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.
Thursday, August 11, 2011
Monday, August 1, 2011
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.
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.
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