First Quarter Report 2011
In this quarter we had the beginning of a war in Libya, the ouster of two long time dictators in Egypt and Tunisia, a 7% stock market correction, public uprisings in Bahrain and Wisconsin while Japan the third largest economy in the world suffered a horrific earthquake and tsunamis. When you add all of that up you would expect the stock market to be down a lot and yet it managed to finish up over 5% for the quarter.
This letter is going to be a little different than our previous ones. We are going to talk about what we think we see coming next in the world economic system over the next ten years and why the problems of this quarter were forgotten for now but won’t be forever. This is a very long letter and we apologize for that. That said, when we are discussing something new that we are going to do with your money, you need to know about it.
You need to look at the last page of this report to see a chart that we think graphically shows THE PROBLEM we are faced with in the United States. That chart is a graph of the debt of our country divided by the income of our country and we define income as GDP (Gross Domestic Product). This chart is THE problem we are going to have to deal with as a country and as investors. As a country we have borrowed too much money in relation to what we earn and there is going to be a reversal of that trend over the next 20 years. We don’t think that the U.S. government’s debt is going to continue to grow as a percent of GDP anymore and that is going to cause problems for our country. This debt subject has been one we have been fighting about at Trend Management for the last 18 months, and after 25 books and numerous articles we have come to some conclusions that we feel comfortable enough to talk about how we might invest your money as this debt unraveling occurs.
As you can tell from the chart, in 1987 the total debt as a percent of our GDP got to levels last seen during the Great Depression and just kept going up from there. Investors have been talking about a U.S. debt debacle for 24 years now while comfortably predicting another depression was coming because of all of this debt. To sum up their thought process, the end of the U.S. as we know it was at hand in 1987, 1991, 2001 and there is no hope of avoiding it (even though we did for 25 years). We don’t share that dire view but we are aware of it.
During that period from 1987 until 2008 the U.S. survived and prospered which is the opposite of what occurred in the 30’s when this country last tried to deleverage. The aftermath of the 1929 deleveraging was a horrible depression. A natural question to ask is: “Why didn’t this large debt to GDP ratio in 1987 cause a depression like it did in the 30’s?”. The answer we think is that we had countries willing to invest their surplus money back in the U.S. to fund our government debt at the same time our Federal Reserve didn’t let the banks go under (like they did in the 30’s). If our banks had gone under like they did in the 30’s a rapid debt deleveraging would have caused another depression which we have been spared from for now. Those emerging market countries that had a trade surplus with us (mostly Asian countries) also helped continue our debt build-up by reinvesting their earnings (from selling to us manufactured goods) into our treasury bonds. Those emerging countries received a good interest rate on their money while trusting our Federal Reserve to protect the value of their investment (they trusted us to not depreciate our currency). One of the byproducts of the emerging countries buying our debt is that it helped “prop” up the value of the U.S. dollar which allowed our citizens and government to spend more money than we should have. The U.S. consumers purchasing power benefited from this higher dollar because it lowered the cost of goods he bought shipped in from mostly Asia. One of the consequences of this spending “orgy” enabled by our emerging market friends propping up our currency was that our manufacturing base and middle class was severely depleted by the off shoring of these jobs that used to be in the U.S. There has been lots of talk about how unfair this trend has been to the young and uneducated in this country (it was terrible), but the flip side of this argument that few people want to talk about is how the low inflation this out sourcing caused was a huge benefit to the elderly and those who had money over the last 30 years (it was fun to be retired). This disinflationary trend has been going on for 30 years which is what our next chart shows below.
What the chart above shows is that from 1955-1980 you would have made more money investing in the stock market and “tangible stuff” than you would have if you lent your money to someone who bought something tangible with their money. From 1980 present you would have been better off to have lent people money and collected interest rather than own something. What we think is the next consequence of our debt deleveraging is that you will want to own stuff and stocks again and not be a lender or bond holder at these rates or higher rates for awhile in the U.S. The 30 year trend in lending money over owning things in the U.S. is over for awhile. Why we feel that way is next.
federal government is going to change the rules. It won’t be a default like the Governor did, it will be a
papering over of our obligations which is called inflation. We have politicians that won’t raise taxes, we have politicians that won’t lower spending so to fix this stalemate the FED will solve this problem by
The above chart is a long-term picture of the U.S. dollar versus the currencies of emerging market countries that we are running big trade deficits with. The solution to our problems of high unemployment, high debt, and low GDP growth is to take the value of our dollar to new lows versus these currencies which will make it easier for our U.S. based manufacturers to compete with these emerging countries (most of these countries are in Asia). Our currency will go down until we have a
TRADE SURPLUS with these countries again. We don’t see ANYWAY our currency doesn’t go down versus those currencies over the next 10 years. It’s inevitable in our view. When your currency goes down your ability to buy things with money IN TODAY’S PURCHASING power goes down with it which is what we have to protect you from. Another way to say that is if your currency goes down you will have inflation eventually. A hamburger that used to cost you a dollar in 2008 might cost you 3 dollars in 2018
which means you are going to buy less of them unless your purchasing power goes up. If you are an Asian creditor and you see your largest client printing over 200% more dollars in a two year time frame to pay its debts (which has historically ruined the printing country’s currency) you have to think twice about continuing to LEND that country ANY money. The happy side of this equation is that as our currency goes down that poor uneducated person in the U.S. with no money actually gets a job instead
of living off of the system which gives him or her the ability to buy that $3 hamburger instead of having the government ration him/her a burger once a month. There is going to be a constant monetary battle in this country where increasing GDP by printing money will outweigh the effects of higher inflation. There will be more jobs and GDP to help us deal with the debt but the loser will be anybody who LENDS MONEY to the government or states to do this (see chart 2 above). Our government has initiated policies that will attack the lenders of money who did so well over the last 30 years.
What happens when you don’t grow GDP but your debts keep growing? If you want to view this battle in real time look at Wisconsin. What’s that fight all about? In its most basic sense Wisconsin can’t pay their state workers the money that they were promised 20 years ago by their politicians. The citizens of Wisconsin didn’t earn enough GDP to support the state workers that are still working and, more accurately, the retired workers and their benefits. Most of Wisconsin’s problems are based on the health care and retirement costs of their elderly state workers. The more their older workers get paid the less young workers the state can hire UNLESS YOU GROW Wisconsin’s revenue in relation to its debt. We went through this same problem with GM and Chrysler in 2008 when they had $100 billion of pension and health care liabilities for older workers and the market capitalization of those two companies was valued at only $5 billion dollars. The car companies solved that problem by filing for bankruptcy and giving part of the ownership of the company to the union to satisfy those claims. The states can’t do that (can Wisconsin give their state workers the Packers?). A state cant file bankruptcy and more importantly they can’t print “Wisconsin bucks” to paper over these past promises their politicians made so they are going to default (just like GM and Chrysler did) on their obligations to their workers. For better or worse the Governors of a lot of states are going to have to say no, we can’t pay that bill anymore which then starts the battle you just watched in Wisconsin. The Governor of Wisconsin defaulted on the obligations that other politicians had made to the workers because he didn’t have the money to pay those obligations. Look for this type of fight to continue in other states.
Our current Federal Reserve chairman is an expert on debt deflations and the problems that come with that. He wrote about the debt deflation of the 30’s in a book called “Essays of the Great Depression” by Ben Bernanke. I think you should read it. When a FEDERAL government comes up against a problem where they are either going to default on their obligations or print money to solve it the solution is almost always to print money and deal with the inflation later. Initially the printing of the money causes EVERYTHING to go up in price, which is what we talked about in 2009 and was one of the main reasons we were so confident in owning stocks in 2009 and 2010. The Government is printing money and you are benefiting from it right now with your account going back up. The first signs of inflation from the Fed printing money are called profits in your stock portfolio. We welcome that inflation. At some point in a typical cycle REAL COMMODITY inflation comes back and your currency starts to go down more than the government is comfortable with. When that event occurs the Federal Reserve will try and tighten monetary policy and slow inflation down which will also drive the value of your currency back up. The problem the Fed is going to run into this time is that with all of the debt we have outstanding, they can’t tighten credit too much to slow down the economy or we won’t earn enough GDP to pay our HUGE debts to our foreign creditors. This problem means our currency has to go down more than the Fed would like in order to give our exporters a chance to compete with Asia and earn a trade surplus. It will also make it easier for our currency to go down when those same Asian countries who were big buyers of our bonds for 30 years decide to do something else with their money. China is a rich country but its people are poor (their GDP per person is one tenth of ours and yet they have 2.85 trillion dollars in foreign reserves.). If they don’t increase the amount of money their citizens get (especially with food costs going up) China may soon learn what the presidents of Egypt and Tunisia did, RUN. China is battling massive inflation in their country today and they don’t like the social unrest this is causing. Every dollar that China invests in the United States is one less dollar their citizens have for food, healthcare, and improving their living standards. Don’t you think the citizens of China would benefit MORE from that 2.8 trillion in foreign reserves THEIR LEADERS have invested outside their country if those leaders spent that money on THEM rather than subsidize our U.S. healthcare needs? Of course they would. However, China has up until now been more willing to invest that money in U.S. treasury bonds which has helped HOLD UP the U.S. dollar while benefiting their export company leaders rather than the average Chinese person. A good question to ask is, “Who OWNS these privileged exporters?” I will give you a hint, it’s not the poor people of China. We feel the “stiffing” of the average Chinese person is over and it has ramifications for what’s next in our country. As our Fed prints all of this money it is causing a large rise in food prices worldwide. The average U.S. consumer pays around 15% of his or hers income to eat. In the Middle East and Asia that number is over 60%. Is it any wonder there are riots across the world right now as food prices double from a year ago? What good is it to have a manufacturing job in China if you can’t afford to eat? It is NOW in the best interest of politicians AROUND THE WORLD to try and slow down food inflation before their people riot and throw them out. One way to do that is raise the value of your currency which makes food cheaper for your people to eat. The easiest way to raise your currency is stop buying any U.S. bonds and let the U.S have some of your inflation.
As you can tell from this letter so far the stars are aligned for everybody to do the opposite of what they have done for the last 30 years and that the chart borrower vs saver is going to reverse to the upside again. Everybody’s self-interest is aligned in reversing that chart. The emerging market countries will want their currencies to go up to feed their people which means they won’t want to buy a lot of our debt which will remove one LARGE buyer of our currency. The U.S. will want it’s currency to go down to
service its debt (remember we borrowed in dollars and we can print a lot of them) and help paper over the promises they have made to their citizens over the last 30 years that they can’t keep. This won’t be the end of the world for the U.S. or the emerging countries that have been supporting us, just a change in modus operandi. We are going back to a 20 year run where it is better to be a borrower rather than a lender in this country and we think the middle class and poor might actually like this NEW/OLD world when they see jobs show up again. The group who won’t like this are the elderly (that’s me) and anyone who has money invested in something that isn’t tangible. Those two groups are the target because they have benefited more than the poor and the young during the last 30 years (see borrower vs lender chart above) and the cycle is going to reverse. Please keep in mind that being old and rich wasn’t such a bad thing from 1955 to 1980, it was just better to be that way from 1980 on. The obligations that our politicians promised us can’t be paid with “stable dollars” so just like the Governor of Wisconsin did, our federal government is going to change the rules. It won’t be a default like the Governor did, it will be a papering over of our obligations which is called inflation. We have politicians that won’t raise taxes, we have politicians that won’t lower spending so to fix this stalemate the FED will solve this problem by printing more money which we think will bring inflation back. The politicians who won’t raise taxes will not index the tax tables for inflation so as our income goes up from inflation so will our taxes (and the no taxers will claim ignorance on this subject) and the politicians who won’t cut spending will stand by while your money is papered over and some rationing occurs of their favorite projects (they will also claim ignorance on this). If you are old enough to remember the Vietnam War one of our presidents had to decide between choosing guns or butter, he chose both. By not making a choice he actually made a choice to let the Fed fix this problem by printing money to satisfy everyone. The Fed allowed us for awhile to have both guns and butter which caused the inflation problems of the 60’s and 70’s. Today we are faced with a similar dilemma, cut taxes or cut spending, and our elected leaders will do neither (don’t you know the Governor of Wisconsin wishes he could do nothing?), which means here comes the inflation. So, how does Trend Management plan to deal with this?
If you haven’t fallen asleep after reading the last five pages we will give you a simple answer to what we plan to do next. In general we are going to be an owner of stuff in the U.S. and a lender of money outside of the U.S. That pretty well sums it up. A country that has a depreciating currency isn’t a horrible thing if you own something besides the actual currency. One of the biggest daily percentage up moves in the Dow Jones Industrial average was the day Richard Nixon and Paul Volker devalued the dollar in August of 1971. The Dow was at 856 and it closed at 889 the next day. Fifteen months later the Dow was at 1020 for a total gain of 19%. During that same time frame ten year government bond rates actually went down from 6.58% to 6.37%. It wasn’t until the late 70’s before the bond buyers figured out what was going on and demanded much higher interest rates on their money. We think something similar to that is going to occur. Until the stock market gets over valued from all of this money the Fed is printing we feel comfortable owning stocks that we think we can understand that are priced fairly. At
some point the U.S. dollar is going to drop and that will push the stock market up for awhile without causing any inflation in the governments CPI index. Everyone will be happy for awhile until inflation comes roaring back. Because this last crash was so traumatic investors will wrongly ignore the rising inflation and cling to their bond portfolio’s way to long (just like the generals we are always fighting the last war instead of the current one). At some point the Fed will tighten and we will sell stocks in the U.S. and invest the money in an emerging economy that has higher interest rates than the U.S. does. We hope to make money from the interest on that debt PLUS get an appreciation in the currency of the country we own versus the U.S. dollar. If we can’t find emerging market debt we like we will invest our
money in short-term treasury debt until we are sure that the Fed tightening is over and the debt deflation is under control. We don’t think we will sell 100% of your stock holdings but we are guessing it might become a 50/50 type of account (versus 100% stock today) split between stocks and bonds. We are telling you this ahead of time to give you some time to think this over. Our best guess is we don’t do any of these types of macro moves this year. More than likely this is a 2012 or 2013 event but we are preparing for it now. Before we do this we will announce it in our letters and we will set up a meeting with everyone to discuss what you want us to do. We want to see you in our office and go over this when we start to make these changes. It’s important, it matters and we need to see you when it happens.
We promise you our next letter will go back to talking about how our stocks are doing and it won’t be this long. We wanted to get this letter in your hands to give you time to think about what we think is coming next. It is easy to talk about this stuff but it’s harder in real life to do it and we have a plan on how we will do it but our timing won’t be perfect. We are pretty sure we will sell stocks too soon and buy bonds too soon and everyone will want to shoot us. After what we all experienced in 2008 that’s a risk we are willing to take.
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR