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.
Monday, April 25, 2011
Tuesday, December 14, 2010
Corporate Free Cash Flows are High
Recently posed Question:
Why do you favor U.S. equities, when bonds and emerging markets are doing well?
Answer:
When I see 10% free cash flow in a time when yields on Treasuries are at 3%-3½%—and if I have any faith in management that they won’t take that free cash flow and pour it down a rat hole—10% looks a whole lot better to me than 3½%, especially if such companies are doing business in areas that are growing.
Why do you favor U.S. equities, when bonds and emerging markets are doing well?
Answer:
When I see 10% free cash flow in a time when yields on Treasuries are at 3%-3½%—and if I have any faith in management that they won’t take that free cash flow and pour it down a rat hole—10% looks a whole lot better to me than 3½%, especially if such companies are doing business in areas that are growing.
Tuesday, November 9, 2010
End of Q3 2010 Commentary
Market Snapshot
We experienced a roller coaster, with a small correction in August, followed by what turned out to be one of the best September’s on record. Earnings have been good, though we have much mixed data, and are stuck in a “jobless recovery”. The government tells us that the recession ended last July, but Warren Buffett disagrees. Hmmm? The government also likes to tells us that prices are under control, but when we look at the CPI we are supposed to look at it “ex-food, ex-fuel”… On the optimistic side, much of the September rally has been attributed to a likely changing of the guard in Washington DC. A recent poll shows that 85% of the population is “angry” with the economy—never good for the incumbents. This is from Phil Gramm:
Let’s just hope that prescriptions by any political “new guard” don’t precipitate any major policy missteps. Investors have continued to pile into equities, with cash coming off the sidelines from money market funds, as well as a robust outflow of funds from the Bond markets into Equities. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products.
As an example of our risk-adjusted approach to equities, we have favored purchases in oil and oil drillers; for example, such companies trade at just over 9 times earnings, which is about half of the broader stock market multiple of 15-20 times earnings. We feel that such an example plays well on a bottom-up company analysis, on a top-down global macro analysis, on a global demand basis, on a currency basis (if the dollar weakens), and on a “black swan event” basis (Middle East instability). Further, if the economy weakens, oil prices are likely to stay in a $65-85 range; if the economy continues to expand, the range could reach $100 again. Here in early October in fact, oil has reached $80/barrel, and the Obama Administration just removed the moratorium on oil drillers in the Gulf—all positives for this sector.
Buy Stocks that Look Like Bonds and Bonds that Look Like Stocks
What do we mean by this? Simply, for new money purchases we are actively screening for equity valuations trading for 7-12x earnings, with dividend yields between 3-6% as an added bonus if we can get it. By buying the earnings stream of a high quality company at these valuations, we are much more certain in our investment thesis in terms of risk. In other words, we are looking to buy an earnings stream for ½ to ¾ of the valuation placed on the broader market, which only yields 1.5-2%. So any stock that pays 3-4% at a minimum is yielding twice as much as the S&P 500 with ½ to ¾ of the price risk. With the high grade corporate bond index paying between 4-5% yields, it becomes clear that if we can find great companies with even higher payout attributes, we are buying stocks that resemble bonds.
To flip the equation, in the bond market we are looking for high grade corporate bonds (4-5%) and “vanilla flavored” high yield bonds (7-8%). Why? Because we don’t trust the government, to put it bluntly. This mindless money-printing should lead all investors to ask the question: who do I trust more to pay me back? Warren Buffett or the USA? Increasingly the answer is corporate America, since we can easily examine a corporate balance sheet and determine the percentage of the company that is financed by debt. In a word, debt at the corporate level is a finite number; whereas government debt is dangerously in the other direction. Considering that the 10-year Treasury pays only 2.5%, and in the context of our view that inflation will eventually come home to roost, any holders of Treasury securities will lose badly to inflation or erosion of capital.
Often it takes time for the market to capture the intrinsic value of securities. While there are those who “believe” in the EMH (Efficient Market Hypothesis), we note that it is extremely important to realize that an “efficient” market doesn’t mean the market is always “rational”; in fact the inverse is true. “Efficiency” means that the market will efficiently produce a price, matching a buyer with a seller. “Efficient” pricing led to extremely high short-term valuations in 1999/2000, and extremely low short-term valuations in March 2009—but was it rational long term?
Inflation Is Still A Monetary Phenomenon!
Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. MV=PQ is the equation, and it essentially breaks down into a simple explanation such as “the more money is printed or created by the government, the higher the price level (prices) will be”. In other words, inflation. There has been discussion that increasing inflation will reduce unemployment; however Milton Friedman’s work in 1968 explained why any gain in employment would be temporary—it would last only so long as people underestimated the rate of inflation!
Looking at the Fed’s rather aggressively attempts at reflation, there is some concern now that the Fed may not be sparking the “good” inflation that is caused by strong demand and reduced slack in the economy, but rather the “bad” inflation that behaves more like a tax hike. The Fed is hoping that the wealth effect produced by a rising stock market will offset the concerns. The Fed’s policies produce asset classes that are re-flated due to a commensurate newfound liquidity creation of dollars and Treasuries via debt monetization (i.e. using one credit card to pay off another). The Fed has signaled that it again may resort to Quantitative Easing (being called QE2). This should keep a lid on mortgage rates (for now), but at what future cost to the economy is anyone’s guess…
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by this measure the Fed seems to be succeeding.
In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises. In such an environment, it is important to remember “why we invest”, which is to outpace inflation. If the stock market goes up 30% but oil and other commodities go up 60%, you will have wanted more exposure to those sectors within the market.
In a long-term inflationary environment, we expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, beginning in the second half of this decade (which is another way of saying that we would expect inflation to be largely a global phenomenon). Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle.
In short, nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. We do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, precious metals and TIPS. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where we would expect the opportunities to emerge. The recent TIPS auction produced a negative yield for the first time ever… bolstering the case for inflation over deflation.
History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and the opportunity.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a weaker environment it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings. Additionally, the recent news that China’s Yuan is floating higher adds to the demand for commodities.
Currencies
Increasingly we are hearing about a troubled dollar, but the truth is that there is a global “race to the bottom” in currencies. Governments are printing money to inflate their way out of the global meltdown. And while some politicians are trying to put new tooth into the old Smoot-Hawley Tariff Act of the 1930’s (you probably think we’re joking, but we are not), the truth is that we are in an Economic War of Protectionism which is going at full throttle—countries with cheaper currencies are hoping to benefit growth of exports in order to grow their top line GDP numbers. But at what cost? It’s all an illusion to make it appear that things are better; the reality is that many countries are beginning to discuss a global currency alternative, or IMU (International Monetary Unit)—by the way this was a long time prediction by Nobel-prize winning economist Robert Mundell, who also predicted the rise of the Euro, says of the very unstable relationship between the euro-dollar rate “[this is a] terrible things for the world economy. We’ve never been in this unstable position in the entire currency history of 3,000 years”… what could transpire in the future that leads us to the IMU? An important question to contemplate, and one to which the price of gold may be sending us an answer.
Gold
Irving Fisher, economist of the 1920’s whose ideas were overshadowed by John Meynard Keynes, is the original proponent of a strong dollar backed by commodities.
If the Fed would have listened to gold (or the nominal GDP model) over the past 15 years, the US would probably not be in the mess it is in today. Gold prices fell from $400 per ounce to $255 an ounce between 1996 and 1999. This signaled deflation, but the Fed chose to ignore the signal and raised interest rates anyway in 1998 and 1999. Deflation, recession and a stock market crash were the result.
In the wake of the stock market crash, the Fed started cutting rates because it feared deflation. Gold started to rise and by late 2003 it was back above $400/oz. But the Fed held rates at 1% anyway, which created a housing bubble. When that bubble burst, the Fed started cutting rates again and gold prices have now moved to more than $1300/oz. At this point, one would think the Fed would pause before pumping even more money into the system and targeting higher inflation.
But it isn’t. The Fed continues to hold interest rates at zero, proposes another round of “quantitative easing” and plans to target 2% inflation. All because it won’t listen to gold and it’s unable to see that banks are afraid to use the money the Fed is pumping in because, down the road, the Fed will be forced to take it out or face serious inflation.
That’s what gold is saying. By signaling that it won’t quit anytime soon, the Fed is trying to force banks to change their behavior. If it works, look out for inflation to reach multiples of 2% in the years ahead. The Fed hasn’t been successful yet, when it ignores gold and commodity prices.
Mortgages
If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Recently the 30 year fixed mortgage dipped to about a 60-year low. It’s still cheap money, and it should be considered a very temporary “gift” from the Fed. The Fed is re-upping its bet of Quantitative Easing (buying mortgage backed securities on the yield curve to artificially keep mortgage rates low). Take advantage of this now, especially if you currently hold an adjustable rate mortgage. This gift, if you decide not to take advantage of it, will self-destruct within 24 months…
Fixed Income Commentary
Corporate bonds, both investment grade and high yield, look relatively attractive. In fact high grade corporate bonds are now trading on a near-equal basis with Treasury securities, meaning that sovereign debt is trading on credit-worthiness and balance sheet strength (instead of on ability to tax). As far as we know, this has never occurred before in history. Well, after all, who would you trust more to pay back a loan right now? Warren Buffett or the U.S. government? We’d choose Buffett.
Treasury securities with longer maturities should be avoided at all costs in this environment. TIPS offer some inflation protection, though recent auctions have produced negative real yields since investors are becomingly increasingly convinced that inflation is coming.
CA Municipal Bonds
The CA political atmosphere is heating up, with lots of talk; hopefully the “winners” can actually deliver on their rhetoric in terms of fixing the state’s woeful financial condition. The problems are big, but as a great politician once said: “the answers aren’t easy, but they are simple.” Please make your vote heard on November 2, unless you have already changed your legal residency to Nevada.
We experienced a roller coaster, with a small correction in August, followed by what turned out to be one of the best September’s on record. Earnings have been good, though we have much mixed data, and are stuck in a “jobless recovery”. The government tells us that the recession ended last July, but Warren Buffett disagrees. Hmmm? The government also likes to tells us that prices are under control, but when we look at the CPI we are supposed to look at it “ex-food, ex-fuel”… On the optimistic side, much of the September rally has been attributed to a likely changing of the guard in Washington DC. A recent poll shows that 85% of the population is “angry” with the economy—never good for the incumbents. This is from Phil Gramm:
Let’s just hope that prescriptions by any political “new guard” don’t precipitate any major policy missteps. Investors have continued to pile into equities, with cash coming off the sidelines from money market funds, as well as a robust outflow of funds from the Bond markets into Equities. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products.
As an example of our risk-adjusted approach to equities, we have favored purchases in oil and oil drillers; for example, such companies trade at just over 9 times earnings, which is about half of the broader stock market multiple of 15-20 times earnings. We feel that such an example plays well on a bottom-up company analysis, on a top-down global macro analysis, on a global demand basis, on a currency basis (if the dollar weakens), and on a “black swan event” basis (Middle East instability). Further, if the economy weakens, oil prices are likely to stay in a $65-85 range; if the economy continues to expand, the range could reach $100 again. Here in early October in fact, oil has reached $80/barrel, and the Obama Administration just removed the moratorium on oil drillers in the Gulf—all positives for this sector.
Buy Stocks that Look Like Bonds and Bonds that Look Like Stocks
What do we mean by this? Simply, for new money purchases we are actively screening for equity valuations trading for 7-12x earnings, with dividend yields between 3-6% as an added bonus if we can get it. By buying the earnings stream of a high quality company at these valuations, we are much more certain in our investment thesis in terms of risk. In other words, we are looking to buy an earnings stream for ½ to ¾ of the valuation placed on the broader market, which only yields 1.5-2%. So any stock that pays 3-4% at a minimum is yielding twice as much as the S&P 500 with ½ to ¾ of the price risk. With the high grade corporate bond index paying between 4-5% yields, it becomes clear that if we can find great companies with even higher payout attributes, we are buying stocks that resemble bonds.
To flip the equation, in the bond market we are looking for high grade corporate bonds (4-5%) and “vanilla flavored” high yield bonds (7-8%). Why? Because we don’t trust the government, to put it bluntly. This mindless money-printing should lead all investors to ask the question: who do I trust more to pay me back? Warren Buffett or the USA? Increasingly the answer is corporate America, since we can easily examine a corporate balance sheet and determine the percentage of the company that is financed by debt. In a word, debt at the corporate level is a finite number; whereas government debt is dangerously in the other direction. Considering that the 10-year Treasury pays only 2.5%, and in the context of our view that inflation will eventually come home to roost, any holders of Treasury securities will lose badly to inflation or erosion of capital.
Often it takes time for the market to capture the intrinsic value of securities. While there are those who “believe” in the EMH (Efficient Market Hypothesis), we note that it is extremely important to realize that an “efficient” market doesn’t mean the market is always “rational”; in fact the inverse is true. “Efficiency” means that the market will efficiently produce a price, matching a buyer with a seller. “Efficient” pricing led to extremely high short-term valuations in 1999/2000, and extremely low short-term valuations in March 2009—but was it rational long term?
Inflation Is Still A Monetary Phenomenon!
Milton Friedman said it best: “Inflation is always and everywhere a monetary phenomenon”. MV=PQ is the equation, and it essentially breaks down into a simple explanation such as “the more money is printed or created by the government, the higher the price level (prices) will be”. In other words, inflation. There has been discussion that increasing inflation will reduce unemployment; however Milton Friedman’s work in 1968 explained why any gain in employment would be temporary—it would last only so long as people underestimated the rate of inflation!
Looking at the Fed’s rather aggressively attempts at reflation, there is some concern now that the Fed may not be sparking the “good” inflation that is caused by strong demand and reduced slack in the economy, but rather the “bad” inflation that behaves more like a tax hike. The Fed is hoping that the wealth effect produced by a rising stock market will offset the concerns. The Fed’s policies produce asset classes that are re-flated due to a commensurate newfound liquidity creation of dollars and Treasuries via debt monetization (i.e. using one credit card to pay off another). The Fed has signaled that it again may resort to Quantitative Easing (being called QE2). This should keep a lid on mortgage rates (for now), but at what future cost to the economy is anyone’s guess…
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by this measure the Fed seems to be succeeding.
In a reflationary period it is quite possible for all types of assets to go up in value, and then based upon this 2011/2012 time frame, commodities and stocks could decouple in favor of commodities and commodity-related enterprises. In such an environment, it is important to remember “why we invest”, which is to outpace inflation. If the stock market goes up 30% but oil and other commodities go up 60%, you will have wanted more exposure to those sectors within the market.
In a long-term inflationary environment, we expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, beginning in the second half of this decade (which is another way of saying that we would expect inflation to be largely a global phenomenon). Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle.
In short, nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. We do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, precious metals and TIPS. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where we would expect the opportunities to emerge. The recent TIPS auction produced a negative yield for the first time ever… bolstering the case for inflation over deflation.
History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. For example, four years after the peak of 1929, FDR closed the banks and made it illegal for private citizens to own gold. In January 1934—five years after the bubble—he devalued the dollar, crushing people’s savings. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. The same thing happened five years after the market peaked in the late 1960s. Five years later, Nixon took the dollar off the gold standard (this time for good). Commodity prices soared for the next ten years, with the price of gold reaching $850/oz by the time it was over. Fast forward—the stock market popped in March 2000, and five years later in the Spring of 2005, the bull market in commodities was on. Oil went from $40 to $140; gold went from $400 to $1000/oz. We just had another peak in the stock market in October 2007. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012. This is the risk, and the opportunity.
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a weaker environment it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings. Additionally, the recent news that China’s Yuan is floating higher adds to the demand for commodities.
Currencies
Increasingly we are hearing about a troubled dollar, but the truth is that there is a global “race to the bottom” in currencies. Governments are printing money to inflate their way out of the global meltdown. And while some politicians are trying to put new tooth into the old Smoot-Hawley Tariff Act of the 1930’s (you probably think we’re joking, but we are not), the truth is that we are in an Economic War of Protectionism which is going at full throttle—countries with cheaper currencies are hoping to benefit growth of exports in order to grow their top line GDP numbers. But at what cost? It’s all an illusion to make it appear that things are better; the reality is that many countries are beginning to discuss a global currency alternative, or IMU (International Monetary Unit)—by the way this was a long time prediction by Nobel-prize winning economist Robert Mundell, who also predicted the rise of the Euro, says of the very unstable relationship between the euro-dollar rate “[this is a] terrible things for the world economy. We’ve never been in this unstable position in the entire currency history of 3,000 years”… what could transpire in the future that leads us to the IMU? An important question to contemplate, and one to which the price of gold may be sending us an answer.
Gold
Irving Fisher, economist of the 1920’s whose ideas were overshadowed by John Meynard Keynes, is the original proponent of a strong dollar backed by commodities.
If the Fed would have listened to gold (or the nominal GDP model) over the past 15 years, the US would probably not be in the mess it is in today. Gold prices fell from $400 per ounce to $255 an ounce between 1996 and 1999. This signaled deflation, but the Fed chose to ignore the signal and raised interest rates anyway in 1998 and 1999. Deflation, recession and a stock market crash were the result.
In the wake of the stock market crash, the Fed started cutting rates because it feared deflation. Gold started to rise and by late 2003 it was back above $400/oz. But the Fed held rates at 1% anyway, which created a housing bubble. When that bubble burst, the Fed started cutting rates again and gold prices have now moved to more than $1300/oz. At this point, one would think the Fed would pause before pumping even more money into the system and targeting higher inflation.
But it isn’t. The Fed continues to hold interest rates at zero, proposes another round of “quantitative easing” and plans to target 2% inflation. All because it won’t listen to gold and it’s unable to see that banks are afraid to use the money the Fed is pumping in because, down the road, the Fed will be forced to take it out or face serious inflation.
That’s what gold is saying. By signaling that it won’t quit anytime soon, the Fed is trying to force banks to change their behavior. If it works, look out for inflation to reach multiples of 2% in the years ahead. The Fed hasn’t been successful yet, when it ignores gold and commodity prices.
Mortgages
If you have not done so, take advantage of still-historically low 30 year fixed mortgage rates. Recently the 30 year fixed mortgage dipped to about a 60-year low. It’s still cheap money, and it should be considered a very temporary “gift” from the Fed. The Fed is re-upping its bet of Quantitative Easing (buying mortgage backed securities on the yield curve to artificially keep mortgage rates low). Take advantage of this now, especially if you currently hold an adjustable rate mortgage. This gift, if you decide not to take advantage of it, will self-destruct within 24 months…
Fixed Income Commentary
Corporate bonds, both investment grade and high yield, look relatively attractive. In fact high grade corporate bonds are now trading on a near-equal basis with Treasury securities, meaning that sovereign debt is trading on credit-worthiness and balance sheet strength (instead of on ability to tax). As far as we know, this has never occurred before in history. Well, after all, who would you trust more to pay back a loan right now? Warren Buffett or the U.S. government? We’d choose Buffett.
Treasury securities with longer maturities should be avoided at all costs in this environment. TIPS offer some inflation protection, though recent auctions have produced negative real yields since investors are becomingly increasingly convinced that inflation is coming.
CA Municipal Bonds
The CA political atmosphere is heating up, with lots of talk; hopefully the “winners” can actually deliver on their rhetoric in terms of fixing the state’s woeful financial condition. The problems are big, but as a great politician once said: “the answers aren’t easy, but they are simple.” Please make your vote heard on November 2, unless you have already changed your legal residency to Nevada.
Wednesday, August 4, 2010
Valuations Favor Stocks
Stocks: The second quarter of 2010 was not good, with Mr. Market struggling between optimism, and finally caving in to pessimism. A slide of over 11% for the quarter ensued. Thus far in July we have recouped about 6%. We continue to selectively make purchases in areas that appear undervalued and underappreciated for their earnings stability, necessity, and stable of products. As an example of our risk-adjusted approach to equities, we have favored new purchases in oil and oil drillers, health care companies, mining/materials, and telecomm. While the broader stock market trades at 15x earnings, we are finding exceptional companies trading between 5-10x earnings, which provides a greater “margin of safety” in investing. We focus on bottom-up company analysis within a greater context of top-down global macro analysis, global demand, and currency issues. In fact, valuations of the strongest, best-managed, highly capitalized multinational businesses are priced at a deep discount (about 35%) to where they have traded on a normalized 10 year basis.
As a consequence of low interest rates, investors are very interested in purchasing higher yielding securities. This has led some to some investors buying longer 10-30 year bond maturities as they reach for yield, which frankly we view as a mistake. Though we have not yet seen investors flock to higher dividend paying securities in the stock market, it would not surprise us to see this movement gain momentum going forward. Corporate balance sheets have improved dramatically, and it is now possible find stable stocks with healthy dividends whose yield exceeds the 10/20/30 year bond.
Bonds: Investors continue to throw money at the bond markets with little consideration to the risk inherent in choosing an asset class that is grossly overpriced. The yield on the 10 year Treasury bond implies investors are paying a price-to-earnings ratio of 34x for these interest payments. Over the past three years, $572 billion has flowed into bond mutual funds. Over the same period, nothing has flowed into stock mutual funds. Corporate cash levels are at the highest percentage of total assets ever, and total cash sitting in money market funds stands at $9.4 trillion, also the highest level in history. The message is that we are on the right track in terms of how we value cash flows, particularly the entities that produce those cash flows. We would rather own a high quality corporation, trading at 5-10x earnings, paying a 4-5% dividend (that can grow relative to inflation) than an asset class (10 year Treasury) trading 2x stock market valuations that on a risk-adjusted and inflation-adjusted basis are likely to lose money over the next decade. Are we facing a future “lost decade” in the bond market?
Value Investing
This is worth repeating from Bill Miller, legendary investor:
“If your expectation is that we will outperform the market every year, you can expect to be disappointed. We would love nothing better than to beat the market every day, every month, every quarter and every year…Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value…
Our goal is to construct portfolios that have the potential to outperform the market over an investment time horizon of three to five years without assuming any undue risk. If we achieve that goal, we believe we will be doing our job, whether we beat the market each and every year or not.”
At ACCIMI we agree strongly with Bill Miller’s view. Often it takes time for the market to capture the intrinsic value of securities. While there are those who “believe” in the EMH (Efficient Market Hypothesis), we note that it is extremely important to realize that an “efficient” market doesn’t mean the market is “always rational”; in fact the inverse is quite true. “Efficiency” means that the market will efficiently produce a price, matching a buyer with a seller. “Efficient” pricing led to extremely high valuations in 1999/2000, and extremely low prices in March 2009—but was it rational?
Our media, and the certain parts of the financial services industry, continue to focus on the shorter term-- economic announcements hit the wire and investors are led to believe that all of this information is important and that it will have a direct impact on a company’s performance. Nothing could be further from the truth. In fact, sometimes we can capitalize on investors’ shortsightedness by taking advantage of lower prices over a short period of time. Over a five year period, the price of a stock will largely track the fundamentals of the company, and its actual earnings rather than its quarterly economic reports.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by this measure the Fed seems to be succeeding, though there *are* some deflationary signals that exist. In a reflationary period it is quite possible for all types of assets to go up in value, commodities and stocks could decouple in favor of commodities and commodity-related enterprises between 2011 and 2012. In such an environment, it is important to remember “why we invest”, which is to outpace inflation. If the stock market goes up 30% but oil and other commodities go up 60%, you will have wanted more exposure to those sectors within the market.
In a long-term inflationary environment, we expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, which is another way of saying that we would expect inflation to be largely a global phenomenon. Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle. And what is the distinction between inflation and debasement of a currency in real purchasing power?
Well, the real difference is that the government gets yelled at for the former, and gets an invisible hall-pass for the latter. So bet on the latter. A doubling of the money supply in the last 18 months, again using the Milton Friedman formula, and monetization of debt, yields a currency that is worth half its value in purchasing power. Here’s where it gets even trickier though: let’s say that much of the rest of the world agrees in principle to also print more and more money, as a coordinated effort. Now what? Is a new global currency standard emerging? Nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. We do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, agriculture, oil, and precious metals. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where we would expect the opportunities to emerge.
This Time Is Different, Or Not: History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012.
History has shown that stock markets move in very broad cycles. Up cycles usually give us sustained earnings growth, P/E multiple expansion, and upward sloping economic indicators. Common characteristics of down cycles usually show low/no earnings growth, P/E contraction, and downward sloping economic data. For down cycles, the cause of the final multi-year leg down is nearly always different. However, a bottom is usually finally in place once the major economic indicators are completely gutted, along with P/E multiples, and trailing long term stock returns. Interestingly in March 2009, the items just listed matched the 1982 lows, and arguably March 2009 was a more extreme bottom. Interestingly, in 1983 once the initial spike of new orders occurred post-recession, there was much talk of a “double dip”, leading stocks to trade in a broad range for six to nine months. Sound familiar?
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a weaker environment it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
Mortgages
Recently the 30 year fixed mortgage dipped to about a 60-year low. Take advantage of this now, especially if you currently hold an adjustable rate mortgage.
Fixed Income Commentary
In the context of our general comments on Treasury securities, high grade corporate bonds look relatively attractive. In fact high grade corporate bonds are now trading on a near-equal basis with Treasury securities, meaning that sovereign debt is trading on credit-worthiness and balance sheet strength (instead of on ability to tax). As far as we know, this has never occurred before in history. Well, after all, who would you trust more to pay back a loan right now? Warren Buffett or the U.S. government? We’d choose Buffett.
Treasury securities with longer maturities should be avoided at all costs in this environment. TIPS offer some inflation protection, but are based upon CPI numbers which are controlled by a government currently desperate to avoid automatic increases in budgetary items based upon CPI.
CA Municipal Bonds
The CA political atmosphere is heating up. Our prediction: Whoever wins will usher in a new era of “hope” for CA, and then around April or May of 2011, it will become quite apparent that CA is drowning in debt, and the CA legislature will fail Californians yet again. We are already beginning to lower our exposures to CA municipals, even short term durations. Both AMBAC and MBIA, the primary issuers of muni debt, are in big financial trouble, and by law they cannot issue municipal debt at a higher rating than their own firm. At some point the Federal government will need to act as a backstop for municipal debt in all 50 states, 48 of which are drowning in red ink.
Big Question Posed: So are we headed for a double-dip recession? Or not?
We read volumes of research, and frankly the signals are mixed, with some research pointing to an “oversold” condition, and some research pointing to an “overbought” condition. The truth is that nobody knows, and because nobody knows we are erring on the side of finding high quality businesses trading for 5-10x earnings (versus 15-17x for the S&P 500). If we run into a double-dip recession, we have already established a huge “margin of safety” by purchasing companies that are trading a low multiples relative to their asset base, balance sheets, dividends, and prospects. If we go into expansion mode, the market may begin to appreciate these companies via expanding market multiples. So in total we feel that our allocation to stocks looks attractive on a risk-adjusted basis.
However, we view our economy as being at an inflection point based on “which policies” are adopted going forward. Pro-growth, pro-incentive, lower-tax policies would be welcomed by the markets, and we think would propel them to new highs. Concerns over our debt burden would be assuaged by a higher growth economy that could service its debt service (due to the higher growth). This becomes a virtuous cycle, particularly to our creditors, who might then not have concerns about buying our Treasury bonds. An anti-growth, let-the-tax-cuts-expire policy (otherwise known as a tax increase), coupled with some of our impending new laws (higher regulation equals higher costs, healthcare is a new entitlement program) could be the thing that propels us downward. The historians out there like to overlay the Great Depression stock charts over the last several years—and it looks strikingly similar, so “policy” does matter. With all of the recent efforts to not repeat the Great Depression, it would be a shame to replicate it because of what looks like such an easy call on policy matters. There could end up being a bipartisan compromise based on the Administration’s latest efforts to extend unemployment benefits (i.e. Republicans could counter “OK, but we want tax cut extension”), though tax cuts are a primary issue of this November’s elections. If the polls are correct, something like tax cuts or stimulus could transpire by April of 2011-- lots of uncertainty in the interim.
As a consequence of low interest rates, investors are very interested in purchasing higher yielding securities. This has led some to some investors buying longer 10-30 year bond maturities as they reach for yield, which frankly we view as a mistake. Though we have not yet seen investors flock to higher dividend paying securities in the stock market, it would not surprise us to see this movement gain momentum going forward. Corporate balance sheets have improved dramatically, and it is now possible find stable stocks with healthy dividends whose yield exceeds the 10/20/30 year bond.
Bonds: Investors continue to throw money at the bond markets with little consideration to the risk inherent in choosing an asset class that is grossly overpriced. The yield on the 10 year Treasury bond implies investors are paying a price-to-earnings ratio of 34x for these interest payments. Over the past three years, $572 billion has flowed into bond mutual funds. Over the same period, nothing has flowed into stock mutual funds. Corporate cash levels are at the highest percentage of total assets ever, and total cash sitting in money market funds stands at $9.4 trillion, also the highest level in history. The message is that we are on the right track in terms of how we value cash flows, particularly the entities that produce those cash flows. We would rather own a high quality corporation, trading at 5-10x earnings, paying a 4-5% dividend (that can grow relative to inflation) than an asset class (10 year Treasury) trading 2x stock market valuations that on a risk-adjusted and inflation-adjusted basis are likely to lose money over the next decade. Are we facing a future “lost decade” in the bond market?
Value Investing
This is worth repeating from Bill Miller, legendary investor:
“If your expectation is that we will outperform the market every year, you can expect to be disappointed. We would love nothing better than to beat the market every day, every month, every quarter and every year…Unfortunately, when we purchase companies we believe are mispriced, it is often difficult to determine when the market will agree with us and close the discount to intrinsic value…
Our goal is to construct portfolios that have the potential to outperform the market over an investment time horizon of three to five years without assuming any undue risk. If we achieve that goal, we believe we will be doing our job, whether we beat the market each and every year or not.”
At ACCIMI we agree strongly with Bill Miller’s view. Often it takes time for the market to capture the intrinsic value of securities. While there are those who “believe” in the EMH (Efficient Market Hypothesis), we note that it is extremely important to realize that an “efficient” market doesn’t mean the market is “always rational”; in fact the inverse is quite true. “Efficiency” means that the market will efficiently produce a price, matching a buyer with a seller. “Efficient” pricing led to extremely high valuations in 1999/2000, and extremely low prices in March 2009—but was it rational?
Our media, and the certain parts of the financial services industry, continue to focus on the shorter term-- economic announcements hit the wire and investors are led to believe that all of this information is important and that it will have a direct impact on a company’s performance. Nothing could be further from the truth. In fact, sometimes we can capitalize on investors’ shortsightedness by taking advantage of lower prices over a short period of time. Over a five year period, the price of a stock will largely track the fundamentals of the company, and its actual earnings rather than its quarterly economic reports.
Re-flation of Assets
The economic debate has centered on deflation versus inflation. Based upon a fiat currency (our currency has been this way since we went off the gold standard), inflation is always preferable to deflation. Deflationary risks are to be avoided if at all possible, and by this measure the Fed seems to be succeeding, though there *are* some deflationary signals that exist. In a reflationary period it is quite possible for all types of assets to go up in value, commodities and stocks could decouple in favor of commodities and commodity-related enterprises between 2011 and 2012. In such an environment, it is important to remember “why we invest”, which is to outpace inflation. If the stock market goes up 30% but oil and other commodities go up 60%, you will have wanted more exposure to those sectors within the market.
In a long-term inflationary environment, we expect that foreign currencies may also be useful vehicles, but not as clearly as precious metals and commodities. The reason is that the U.S. is certainly not the only country demonstrating open-checkbook monetary and fiscal policy here. That means that currency positions largely represent the choice of which currency is "less bad." It's quite likely that hard assets such as precious metals and other commodities will advance relative to a wide range of currencies, which is another way of saying that we would expect inflation to be largely a global phenomenon. Conversely, while some currencies will most probably depreciate less than others against a fixed basket of commodities (i.e. exchange rates between different currencies will fluctuate even in a global inflation), those choices may turn out to be more subtle. And what is the distinction between inflation and debasement of a currency in real purchasing power?
Well, the real difference is that the government gets yelled at for the former, and gets an invisible hall-pass for the latter. So bet on the latter. A doubling of the money supply in the last 18 months, again using the Milton Friedman formula, and monetization of debt, yields a currency that is worth half its value in purchasing power. Here’s where it gets even trickier though: let’s say that much of the rest of the world agrees in principle to also print more and more money, as a coordinated effort. Now what? Is a new global currency standard emerging? Nearly all developed economies are behaving badly in terms of fiscal and monetary discipline. We do expect that there will be relative valuation differences in currencies and policies that will provide a basis for currency positions as we gradually transition from a low-inflation world eager for safe-havens to a post-credit crisis inflationary outcome several years from now. But the most likely beneficiaries (and the securities that we would be inclined to accumulate on significant deflation fears), are likely to be commodities, agriculture, oil, and precious metals. As usual, we'll respond to the data as it emerges, but the foregoing is a reflection of where we would expect the opportunities to emerge.
This Time Is Different, Or Not: History As Prequel
On a historical basis, every major stock market peak of the 20th Century was followed by a crash in the U.S. dollar five years later. People who kept their savings in dollars saw the purchasing power of their savings shrink substantially. Commodity prices had triple-digit rises in the mid-1930s and speculators once again made a fortune. Based upon this precedent, we could foresee a raging bull market in commodities (due to a falling US dollar value, big inflation, or both) somewhere between mid-2011 and the fall of 2012.
History has shown that stock markets move in very broad cycles. Up cycles usually give us sustained earnings growth, P/E multiple expansion, and upward sloping economic indicators. Common characteristics of down cycles usually show low/no earnings growth, P/E contraction, and downward sloping economic data. For down cycles, the cause of the final multi-year leg down is nearly always different. However, a bottom is usually finally in place once the major economic indicators are completely gutted, along with P/E multiples, and trailing long term stock returns. Interestingly in March 2009, the items just listed matched the 1982 lows, and arguably March 2009 was a more extreme bottom. Interestingly, in 1983 once the initial spike of new orders occurred post-recession, there was much talk of a “double dip”, leading stocks to trade in a broad range for six to nine months. Sound familiar?
Positioning Globally for Any Environment
The sectors we like most are commodity-related equities, including oil, coal, mining, agriculture, metals; we also like select healthcare, medical device, and biotech companies as well as a few select technology names that exhibit reasonable valuations (Growth At a Reasonable Price, GARP). The reasoning for our commodities-related/oil/metals bent is many-fold: 1) they are needed , (2) they appear undervalued and are economically sensitive; if they drop due to a weaker environment it shouldn’t be disastrous due to their inherent value, and if the market goes up, they go up too, (3) commodities are priced in US$, so if the dollar goes down, it takes more US$ to buy them, meaning the producers of these commodities will have higher earnings, (4) during inflationary periods they tend to hold up the best, (5) if we experience a currency devaluation for whatever reason (and inflation is but another means of achieving this), see #1-4. So we are adding positions that can withstand gale force winds based on macroeconomics and/or deliver strong earnings.
Mortgages
Recently the 30 year fixed mortgage dipped to about a 60-year low. Take advantage of this now, especially if you currently hold an adjustable rate mortgage.
Fixed Income Commentary
In the context of our general comments on Treasury securities, high grade corporate bonds look relatively attractive. In fact high grade corporate bonds are now trading on a near-equal basis with Treasury securities, meaning that sovereign debt is trading on credit-worthiness and balance sheet strength (instead of on ability to tax). As far as we know, this has never occurred before in history. Well, after all, who would you trust more to pay back a loan right now? Warren Buffett or the U.S. government? We’d choose Buffett.
Treasury securities with longer maturities should be avoided at all costs in this environment. TIPS offer some inflation protection, but are based upon CPI numbers which are controlled by a government currently desperate to avoid automatic increases in budgetary items based upon CPI.
CA Municipal Bonds
The CA political atmosphere is heating up. Our prediction: Whoever wins will usher in a new era of “hope” for CA, and then around April or May of 2011, it will become quite apparent that CA is drowning in debt, and the CA legislature will fail Californians yet again. We are already beginning to lower our exposures to CA municipals, even short term durations. Both AMBAC and MBIA, the primary issuers of muni debt, are in big financial trouble, and by law they cannot issue municipal debt at a higher rating than their own firm. At some point the Federal government will need to act as a backstop for municipal debt in all 50 states, 48 of which are drowning in red ink.
Big Question Posed: So are we headed for a double-dip recession? Or not?
We read volumes of research, and frankly the signals are mixed, with some research pointing to an “oversold” condition, and some research pointing to an “overbought” condition. The truth is that nobody knows, and because nobody knows we are erring on the side of finding high quality businesses trading for 5-10x earnings (versus 15-17x for the S&P 500). If we run into a double-dip recession, we have already established a huge “margin of safety” by purchasing companies that are trading a low multiples relative to their asset base, balance sheets, dividends, and prospects. If we go into expansion mode, the market may begin to appreciate these companies via expanding market multiples. So in total we feel that our allocation to stocks looks attractive on a risk-adjusted basis.
However, we view our economy as being at an inflection point based on “which policies” are adopted going forward. Pro-growth, pro-incentive, lower-tax policies would be welcomed by the markets, and we think would propel them to new highs. Concerns over our debt burden would be assuaged by a higher growth economy that could service its debt service (due to the higher growth). This becomes a virtuous cycle, particularly to our creditors, who might then not have concerns about buying our Treasury bonds. An anti-growth, let-the-tax-cuts-expire policy (otherwise known as a tax increase), coupled with some of our impending new laws (higher regulation equals higher costs, healthcare is a new entitlement program) could be the thing that propels us downward. The historians out there like to overlay the Great Depression stock charts over the last several years—and it looks strikingly similar, so “policy” does matter. With all of the recent efforts to not repeat the Great Depression, it would be a shame to replicate it because of what looks like such an easy call on policy matters. There could end up being a bipartisan compromise based on the Administration’s latest efforts to extend unemployment benefits (i.e. Republicans could counter “OK, but we want tax cut extension”), though tax cuts are a primary issue of this November’s elections. If the polls are correct, something like tax cuts or stimulus could transpire by April of 2011-- lots of uncertainty in the interim.
Sunday, March 21, 2010
Corporate Bonds more Attractive than U.S. Treasury
To follow up with our recent post on bond yields, here is another story emphasizing the point.
http://www.bloomberg.com/apps/news?pid=20601010&sid=aYUeBnitz7nU
This Bloomberg story shows several instances where high quality corporations have recently issued debt with yields just a few basis points shy of a similar-duration US Treasury. What does this mean?
It means that investors would much rather put their faith in a high quality company's ability to pay its debts than in the U.S. government (with its endless money-creation and ability to tax).
Rumor has it that the USA is about to lose its AAA credit rating, and get bumped to AA. It's about time, and the "market" for US bonds (i.e. China, India, Japan) is sending a wakeup call to our leaders in the USA to right the ship and become sensible in our financial dealings. If we don't, it is very likely that US bond yields will continue to rise in anticipation of a bond market that requires a higher rate of return for the risk.
http://www.bloomberg.com/apps/news?pid=20601010&sid=aYUeBnitz7nU
This Bloomberg story shows several instances where high quality corporations have recently issued debt with yields just a few basis points shy of a similar-duration US Treasury. What does this mean?
It means that investors would much rather put their faith in a high quality company's ability to pay its debts than in the U.S. government (with its endless money-creation and ability to tax).
Rumor has it that the USA is about to lose its AAA credit rating, and get bumped to AA. It's about time, and the "market" for US bonds (i.e. China, India, Japan) is sending a wakeup call to our leaders in the USA to right the ship and become sensible in our financial dealings. If we don't, it is very likely that US bond yields will continue to rise in anticipation of a bond market that requires a higher rate of return for the risk.
Monday, March 15, 2010
Solution to Pension Promises
Here's a link to a great piece from Barron's over the weekend, which addresses the debt albatross hanging around society's neck.
http://online.barrons.com/article/SB126843815871861303.html?mod=BOL_hpp_popview#articleTabs_panel_article%3D1
What to do? What to do?
Why don't we apply the same solution set that can be found at www.cato.org referencing their many-year-old "6.2% Solution" for Social Security. Namely, we need to create a "bridge" from one generation to the next in order to keep the promises we made from two generations ago. Why? Because that "social contract" is completely unsustainable and is literally creating insolvency issues at a local, State, and Federal level.
What would happen? Freeze all pensions today, ideally "earmarking" the frozen portion to each individual. This means that society will honor its social contract in terms of the net-present-value (NPV) of its pension obligations to you (defined benefit plan), but starting tomorrow, like "everyone else", you need to use a 401k-style approach (defined contribution plan). This solution will take 25 years, but it will work. Make it apply to anyone under 50 automatically. If you are 51-55, you can opt "in" or "out". If you opt in, it means you get the NPV of your currently accrued benefits + whatever your 401k-style plan grows to. Anyone over 55 would automatically stay in the current pension system.
How would the bridge work? First off, it is widely known that public sector jobs now either match or exceed private sector jobs in terms of compensation, benefits, etc. This "bridge", besides keeping past social contract promises, also encourages people to buck-up and become entrepreneurs in the American system while simultaneously discouraging people from "getting taken care of by the state". If the perceived benefits from going "public" decline, the benefits of going "private" increase.
Over 25-30 years, the "old" pension system quite literally gets phased out, along with its tremendous debt burden. This additionally creates an additional huge voting bloc that will want investor-friendly rules and regulations, stable money policies, tax incentives and the like. Thus, US politicians will need to answer to this investor class, which simply reinforces the traditions of the American entrepreneurial system, while also backing the USA away from its debt-induced tipping point (toward a welfare state system). A welfare state is simply unsustainable, and not unstoppable (yet).
This whole idea isn't "perfect", but it's a good starting point for a conversation-- a conversation that is long overdue...
http://online.barrons.com/article/SB126843815871861303.html?mod=BOL_hpp_popview#articleTabs_panel_article%3D1
What to do? What to do?
Why don't we apply the same solution set that can be found at www.cato.org referencing their many-year-old "6.2% Solution" for Social Security. Namely, we need to create a "bridge" from one generation to the next in order to keep the promises we made from two generations ago. Why? Because that "social contract" is completely unsustainable and is literally creating insolvency issues at a local, State, and Federal level.
What would happen? Freeze all pensions today, ideally "earmarking" the frozen portion to each individual. This means that society will honor its social contract in terms of the net-present-value (NPV) of its pension obligations to you (defined benefit plan), but starting tomorrow, like "everyone else", you need to use a 401k-style approach (defined contribution plan). This solution will take 25 years, but it will work. Make it apply to anyone under 50 automatically. If you are 51-55, you can opt "in" or "out". If you opt in, it means you get the NPV of your currently accrued benefits + whatever your 401k-style plan grows to. Anyone over 55 would automatically stay in the current pension system.
How would the bridge work? First off, it is widely known that public sector jobs now either match or exceed private sector jobs in terms of compensation, benefits, etc. This "bridge", besides keeping past social contract promises, also encourages people to buck-up and become entrepreneurs in the American system while simultaneously discouraging people from "getting taken care of by the state". If the perceived benefits from going "public" decline, the benefits of going "private" increase.
Over 25-30 years, the "old" pension system quite literally gets phased out, along with its tremendous debt burden. This additionally creates an additional huge voting bloc that will want investor-friendly rules and regulations, stable money policies, tax incentives and the like. Thus, US politicians will need to answer to this investor class, which simply reinforces the traditions of the American entrepreneurial system, while also backing the USA away from its debt-induced tipping point (toward a welfare state system). A welfare state is simply unsustainable, and not unstoppable (yet).
This whole idea isn't "perfect", but it's a good starting point for a conversation-- a conversation that is long overdue...
Monday, March 8, 2010
Ribbit Mobile is Like TiVo For Business
I usually just discuss some market news item, investment, give policy analysis, or distill some complex issue as it relates to investments. Today, instead, I wanted to advise you with a way to simplify and distill your work life: Ribbit Mobile.
Huh? What? What is Ribbit Mobile?
The best way to describe it is to first tell you why I love it. I get cold-called from different suppliers ALL day (hedge funds, mutual funds, separate account managers, etc.). If I don't recognize a phone number coming in, I let it roll to the Ribbit Mobile phone system, which transcribes the voice message into a readable email and text within a couple of minutes. If I erroneously missed the call, I call right back; but otherwise, the cold call message gets transcribed. Then...I don't have to talk to them, lose my train of thought, waste time with them, try to understand what they're selling...none of it. It goes to voicemail/text message version.
Frankly, sometimes it even helps if I legitimately miss a call, because I can read the gist and call back with a really well-thought-out response, possibly with some research, or answer for somebody. It actually improves my business and my service.
So now that you know WHY I like it, I'll tell you how I think of it: it's like "TiVo for Business". Yes, just as Tivo improves TV-watching productivity, Ribbit Mobile improves my phone-answering productivity. By a ton! You need to check this out:
http://www.ribbit.com/mobile/
If you want to thank me, just call ACC Investment Management, Inc. at 650-344-1600, but don't be surprised if I don't answer.
Huh? What? What is Ribbit Mobile?
The best way to describe it is to first tell you why I love it. I get cold-called from different suppliers ALL day (hedge funds, mutual funds, separate account managers, etc.). If I don't recognize a phone number coming in, I let it roll to the Ribbit Mobile phone system, which transcribes the voice message into a readable email and text within a couple of minutes. If I erroneously missed the call, I call right back; but otherwise, the cold call message gets transcribed. Then...I don't have to talk to them, lose my train of thought, waste time with them, try to understand what they're selling...none of it. It goes to voicemail/text message version.
Frankly, sometimes it even helps if I legitimately miss a call, because I can read the gist and call back with a really well-thought-out response, possibly with some research, or answer for somebody. It actually improves my business and my service.
So now that you know WHY I like it, I'll tell you how I think of it: it's like "TiVo for Business". Yes, just as Tivo improves TV-watching productivity, Ribbit Mobile improves my phone-answering productivity. By a ton! You need to check this out:
http://www.ribbit.com/mobile/
If you want to thank me, just call ACC Investment Management, Inc. at 650-344-1600, but don't be surprised if I don't answer.
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