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.