Third Quarter Report 2012
The performance of our accounts was great in the first quarter of this year, terrible in the second quarter and pretty good this quarter. In total, it has been a good year so far and we are hoping there aren’t any European moments, wars or flash crashes left to ruin what has been a good year. We are going to spend a lot of time in this letter trying to simplify the fears about the world economy and how we think the U.S. Fed and the world monetary authorities are going to act.
I am reading my second book about Paul Volker, a past chairman of the U.S. Federal Reserve. The book is called Changing Fortunes and was written in 1991. In this book Paul Volker spends most of his time talking about how he and his Japanese counterpart worked to manipulate exchange rates to balance out trade deficits. In other words, if we had a trade deficit with Japan and the yen was trading at 250 to the dollar, they would try and raise the value of the yen to 200 yen to the dollar to see if our exports and imports with Japan would balance out. If they didn’t balance out, they would raise the exchange rate some more until we reached parity. After World War II the exchange rate was 360 yen to the dollar and today it is up almost 80% to 76 yen to the dollar. Today our exports and imports with Japan are basically in balance. The lead times to balance out trade deficits take a while but changing exchange rates will work over time.
Let us give you a real life example of how this would work in Greece IF THEY EVER left the Euro. Let’s say you own a manufacturing business in Greece and 40% of the cost of manufacturing your product is labor. As long as Greece is still in the Euro your only hope to lower costs to compete with Asian manufactures is to fire people or get them to take wage concessions. That is what they have been doing now for three years in Greece. Let’s say that you are able to get your workers to take a 25% cut in wages so that you are competitive with Asia. If we assume the price of your product doesn’t go down your labor costs are now only 30% (40%*.75=30%) of the cost of selling your product which is a total savings of 10%. Another way to lower the cost of your product if you weren’t in the Euro would be to have your currency go down by 10% which will give you the same result as if you cut the cost of your labor by 25%. Over the last 150 years most monetary authorities have chosen to drop the value of their currency to improve their business’s competiveness with foreign competition rather than cut the wages of their workers. This was talked about extensively in Volker’s book.
The problem a country has when they cut the wages of their workers by 25% is that other businesses that rely on selling to those consumers lose sales because their customers just took a 25% cut in pay and they don’t have money to buy their products. This starts a negative feedback loop of less consumption, fewer homes being built and debt reduction. If that is left unchecked the country goes into a depression like in 1929. Keep in mind that if a worker’s salary goes down by 25% his/her DEBT PAYMENTS DO NOT GO down by 25%. Lower wages help cause the system to implode, banks to go under and it’s a real mess.
Today, Greece is in a depression and they are trying to cut their wages to get out of it. In our opinion this won’t work. The only way out for them is to leave the Euro, depreciate their currency and print
money to give to their banks to cover the bad debts their citizens can’t pay right now. We have been predicting they would do this for a while and it hasn’t happened, so it’s obvious the Greek authorities would rather stay in the Euro and have 30% unemployment than have 10% unemployment and inflation. This will change at some point but so far Greece isn’t doing what we think would “solve” the problem.
We bring the Greek situation up because it matters to us even in this country when trying to predict what happens to our stock market and what we do with your investments. If our Fed had decided to not print money in 2008 and in essence asked our workers to lower their wages to be more competitive with China we would not own any stocks today. NONE. We would be in the same mess Greece is in now. Fortunately we are not. Because Ben Bernanke printed two trillion dollars and isn’t done yet, we think it is better to own assets (stocks are an asset) than to sell them like they are doing in Greece. It hasn’t always been pretty to be fully invested in this market the last three years, but we think we know what the Fed is trying to do and stocks are still a better bet than cash in the bank at zero. We want to give you some ideas of what we think the Fed is going to do next which is guiding our thinking on how we invest your money.
There is a school of thought in economic land that if consumers continue to borrow money the economy will continue to grow. The more people borrow, the more they spend and that usually means business is good. During recessions the RATE OF GROWTH of borrowing usually slows down which then slows down the economy. Most of the time, the Fed will raise interest rates to slow down the growth of debt. By making debt more expense to borrow consumers will slow down their borrowing which kills the economy and usually inflation as well. Once the consumer slows down their borrowing, the Fed then cuts interest rates to stimulate debt creation and the cycle starts again. The chart below demonstrates why we think the Fed is doing what they are doing.
The chart shows the yearly rate of change of debt growth for the consumer sector going back to 1951. As you can see, the U.S. consumer has been confident enough since 1951 to increase the amount of debt he/she wants to “own” every year by 9% on average. Some years consumers borrow more than 9%, some years less but that’s the average and it never went below zero until 2009. Since 2009, consumers in our country have done something they have never done before since the Great Depression; they are getting liquid and paying down debt at a 1.66% clip. This hasn’t happened in the modern era since we have data. We think it’s a big reason the Fed is printing so much money. We aren’t trying to tell you it’s right or wrong, but we are just trying to figure out what they are doing and trade ahead of them to make money. We want to make money and if we think we know what the Fed is doing it certainly helps us make money for you. To stimulate consumer spending habits the Fed is buying up home loans (mortgage bonds) to lower the interest rate that you pay on your home loan, thus increasing the chances that you will take on more debt or spend that excess money on “stuff.” If you have a $100,000 home loan at 6%, your interest payments are $6000 a year. Lower that rate to 3.5% and you free up $2,500 dollars of discretionary spending. The Fed will keep buying home loans until the consumer sector is confident enough to take on debt or the consumer FEARS INFLATION more than they do deflation. Once the U.S. consumer starts to take on more debt, we think that will be a sign the Fed will use to help it decide when it’s time to stop printing money. So far the consumer has not taken the bait and increased debt, hence quantitative easing 3 (QE 3) was announced in September.
Another macro criticism we hear a lot about is that our country’s debt to GDP ratio is at 100% and when that happened in Greece, Ireland or Spain they fell off a cliff and never came back. We are concerned about our country’s debt. It’s a mess our leaders should have fixed but didn’t. Our country’s debt is the issue our “trusted” political leaders will deal with when they get done lying to us during this election. What is different for us, though, compared to Europe’s indebted countries is that we can print money and have a singleness of purpose that they do not have. In Europe, the ECB (their Fed) has 17 countries they need to keep happy and those 17 countries couldn’t agree on what to do to help Greece, Spain or Ireland. That indecision (mostly Germany’s fault) has really kept them from recovering (see Greece example above). Those countries needed liquidity and debt relief and they didn’t get it. We can’t say that about our Fed which is flooding us with money and trying to lower the value of our dollar as well. What we think the Fed is going to do for the next 10 years or so is keep the interest rate on our debt below what the rate of growth in GDP is. If GDP with inflation grows at 5%, interest rates will be below that number to help increase our ability to pay our debts. If GDP is 2%, interest rates will be zero and if GDP goes to 10%, rates will be less than 10%. By doing this debt will shrink gradually to lower the debt to GDP ratio and we will get out of the debt trap we are in. When we predicted that interest rates would go up we blew that call. WE didn’t anticipate the Fed MANIPULATING interest rates to keep them under GDP. That’s our fault and we are confessing that sin now. It is our opinion that you can ignore 95% of what they say on CNBC as it pertains to interest rate and just focus on debt creation in the private sector and GDP. When debt goes up, GDP will too, and the Fed will keep interest rates below GDP. They will keep buying mortgages, printing money and doing what they have to gradually bring down the debt to GDP ratio.
I am sure by now you are thinking that the most important people in the world are the leaders of the large Central banks. Yes, they have been for the last 5 years. What would change that? Here are two problems we are wrestling with that are not easy for us to answer. We are worried about a war in the Middle East or in China. You might think that’s an ignorant worry. In the Middle East, it seems they have been at war for at least 1000 years. That might be true, but some wars cause more issues than others. At some point the world is either going to let a crazy guy in Iran have a nuke, or they won’t. Our guess is they won’t and that is our biggest unquantifiable worry. How does a war with Iran play out EVEN IF the U.S doesn’t send troops. Let’s go over some of our homework we have been doing on this subject.
In May of 1940 Germany started invading their neighbors and the stock market dropped 16.5% in three months. The markets stabilized for 15 months before Japan bombs Pearl Harbor and the markets drop another 19% before bottoming for good in April of 1942. The total drop in the market was around 36% and it happened in two waves. From April of 1942 on the market goes up and never looks back. If you held stocks through that period you would not have got back to break even until July of 1943 or around 38 months from when Germany started invading its neighbors. In June of 1950, the Korean War starts and the market dropped 12% in one month before bottoming out and going back up. There was no wait time to speak of in getting back to break even. The market never went lower after that drop. In August of 1990, Saddam invades Kuwait and the stock market dropped 16% in three months before bottoming out. The market then went up from there and was never lower than what it was in November of 1990. It took seven months for investors to get back to break even from when Saddam invaded Kuwait. We have not included the Vietnam War in this example because that’s a war that was gradual in nature and not a sudden event, so different from what we are anticipating. If you want to use the year troops were deployed in Vietnam as the starting point of that war then we would use 1965 when the S+P was at 84. When Saigon fell in 1975 the market was at 84. The stock market actually went up in 1965 after the US committed troops, but we just don’t feel like this war helps us with our decision making. If you add up the four events, minus Vietnam, above that were sudden in nature, you have an average decline of 16% from the time the war started (or was thought to be starting) until the market bottomed. The time it took for the market to drop 16% was 3 months. From there the market bottomed and was never lower except for Pearl Harbor in 1941. We are aware that the U.S. fought two wars this decade. If you want to include 9/11 into this equation, the market dropped from 1183 on the S+P to 965 for a drop of 18.4% in three weeks after the towers were bombed. If you include this event in your calculations the average market drop would be 16.5% and the time to get to the bottom was less than three months.
So, what do we do with this information? We have zero credibility in predicting wars, but we are worried about the possibility. Assuming the above history matters, if there is a war that breaks out the odds favor the market will decline around 17% and then bottom. From there the market will not go below that level in our lifetime based on war fears. Let’s assume we knew the day before that a war was going to break out with Iran. Should we sell all stocks in a taxable account to make what history says is a POTENTIAL 13% gain after tax? In each instance above (ex Pearl Harbor) the market never went lower than the initial decline of 16%. Would it be worth it to cash in and then TRY and catch the next bull market? What if the market only goes down 10% and then goes up? For now, it’s not worth trying to do this. In the Great Recession without the “benefit” of a war we have had declines of 20%, 17% and
10% over the last three years and our macro system during that time “told” us to sit through it. Should the market get over valued (above 1510 on the S+P 500 this year) then maybe it makes more sense. Should our monetary work go negative, we would sell some stocks war or no war. We are giving you this information and looking for your opinion. Let us know what you think.
The fiscal cliff is coming, the fiscal cliff is coming. The other fear we get is the fiscal cliff will cause us to go into a recession. We agree it’s not going to help the economy at all. In fact we just can’t believe our politicians have gotten us into this mess just to protect their jobs. It’s our fault we let them get away with it. We are currently running a budget deficit of around 8% of GDP, which is WAY above normal. Even in World War II we hardly did that so the government is currently in a very simulative mode to jump start the economy and get themselves reelected. To reduce the yearly budget deficit from 1.2 trillion to 500 billion (500 billion would be about 3.2% of GDP which is close to normal) the Government needs to raise taxes and cut spending by 700 billion. This is the fiscal cliff everyone is rightly worried about. We have a 700 billion dollar fiscal drag staring us in the face which probably won’t happen all at once. What should investors do? Remember that guy Ben Bernanke? What did he do this month? He just decided to lower the interest rate on every home mortgage by implementing QE 3. What does that mean? There are currently 9.6 trillion dollars of home loans in the United States. If you were to lower the interest rate on those loans by 1% (his goal?) you would free up consumer spending by about 100 billion dollars a year. So, the government potentially takes away 700 billion in fiscal stimulus in a worst case scenario and the Fed releases 100 billion back to the masses. After Bernanke announced QE3, he then went to talk to congress in a PRIVATE meeting and it’s amazing that there have been zero leaks about what he told our trusted leaders. He said something to them but it’s not public or being reported in the press. When congress has a private meeting with Ben and no reporter has what was said, we think it must have been important. Our guess is he told them it’s time to cut the deficit, we are making it easy for you to do it now, don’t do it all at once but start the process while I still have control of this mess. We think a fiscal deal will happen before July of next year. Our best guess is they will raise taxes on capital gains from 15% to 20%, lower corporate taxes, eliminate the mortgage interest deduction for home owners, and cut defense spending some more while going after Medicaid and Medicare. If the fiscal deficit goes from 1.2 trillion this year to 800 billion next year that is still a lot of stimulus for the economy (5% of GDP) compared to history. If capital gains taxes were to go up 8.6% to 23.6% from 15% (assuming your gain in your stock is 200%) you would need to see your stock go up by 7.1% to make up for the higher tax. So in other words if your stock was at $10 it would need to go to $10.71 to make up the difference. For now we can live with that. That doesn’t mean we like it, we just have to deal with it.
I am sure after reading this you are getting the impression that the most important person on the planet is Ben Bernanke, and in our opinion, for now that is right. Because we have political grid lock in the world, the monetary authorities have taken over the leadership roles of the economy and some would say the budget as well. Nature abhors a vacuum and Ben has filled the vacuum. If you like to read, here are some helpful articles on Bernanke and what he is trying to do:
Essays on the Great Depression/ Ben Bernanke
http://www.federalreserve.gov/boarddocs/speeches/2003/20030531/default.htm Bens thoughts on Japan
http://www.princeton.edu/~pkrugman/bernanke_paralysis.pdf Ben’s 1999 helicopter speech
If you read the book and the two links above, you will get a glimpse of the playbook he is using. If you have any questions feel free to give us a call on this subject (882-5746). It’s not easy to hack through this and I feel your pain for having read this long letter. On a happier note, the Christmas party will be at Highland Springs again this year on December 20th from 6:00-8:00pm. Mark your calendars and let’s hope for a big rally in Q4 of this year.
Mark Brueggemann IAR, Kelly Smith IAR, Brandon Robinson IAR