit itself to economics.  His books “Free to Choose” and “Capitalism and Freedom” simply reinforce that Capitalism (even with all its warts) is the best system so far discovered in human history.  For a great video discussion between Milton Friedman and Phil Donahue circa 1980, click this link .  It is only about 2 minutes long and is great.

When Will Treasury Rates Re-Set?
Once the Fed stops printing money and stops buying Treasury bonds, what will be the real market for interest rates?  It could be much, much higher. And that could set the economy up for a real big interest-rate shock.  But…not yet, because Ben Bernanke and the Fed just this last week announced that rates will be kept low through 2014… with all of this Quantitative Easing, most people do not realize that the Federal Reserve Bank has been buying about 70% of all newly issued Treasury securities!  The “eventual” concern is that once you start this quantitative easing, you can't stop, because the economic consequences of stopping are too severe.  Another concern is whether there will continue to be enough other buyers of our Treasuries. The only reason we're able to continue to do any quantitative easing at all is because the dollar is the world's reserve currency.  

Frankly, we have wondered why, over the last 3-4 years, the US (the “best house in a bad neighborhood”) failed to issue 7-10 year Treasury securities at extremely favorable rates, which would have allowed the US to effectively retire old debt (higher rates) while issuing new debt (lower rates), simultaneously providing liquidity that was needed.  Effectively the US would have “refinanced” much of the country’s debt load, while also buying the US time to gets is fiscal and policy house in order.   Instead, the US issue short term debt at low rates that is coming due in the next 18-24 months that needs to be repaid or re-issued at the then-prevailing rate.  With an explosion of federal spending and, this adds much risk to Treasuries. 

“Safe Bond” Bubble Danger

Lately we read Peter Schiff’s latest book “The Real Crash: America’s Coming Bankruptcy” and Weidemer/Spitzer’s “Aftershock”.  As you may surmise, these are very happy books discussing the threat of hyperinflation and an end to Pax-Americana that make you want to build a bunker, buy three years’ worth of dehydrated food, a personal water filtration system, firearms, 100 gallons of extra fuel, tobacco, chocolate, and plenty of duct tape.  But they DO point out an interesting point in highlighting US indebtedness, which dovetails into our last 3 years’ opinions on US Treasury Bonds.  The point is not that we know “when” something will happen, but rather that in a rational framework this type of investment carries a great deal of risk in terms of valuation, potential wealth destruction, and loss of purchasing power.

Investors are selling U.S. stocks and buying bonds like they're going out of style. Bond prices have come unhinged from their underlying fundamentals. The bond market is a bubble. Bond holders today are practically guaranteed to lose money... But they're buying more bonds than ever. Remember... the most popular investment is almost always the worst one.  In fact, ICI's historical data indicates investors have been pulling money out of stocks and pouring it into bonds for almost four years... Since June 2008, investors have made net withdrawals of $376.1 billion from equity mutual funds. During the same period, they've poured nearly twice that amount, $723.6 billion, into bond mutual funds. Even though the stock market has more than doubled in value from its March 2009 bottom... investors are still scared of stocks today. They're lusting after the safety of bonds and fleeing the risk they see in stocks. In doing so, they're ignoring the huge risks in bonds... and missing the great benefits of owning stocks over the long term.  Historically, as noted on page 2, the S&P 500 has returned 9.9% on average over 80 years (equity returns + dividends), and currently the implied return of the S&P 500 is below the long term average; so, if we eventually have reversion to the mean, investors should be buying stocks!

At this point, you probably want to know what's so bad about investors buying bonds instead of stocks. They'll still make money. They just won't make as much over the long term... right? And you might also say, they'll never lose money in bonds, especially if they're buying Treasurys or highly rated corporate bonds. But investors aren't aware of just how much money they can lose holding Treasurys and other low-yielding, high-grade bonds... even if all the interest and principal payments are made on time. The ugly truth is, Treasurys and high-grade bonds are virtually guaranteed to lose  money if we're buying them at today's prices.

The Great Disinflation!  Interest rates in 1980 were at 16%, which is not likely to be repeated in our lifetimes.  And lest we forget, this 30 year disinflation period ADDED massively to the returns of bond investors over this time period, since a falling interest rate environment makes the present value of the payments of the total bond payments worth more.  But…the opposite is also true, and unfortunately we live in Opposite World right now; in other words, the odds of an environment of rising interest rates is clearly much higher at these current low levels, which are being engineered by our Fed.
As is evident, 10-year Treasury bonds pay less income today than at any time in the last five decades. If we buy 10-year Treasury bonds today, investors are signing up to make about 2.3% a year, fully taxable, for the next 10 years. That return has no hope of beating inflation. If, as the Obama administration wants, the top income tax rate goes to 39.5% next year, you'll probably make about 1.4% after taxes on a 10-year Treasury at current rates.
The Consumer Price Index says inflation is 2.9% a year, and the Producer Price Index is 3.3%. So let's just say inflation is an even 3% right now. Some sources will say it's just under 2%. If we re-run numbers with that assumption, the returns are still either negative or too tiny to matter. To get the  inflation-adjusted, after-tax return, just subtract our 3% inflation from the after-tax yield...  a -1.6% return. At current prices, an investor will lose about 1.6% a year after taxes and inflation by buying 10-year Treasurys.
Buying even the highest-yielding Treasurys today will lose investors money after taxes and inflation. They're a lousy deal.
All bonds are priced in relation to Treasurys. So when Treasury yields go up (and prices go down), the rest of the bond market moves right along. When talking about Treasury bonds, we're really talking about all bonds.
Still, one might say Treasury bonds are the safest around. And with bonds, the more risk you take, the more yield received. So... what if we take a tiny bit more risk today, perhaps by owning the bonds of the best U.S. corporations? That'd pay more than Treasurys with not much more risk... wouldn't it?  Well, yes, the interest payment is more, but not enough to fight the wealth-destroying effects of inflation. Investment-grade corporate bonds are the second-worst deal in the bond market next to Treasurys.
A good, quick gauge of the market for the safest, highest-rated corporate bonds is the iShares Investment Grade Bond Fund (LQD). Just over 98% of its holdings are investment-grade corporate bonds (rated triple-B or higher by ratings agencies like Moody's or S&P), and roughly 69% are rated A or higher. Sure, the bonds are safe. Investors should get all interest and principal payments. That's not the problem. The problem is the fund pays a yield of just 4.24%. Even if you only assume today's top tax rate (35%), you still wind up with less than 3% after taxes, less than the current rate of inflation. Buying the safest corporate bonds in the world today will lose money after taxes and inflation.
With bond investing, inflation is one of the most important fundamentals, because bonds pay fixed-interest payments, not rising dividends. Their prices have become totally disconnected from the fundamentals. Bonds are a bubble, mostly because they're so vulnerable to the effects of inflation.
It's financially dangerous to own long bonds that pay low, single-digit yields.
Mark Twain once said: History Doesn’t Repeat Itself, but It Rhymes. This whole thing probably sounds ridiculous. But it's happened before and it can happen again.  Folks buying Treasury bonds and high-quality corporate bonds today need to remember what happened to the U.S. bond market starting in 1946... A 35-year bond bear market started that year, lasting until 1981. The long-term effect on those who bought bonds in the mid-1940s was devastating.
If we owned a 30-year U.S. Treasury bond from 1946 to 1981, we'd have wound up with just $170 left out of every $1,000 originally invested – an 83% loss. Put another way, $2.50 worth of Treasury bond income was worth $100 in 1946... and slightly less than $17 in 1981. Maybe we wouldn't hold a bond for 35 years... But it's awfully hard to make money any time in a 35-year bear market. It was a long, devastating bear run for bondholders.  During the great bond bear market of 1946-1981, inflation did its part, too. What cost $1 in 1946 cost $4.67 in 1981. If Treasury yields and prices didn't move from 1946 to 1981, we'd still have lost a lot of money.
Bond Bear   With history as our guide, it sure looks like we're heading into another big bond bear market today. The Fed is doing the same things today as it was in the 1940s. Back then, the Federal Reserve fixed long-term interest rates at a low 2.5% to finance World War II. Today, it's doing the same thing to try to spur a housing and economic recovery. It's targeting 0% interest rates for overnight interbank lending.
The Fed also bought Treasury bonds back then, just like it's doing today. Back in the 1940s, the Fed's Treasury holdings increased 12-fold in just five years, from $2 billion to $24 billion. Since late 2008, the Federal Reserve has increased its Treasury holdings 3.5-fold in about three-and-a-half years, from $479.7 billion in September 2008 to $1.66 trillion as of March 14, 2012. It's all just like it was in 1946, and the result will be the same, with bond investors losing money for many years to come.

Mortgages

Mortgage rates are still near the lowest rates ever recorded. This last week’s announcement from the Fed, that it will hold rates steady for two more years, with a 2% inflation target,  is pushing yields lower.  Some research reports indicate a view that the Fed may stretch this target to 2015 from 2014 in its upcoming August FOMC meeting.  Our view is that Fannie/Freddie’s acting as lender of last resort has put an artificial pricing mechanism into the real estate market.  We acknowledge this artificial price risk, where prices could fall 20-25%, but to also acknowledge that the “price of money” in terms of mortgage rates is incredibly attractive right now. Any investor that qualifies for a mortgage and can lock-and-load on a 30 year fixed mortgage should strongly consider it, regardless of the short term fluctuations of the value (next 5 years) of the property.  In our view it is a risk worth taking. Remember the rule of value investing:  the uncertainty gives us the low price.   

Fixed Income Commentary

Corporate bonds in the high yield category look relatively attractive. We are also finding interesting foreign bond issues (mostly sovereign and Emerging Markets Debt) for new money that look more attractive than US paper in terms of their “ability to pay”.  Generally, higher quality bonds (generally, sovereign debt issues) are not attractive on a forward-looking basis based on our thesis of eventually higher inflation and a higher yield environment.  In such an environment, “quality” bonds offer nothing but low returns and capital destruction. The only plus offered, perversely, is a flight to safety in case of another macro-event. 

Treasury securities with longer maturities should be avoided at all costs in this environment.  Long term Treasury buyers are paying 50x yield right now for “safety”, paying 2%.  Ask the questions: What is risk? What is safety? 

CA Municipal Bonds

CA Municipal Bonds with shorter maturities are still interesting.  While CA has had all sorts of financial issues the last several years, the municipal bankruptcy filing rate has been very infrequent.  The city of Stockton recently filed for bankruptcy, which was like watching a slow-motion train wreck.  However, when a municipality declares bankruptcy, it allows them to renegotiate all pension and union contracts… Other states are essentially in the same boat.  California does have problems, though a recent slate of IPO’s, including Facebook’s May IPO, will help to fill California’s coffers. Scratch that, Gerry Brown just voted in the High-Speed Rail…interesting fact, the “estimated” cost of the High-Speed Rail is $65 Billion.  The current market cap of United Continental Airlines, with all of their planes, infrastructure, and hubs globally, is only $8 Billion.  So CA wants to spend at minimum 8x the entire market cap of the largest airline to build this thing.  Just a thought:  build a line from LA to Vegas, then SF to Vegas, both of which at least stand the chance of profitability, usage, and leisure commerce.  Then build the hypotenuse of the triangle, SF to LA, which would be subsidized by the other two sides.

Uncertainly Certain Uncertainty

Mr. Market and Uncertainly Certain Uncertainty:  So far 2012 has continued to be the best house in a bad neighborhood. The uncertainties that are present in Europe are somewhat quantifiable in terms of how much capital will be required to create a “ring of fire” in Europe (about $2.3 Trillion), though even with this firewall approach begs the question “how much global contagion will be created?” Greece has bought itself some time, Italy is still a large concern, and Spain’s debt was just downgraded again last week. The European Union’s agreement to continue to backstop Greece in the last quarter was significant: it signals that the Eurozone, for good or ill, will continue its stabilization efforts. It also means that we are still in a race to the bottom in currency values. In the US 2012 is an election year, and we sense policy changes in the air whether the current Administration remains, or is replaced. Either way, we think more certainty is coming, regardless of the current uncertain state of affairs. Investors, and the market, “want” to go higher, they want to break out, like heat and combustibles just waiting for oxygen. There is a risk however, that austerity measures could suck the oxygen out of the room. But in our view, the risks of oxygen depletion could be over-ridden with increased certainty and general clarity resulting from fiscal spending restraint coupled with more predictable tax and investment policy.

Risk Adjusted Values: We continue to favor stocks that look like bonds and bonds that look like stocks. 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 find 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 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? Our profligate money-printing should lead all investors to ask the question: who do I trust more to pay me back, corporate America 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.

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”. The first known instance of inflation occurred in Rome, when all coins in the realm were brought in, the edges were shaved off, and more coins were made out of the shaved edgings; all new (smaller) coins were re-cast with the same previous denomination. In other words, inflation (debasement of the currency’s purchasing power). Fed Chairman Ben Bernanke has been expanding the Fed’s balance sheet in a similar fashion. This past week I had the good fortune to be invited to the Hoover Institution in celebration of Milton Friedman’s 100th birthday. It was a fantastic gathering of brainpower. The truly amazing aspect of Milton Friedman is that his body of work did not limit itself to economics. His books “Free to Choose” and “Capitalism and Freedom” simply reinforce that Capitalism (even with all its warts) is the best system so far discovered in human history. For a great video discussion between Milton Friedman and Phil Donahue circa 1980, click this link . It is only about 2 minutes long and is great.

When Will Treasury Rates Re-Set? Once the Fed stops printing money and stops buying Treasury bonds, what will be the real market for interest rates? It could be much, much higher. And that could set the economy up for a real big interest-rate shock. But…not yet, because Ben Bernanke and the Fed just this last week announced that rates will be kept low through 2014… with all of this Quantitative Easing, most people do not realize that the Federal Reserve Bank has been buying about 70% of all newly issued Treasury securities! The “eventual” concern is that once you start this quantitative easing, you can't stop, because the economic consequences of stopping are too severe. Another concern is whether there will continue to be enough other buyers of our Treasuries. The only reason we're able to continue to do any quantitative easing at all is because the dollar is the world's reserve currency. Frankly, we have wondered why, over the last 3-4 years, the US (the “best house in a bad neighborhood”) failed to issue 7-10 year Treasury securities at extremely favorable rates, which would have allowed the US to effectively retire old debt (higher rates) while issuing new debt (lower rates), simultaneously providing liquidity that was needed. Effectively the US would have “refinanced” much of the country’s debt load, while also buying the US time to gets is fiscal and policy house in order. Instead, the US issue short term debt at low rates that is coming due in the next 18-24 months that needs to be repaid or re-issued at the then-prevailing rate. With an explosion of federal spending and, this adds much risk to Treasuries.

“Safe” Bond Bubble Danger:  Investors are selling U.S. stocks and buying bonds like they're going out of style. Bond prices have come unhinged from their underlying fundamentals. The bond market is a bubble. Bond holders today are practically guaranteed to lose money... But they're buying more bonds than ever. Remember... the most popular investment is almost always the worst one. In fact, ICI's historical data indicates investors have been pulling money out of stocks and pouring it into bonds for almost four years... Since June 2008, investors have made net withdrawals of $376.1 billion from equity mutual funds. During the same period, they've poured nearly twice that amount, $723.6 billion, into bond mutual funds. Between this historical data and last week's report, it seems investor psychology didn't survive the financial crisis. Even though the stock market has more than doubled in value from its March 2009 bottom... investors are still scared of stocks today. They're lusting after the safety of bonds and fleeing the risk they see in stocks. In doing so, they're ignoring the huge risks in bonds... and missing the great benefits of owning stocks. At this point, you probably want to know what's so bad about investors buying bonds instead of stocks. They'll still make money. They just won't make as much over the long term... right? And you might also say, they'll never lose money in bonds, especially if they're buying Treasurys or highly rated corporate bonds. We understand this view. And it's almost true. For example, the Treasury won't stop making bond interest payments. Neither will America's biggest, safest corporations. In that way, high-grade bonds are safe. But investors aren't aware of just how much money they can lose holding Treasurys and other low-yielding, high-grade bonds... even if all the interest and principal payments are made on time. The ugly truth is, Treasurys and high-grade bonds are virtually guaranteed to lose money if we're buying them at today's prices. Let's look at the safest bonds first, U.S. Treasury bonds. The 10-year U.S. Treasury bond is widely used as a benchmark for the overall bond market. Here's the 10-year Treasury yield going back to the 1960s...

As is evident, 10-year Treasury bonds pay less income today than at any time in the last five decades. If we buy 10-year Treasury bonds today, investors are signing up to make about 2.3% a year, fully taxable, for the next 10 years. That return has no hope of beating inflation. If, as the Obama administration wants, the top income tax rate goes to 39.5% next year, you'll probably make about 1.4% after taxes on a 10-year Treasury at current rates. The Consumer Price Index says inflation is 2.9% a year, and the Producer Price Index is 3.3%. So let's just say inflation is an even 3% right now. (Some sources will say it's just under 2%. If we re-run numbers with that assumption, the returns are still either negative or too tiny to matter.) To get the inflation-adjusted, after-tax return, just subtract our 3% inflation from the after-tax yield... a -1.6% return. At current prices, an investor will lose about 1.6% a year after taxes and inflation by buying 10-year Treasurys. The highest yielding US Treasury is the 30-year bond, yielding around 3.4%. With income taxes of 35% (this year's top rate) or more and inflation of 3%, investors will lose money in inflation-adjusted terms every year as long as they hold those bonds. Treasury bonds today look safe... unless viewed in the context of inflation. Then, they don't look very good at all.

Buying even the highest-yielding Treasurys today will lose investors money after taxes and inflation. They're a lousy deal. All bonds are priced in relation to Treasurys. So when Treasury yields go up (and prices go down), the rest of the bond market moves right along. When talking about Treasury bonds, we're really talking about all bonds. Still, one might say Treasury bonds are the safest around. And with bonds, the more risk you take, the more yield received. So... what if we take a tiny bit more risk today, perhaps by owning the bonds of the best U.S. corporations? That'd pay more than Treasurys with not much more risk... wouldn't it? Well, yes, the interest payment is more, but not enough to fight the wealth-destroying effects of inflation. Investment-grade corporate bonds are the second-worst deal in the bond market next to Treasurys.

A good, quick gauge of the market for the safest, highest-rated corporate bonds is the iShares Investment Grade Bond Fund (LQD). Just over 98% of its holdings are investment-grade corporate bonds (rated triple-B or higher by ratings agencies like Moody's or S&P), and roughly 69% are rated A or higher. Sure, the bonds are safe. Investors should get all interest and principal payments. That's not the problem. The problem is the fund pays a yield of just 4.24%. Even if you only assume today's top tax rate (35%), you still wind up with less than 3% after taxes, less than the current rate of inflation. Buying the safest corporate bonds in the world today will lose money after taxes and inflation.

With bond investing, inflation is one of the most important fundamentals, because bonds pay fixed-interest payments, not rising dividends. Their prices have become totally disconnected from the fundamentals. Bonds are a bubble, mostly because they're so vulnerable to the effects of inflation. If we put $1,000 into a 3% bond, we're going to get $30 a year and not a penny more for as long as we hold the bond. If inflation is zero, you're fine. But what if inflation is just 2%, which is generally considered a tolerably low level? Our inflation-adjusted, after-tax yield on a 3% bond would be negative.

It's financially dangerous to own bonds that pay low, single-digit yields: Ask any bond broker in the U.S. He'll say business is booming. On February 28, a JPMorgan Chase bond report noted that "almost all [bond] investors we speak with report that they continue to see inflows into their [bond] funds even with yields at these levels. This includes investors from overseas as well." The great mass of know-nothing investors – professional and individual alike – are all blindly following one another, like a column of Boy Scouts marching around, lost in the woods, following each other in circles. This whole thing probably sounds ridiculous. But it's happened before and it can happen again. Folks buying Treasury bonds and high-quality corporate bonds today need to remember what happened to the U.S. bond market starting in 1946... A 35-year bond bear market started that year, lasting until 1981. The long-term effect on those who bought bonds in the mid-1940s was devastating. If we owned a 30-year U.S. Treasury bond from 1946 to 1981, we'd have wound up with just $170 left out of every $1,000 originally invested – an 83% loss. Put another way, $2.50 worth of Treasury bond income was worth $100 in 1946... and slightly less than $17 in 1981. Maybe we wouldn't hold a bond for 35 years... But it's awfully hard to make money any time in a 35-year bear market. It was a long, devastating bear run for bondholders. During the great bond bear market of 1946-1981, inflation did its part, too. What cost $1 in 1946 cost $4.67 in 1981. If Treasury yields and prices didn't move from 1946 to 1981, we'd still have lost a lot of money. With history as our guide, it sure looks like we're heading into another big bond bear market today. The Fed is doing the same things today as it was in the 1940s. Back then, the Federal Reserve fixed long-term interest rates at a low 2.5% to finance World War II. Today, it's doing the same thing to try to spur a housing and economic recovery. It's targeting 0% interest rates for overnight interbank lending, a key interest rate benchmark for the U.S. economy. The Fed also bought Treasury bonds back then, just like it's doing today. Back in the 1940s, the Fed's Treasury holdings increased 12-fold in just five years, from $2 billion to $24 billion. Since late 2008, the Federal Reserve has increased its Treasury holdings 3.5-fold in about three-and-a-half years, from $479.7 billion in September 2008 to $1.66 trillion as of March 14, 2012. It's all just like it was in 1946, and the result will be the same, with bond investors losing money for many years to come.

Mortgages: Mortgage rates are the lowest rates ever recorded. This last week’s announcement from the Fed, that it will hold rates steady for two more years, with a 2% inflation target, is pushing yields lower. Our view is that Fannie/Freddie’s acting as lender of last resort has put an artificial pricing mechanism into the real estate market. Our focus when talking to our Clients has been to acknowledge this artificial price risk, where prices could fall 20-25%, but to also acknowledge that the “price of money” in terms of mortgage rates is incredibly attractive right now. Any investor that qualifies for a mortgage and can lock and load on a 30 year fixed mortgage should strongly consider it, regardless of the short term fluctuations of the value of the property. In our view it is a risk worth taking. Remember the rule of value investing: the uncertainty gives us the low price.

Fixed Income Commentary: Corporate bonds in the high yield category 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”. Generally, higher quality bonds (generally, sovereign debt issues) are not attractive on a forward-looking basis based on our thesis of eventually higher inflation and a higher yield environment. In such an environment, “quality” bonds offer nothing but low returns and capital destruction. The only plus offered, perversely, is a flight to safety in case of another macro-event. Treasury securities with longer maturities should be avoided at all costs in this environment. Long term Treasury buyers are paying 50x yield right now for “safety”, paying 2%. See prior commentary

CA Municipal Bonds: CA Municipal Bonds with shorter maturities are interesting. While CA has had all sorts of financial issues the last several years, the municipal bankruptcy filing rate has been “invoked” very infrequently. When a municipality declares bankruptcy, it allows them to renegotiate all pension and union contracts… Other states are essentially in the same boat. California does have problems, though a recent slate of IPO’s, including the impending Facebook IPO, will help to fill California’s coffers.

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.

This Time Is Different...

For an excellent article that goes beyond Reinhart & Rogoff's book "This Time Is Different: Eight Centuries of Financial Folly", take a look at this link, which is quite good and offers a good prescription for what ails us.

Note: I agree with the "target" of energy policy, but whereas the author believes a form of cap & trade will work, I think that the big infrastructure idea needs to be a comprehensive energy policy, new grid, and massive incentives for all forms of energy to "somehow" create BTU's and get them on the grid. This will create innovation, new ways to find and create energy, create jobs, and ultimately the knowledge we gain can be exported to other countries, delivered by our "services economy".

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

Mr. Market's Mood Swings

The last week of trading has been quite remarkable in its major gyrations. It all started Thursday on renewed fears in Europe, carrying into Friday. Then on Saturday S&P downgraded the US from AAA to AA credit rating. We knew Monday would be ugly, and boy was it, down about -620 that day on the Dow. Relief rally Tuesday, followed by a major intraday swoon, ending with a strong rally after some comments by the Fed. Yesterday, Wed, we lost another -500. And today, Thursday, we have another monster rally of over 500 points.

So what did we do here at ACC? Mostly buying, every down day, particularly on Monday with the 600 point decline. We had raised cash levels for the most part in late April. From a technical perspective, it appears we need to close above 11,238 on the Dow to hold. In our last letter (see "Which Printer Do You Like More" post), we remarked that the "Dow Theory" needed to be confirmed to go higher (i.e. DJIA had to confirm the Transports and Utilities to move higher). It failed to do so, and the 50-day crossed under the 200-day line in what is known as a Death Cross. Now we have rallied higher, and again, technically, we think we need to re-establish the "line" at 11,238. We are 20 points away...so close...yet so far.

If we reach, hold, and clear this level of 11,238 it could bode well in the short term, though fundamental problems in Europe and the US will continue to surface on the Fear meter due to structural debt/entitlement issues. The ECB must hold the line and backstop Italy/Spain/Greece/Ireland/Portugal...if they fail on any ONE of these, they fail on all of them...Then look for the Fed to backstop the ECB...

Robert Mundell, Nobel-prize-winning economist, and Father of the Euro, was also Father of the idea of an International Monetary Unity (IMU). While we may not "formally" ever do this, given global animosity toward the US$ from China/Russia, et. al., it is a strong probability that someday, somehow, we "informally" end up with an IMU if the Fed ends up backstopping the ECB, and as multiple different central banks attempt to print their way out of trouble. We either end up with a "basket of currencies" approach (IMU), or perhaps equally probably, the US$ retains its reserve status...but the jury is out.

Q2 End 2011-- Which Printer Do You Like More?

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 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%). 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, Australia). A corporate debt level can be measured in a finite number; whereas, the US government debt level is getting so large that soon we will need to reference it using Latin phrases, like “ad infinitum”and “ad nauseum”.

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, which reduces the money flowing out, thereby allowing more money to be directed at repaying debt

2) Increase revenue by raising taxes, which increases the money flowing in, thereby allowing more money to be directed at repaying debt

3) Simply stiff its creditors, either through an overt message of “I’m not paying” (default) or the more subtle approach known as inflation.

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.

Now hark back to the prior Quarterly letter, where we mentioned the best Google search ever regarding “Bernanke deflation speech 2002”. Knowing what we know, that then Fed Governor Bernanke is a big proponent that “inflation is always preferable to deflation”, the only conceivable answer is the latter half of #3. Now Fed Chairman Bernanke has been printing money and doubling the US money supply in order to create inflation (the alternative to deflation). By keeping the Fed funds rate artificially low, asset prices (stocks) have risen, and ostensibly the Fed’s logic is that higher asset values will help to reignite the economy. So far, the higher asset part is working, and the reignition part is not.

This quote is from the book The Warren Buffett Way (1994 edition):

“Buffett recognizes that the easiest way for a country to manage its deficits is to debase these claims through higher inflation…Accordingly the faith that foreign investors have placed in the ability of the United States to pay future claims may be misguided. When claim checks held by foreigners rise to an unmanageable level, the temptation to inflate may be irresistible.”

The credit of the United States, represented by the value of a 20-year Treasury bond (TLT) versus the major alternatives to money, as compared to energy as represented by coal (KOL), agriculture (DBA), and hard money as represented by silver (SLV) is now in major decline. In other words the values of the main alternatives to the dollar – energy, food, and real money – are soaring.


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. The banks are making a huge spread of profits just by sitting on the funds and investing in different types of bonds, and there is currently not sufficient borrowing demand for the funds. What we have 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.

In Washington DC, the political environment is a zoo. Right now debate rages in terms of the debt ceiling, spending cuts, entitlement reform, and taxes. Republicans and Democrats have a chasm to cross, and neither wants to yield ground politically in order to frame the next election cycle. A move to the center or center-right on fiscal and entitlement reform, Federal expense restraint, and a permanently low tax structure (personal and business taxes) would position Obama for a second term, would reignite the economy, would ensure America’s credit rating, and could earn him historical kudos. He could take the ammunition away from his opponents with a political deftness resembling jujitsu. The only question is: will he do it?

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. By the way, we are not “metal bugs”; we have intellectually backed into this position over the last two 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.

Which Printer Do You Like More?
Globally we are in a “race to the bottom” in currencies. Which printer do you like more? Here at home we are debasing our currency via the printing presses, and so is the rest of the world (for the most part). This entire scenario is a “coordinated” global response to the last few years. Central banks that print money, including the ECB via the Euro, 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? This is what politicians like to tell us. 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. When we look at this from 30,000 feet, the clear alternative is to invest in strong franchise companies that have real assets, pay solid dividends, are growing, and can grow in a rising price environment and that we think can outpace debasement/inflation.

Greenspan/Guidotti Rule
Greenspan? Greenspan? Oh yeah, remember him? Well, Alan Greenspan and Pablo Guidotti came up with this great rule a long time ago to describe how to identify when a country’s currency is at risk, and at what level a country should be considered a bad credit risk. The simple formula is that a country must have enough reserves (think oil and gold) to be able to pay off any short term impending debts that must be repaid. The United States currently has about $2.2 Trillion that must be repaid over the next 2-3 years. And what is the value our Current Reserves of gold and oil (as collateral)? About $700 Billion. You are reading this correctly. The U.S. currently can collateralize about 32% of what it owes in the very short term. So who’s the Banana Republic now?

The U.S. government has the luxury of having the world's reserve currency, which just means we can print the money we need to buy any commodity we need and repay all of our obligations legally. The Argentines can't just go print dollars. We're the only ones who can do that. So it puts us in a strong position, but it's a double-edged sword. Because we have the power, we can get away with managing much, much larger amounts of debt. The problem is, getting away with managing it doesn't necessarily mean that having it is good for us. We believe that having debts like we have it is very, very bad for us. Total debt in the United States today is about 400% of GDP. It's obvious to anyone that is not sustainable. So the question becomes not how do we keep employment high… not how do we keep interest rates low… but how do we avoid a collapse of our economy because of the debt load.

When PIIGS Fly
Across the pond a big game of “I’m not going to blink”, followed by “Darn it, I blinked” is going on. The PIIGS problem they like to call it (Portugal, Italy, Ireland, Greece, and Spain). Ireland just had its debt rating cut to “junk” status. Here’s the gigantic problem over there; the large banks of Europe own a lot of Greek debt, as well as debt in the others. For now we will limit this to Greece. Germany and the ECB have already succumbed to the blinking noted above, so they are going to give Greece some form of a pass, or soft default, by allowing them to essentially renegotiate the debt payments and extend the term on the debt (similar to allowing someone to pay their 30 year mortgage over 40 years). The problem is that if/when this actually materializes, the large banks that hold the Greek debt will have to write off a big chunk as an “impaired asset” charge. Why is this a problem? Let’s just assume that it was a half-off sale on the debt; this write-off would reduce the amount of capital in the largest banks of Europe by 25%. Some of these banks won’t survive. Then we’re looking at Lehman Brothers all over again in terms of counter-party risk. Banks won’t trust other banks, and the whole thing spirals out of control. And remember, that’s just in dealing with Greece, the only place in the world where “ochi”(“o-khee”) means “no”, and “neh” means “yes”. Perhaps we should impart recent history, and then marry it to the history of Mr. J.P. Morgan, who stopped the Banking Panic of 1906, in order that they (and perhaps we) can stop the bleeding at the Greek border.

Are Commodities Really Going Higher?
Commodities prices have been much higher, particularly in the food sector. Some think that weaker U.S. exchange rate couldn't explain the rise in food prices. Chinese demand and the growth of the middle class in Latin America, the thinking goes, are all far more important factors. It’s all supply and demand, right?
Nope. The single most important variable in the price of anything in the world is the value of the U.S. dollar. As the world's reserve currency, its value is what everything else is measured against, and what commodities are priced in.
Look at these charts. They're the prices of corn and wheat over the last 10 years. Except, instead of being measured in dollars, these commodities are presented here in terms of gold.

We are not having a food crisis. We are debasing the dollar, as we have called out over the last two years. In terms of gold, agricultural commodities prices have fallen by about 50% over the last 10 years. Obviously it's not the price of food that's the problem. It's the collapsing purchasing power of the U.S. dollar that's led us to this situation. The real question we should be discussing isn't food. It's money. And more specifically, the lack of a sound world reserve currency. But it’s easier for politicians to print money and pass a loss of purchasing power to its citizens than it is to make the tough choices. The United States is the only government in the world that can actually afford to underwrite the world's banking system. That's not because we have any real savings, it's only because we control the world's reserve currency. It's a paper standard, which means we can always print more of it.

Climbing the Wall of Worry
“Gosh, what a depressing newsletter. What else have you got for me?” Currently the Dow Jones was nearing 12810, until the employment report came out. The old Dow Theory would be in place if the DJIA were to close above 12810, since the Dow Transports and Dow Utilities indices will have been confirmed by the Industrials. If this occurs, it is a strong signal of a continued bull market.

The employment report was dismal, though the PPI report was pretty good. Real estate and banking are hurting, but corporate America has shown us big profits. Uncertainties abound domestically and globally. And thus, we have all the conditions ripe for the old adage: “the bull market climbs a wall of worry”.

The Bear case is that our problems won’t or can’t be solved. The Bull case is that they can and will be solved, in a rising yield environment, and that 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 returns suffer. This is an environment for short maturity bonds and high dividend paying stocks. 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, let the Wall of Worry continue higher. Let the Dow Theory hopefully be confirmed over the coming months. We are cautiously Bullish, and won’t turn Bearish until everyone else becomes too optimistic.

Fixed Income Commentary
Corporate bonds, both investment grade and 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.

Q1-end 2011 Commentary: Just-In-Time Treasury

Values: 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, which only yields 1.5-2%. Any stock that pays 3-4% in dividends 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 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%). 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, Australia). A corporate debt level can be measured in a finite number; whereas, the US government debt level is getting so large that soon we will need to measure it in light years.

Interesting Note: In March 2011, Bill Gross of PIMCO announced that PIMCO’s Total Return Fund is 100% “out” of Treasury securities as of January 2011.

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.

Re-flation of Assets
For two years we have posited that in a reflationary period it is quite possible for all types of assets to go up in value, and further, that 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.

Just-in-Time Treasury
Remember “just-in-time inventory” efforts used by US corporations to compete with Japanese companies in the ‘90s? As a result, how many days worth of food inventory exists at your local grocery store? 3-4 days. Now, along this line of thinking, how many days of “money inventory” the US government is working on before it needs to “restock the shelves”? 4 days. The U.S. government has printed more money and taken on more debt than it can ever repay. 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.

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. Sound money just means buying gold and silver, and of course there are several ways to do this. For new purchases, we are eyeing silver, which has a long term ratio relationship to gold of 1:16. Based on current prices, with silver bouncing between $20-30/oz., either gold will fall dramatically, or silver will rise dramatically. Based on the current “perfect storm” of reasons to own metals, we think silver could move closer to $100/oz., though the journey could be volatile. By the way, we are not “metal bugs”; we have intellectually backed into this position over the last two years, and do not yet see a compelling reason to back away… since our last quarterly letter, silver prices have broached $40/oz and are at a 31-year high…

What is Quantitative Easing? There's some controversy about it, and it's poorly understood. Quantitative easing, according to the Federal Reserve, is simply monetary policy in another form. And it's simply a way to manipulate interest rates lower to give a boost to the economy. Unfortunately, that's not the case at all because what quantitative easing actually is doing is covering the funding gap of the U.S. government. Total domestic savings in the United States is about $600 billion. The annual fiscal deficit of the U.S. government (that's only one borrower... admittedly it's the largest borrower in the economy, but still only one borrower) is $1.2 trillion, give or take.

So the difference between what we can save as an economy and what we have to spend in stimulus as an economy is about $600 billion. Not surprisingly, that's exactly the amount of money the Federal Reserve says we require in quantitative easing. So it's printing up $600 billion and giving it to the Treasury. The Treasury therefore doesn't have to issue those bonds on the open market. If the Treasury had to actually auction an additional $1.2 trillion worth of debt instead of selling it directly to the Fed, the market prices of U.S. government bonds would be vastly lower. There isn't enough global demand to meet the U.S. government's funding needs.

This is a big problem going forward because once people get used to these low interest rates, a lot of businesses and employment is going to come to depend on them. But the more money the Fed prints to buy them, the more inflationary pressures will be created. So we are creating a conundrum—the U.S. needs to print more money to keep interest rates low, but the more money it prints, the more likely it is that interest rates are going to go much, much higher.

Once the Fed stops printing money and stops buying Treasury bonds, what will be the real market for interest rates? It could be much, much higher. And that could set the economy up for a real big interest-rate shock. And so one of our concerns is that once you start this quantitative easing, you can't stop, because the economic consequences of stopping are too severe. And the only reason we're able to do any quantitative easing is because the dollar is the world's reserve currency.

If we were another country and were printing this much money, the consequences of doing so would be much more immediate. For example, if Argentina decides it's going to double the amount of money outstanding in Argentina, its peso would be devalued immediately, and it would be obvious to everyone.

The U.S. government has the luxury of having the world's reserve currency, which just means we can print the money we need to buy any commodity we need and repay all of our obligations legally. The Argentines can't just go print dollars. We're the only ones who can do that. So it puts us in a strong position, but it's a double-edged sword.

Because we have the power, we can get away with managing much, much larger amounts of debt. The problem is, getting away with managing it doesn't necessarily mean that having it is good for us. We believe that having debts like we have it is very, very bad for us. Total debt in the United States today is about 400% of GDP. It's obvious to anyone that is not sustainable. So the question becomes not how do we keep employment high… not how do we keep interest rates low… but how do we avoid a collapse of our economy because of the debt load.

This quote is from the book The Warren Buffett Way:
“Buffett recognizes that the easiest way for a country to manage its deficits is to debase these claims through higher inflation…Accordingly the faith that foreign investors have placed in the ability of the United States to pay future claims may be misguided. When claim checks held by foreigners rise to an unmanageable level, the temptation to inflate may be irresistible.” (from 1994!)

What you see above is the credit of the United States, represented by the value of a 20-year Treasury bond (TLT) versus the major alternatives to money: energy as represented by coal (KOL), agriculture (DBA), and hard money as represented by silver (SLV). U.S. credit is now in decline, while the value of the main alternatives to the dollar – energy, food, and real money – are soaring.


Best Google Search Ever
We are including this again in case you missed it. Back at the end of 2008, we Googled “Bernanke deflation speech” and found a rather amazing speech he gave as a Fed Governor in 2002. The entire discussion revolved around his knowledge of the Great Depression, what we would do if ever faced with such a situation again, etc. He mentions explicitly in this speech that the U.S. would print money in order to debase the currency, thus paying back creditors in ever-cheaper dollars. He also explicitly sites that inflation of any sort is always preferable to deflation. He also specifically mentions the as-yet (at that time) untried but theoretical Quantitative Easing. Ahem. So what we discovered at the end of 2008 was the future Play Book from a former Fed Governor with academic expertise in the Great Depression who just now happened to be the Fed Chairman. This is why we have been adding to natural gas, oil, agricultural, metals holdings over the last two years with great confidence. We also know from this that “Helicopter Ben” will do his utmost to prevent deflation. The big picture environment is debasement of the currency and inflation.

In periods of inflation, long bonds will get decimated, and we’re already seeing a spike in yields on the 10-year Treasury, part of which we now know if from Bill Gross’ selling out of his entire US Treasury position.

Commodities From a Different Point of View
Commodities prices have been much higher, particularly in the food sector. Some think that weaker U.S. exchange rate couldn't explain the rise in food prices. Chinese demand and the growth of the middle class in Latin America, the thinking goes, are all far more important factors. It’s all supply and demand, right?
Negative. The single most important variable in the price of anything in the world is the value of the U.S. dollar. As the world's reserve currency, its value is what everything else is measured against, and what commodities are priced in.
Look at these charts. They're the prices of corn and wheat over the last 10 years. Except, instead of being measured in dollars, these commodities are presented here in terms of gold.

There's no food crisis. There's a dollar crisis. We are debasing the dollar, as we have called out over the last two years. In terms of gold, agricultural commodities prices have fallen by about 50% over the last 10 years. Obviously it's not the price of food that's the problem. It's the collapsing purchasing power of the U.S. dollar that's led us to this situation. The real question we should be discussing isn't food. It's money. And more specifically, the lack of a sound world reserve currency. But it’s easier for politicians to print money and pass a loss of purchasing power to its citizens than it is to make the tough choices.
The United States is the only government in the world that can actually afford to underwrite the world's banking system. That's not because we have any real savings, it's only because we control the world's reserve currency. It's a paper standard, which means we can always print more of it.

US Budget and Fiscal Direction
There is a chance, if the US budget continues to spiral out of fiscal control, that the U.S. Federal Reserve will lose all its credibility as it tries to help finance U.S. government deficit spending while containing massive losses in the global banking system. Our creditors will likely 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.

Mortgages
Mortgage rates spiked up in November and December of 2010, in response to being correlated with US Treasury yields, which ticked up significantly in yield. This occurred because investors are beginning to smell inflation, thus investors are beginning to demand yield in exchange for higher perceived risk to principal (if inflation rises).

Fixed Income Commentary
Corporate bonds, both investment grade and 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 this environment.