Letter to Clients - February 2010 (Final Installment)

Note: We are publishing this blog post in three installments, because of its length. If you would like to read it in its entirety or send it to a friend, here is a link to a pdf file on Google Docs of the entire article: FI Letter to Clients - February 2010

If you would like to return to the first installment, click here.

Video Introduction (replay)

This is where we left off in our second installment:

Leading up to the crash in 2008, we had rampant inflation driven by excessive debt. At the bottom we were faced with, and indeed experienced, the debilitating effects of deflation. Correcting inflation is easier, if sometimes painful. Attempting to correct deflation is more difficult and much more painful.

The reason for this is the legacy of debt that the inflationary period leaves behind.

The Elephant in the Room

“This country got very, very leveraged up in a lot of respects… at the individual level, in housing, in the government levels, everyplace. Deleveraging is a painful process and it takes a long time. And we’re not done.”

-Warren Buffett, January 20^th, 2010 on CNBC

“It matters little which factor in the vicious spiral (commercial bank liquidations or the fall of the price level) started first; nor what factor, remote or near, started either of them. They could even start together. But once started, they were doomed to continue in a vicious spiral, each accelerating the other. What seems sure is that the crash of the stock market helped to force the rest of our debt structure into liquidation, and that it was the hopeless magnitude of the debt burden which made it so difficult for the economic organism to right itself.”

-“Booms and Depressions”, Irving Fisher, 1932.

I am indebted to the writings of Fisher for providing a real time look at economics during the Great Depression. Thankfully, at the current time, our story departs from that of the early 1930s. Toward the end of 1932, when that book was written, the stock market had fallen for four straight years, declining nearly 90%. While there was a 50% recovery in early 1930 from the 1929 panic lows, the market continued down mercilessly with several “rallies” along the way. During that time, nominal GDP contracted 45% and the absolute level of debt in the country was reduced by over 20%.

In contrast, by March 2009 the stock market was down about 60% from the highs in 2007, and has recovered now to be down a less traumatic 26%. Nominal GDP has fallen a mere 1.3% from the highs in 2008, helped tremendously by government stimulus and inventory restocking in late 2009. Aggregate debt levels (government and private) have remained flat. Important to note, however, regarding debt levels, private sector debt will have fallen slightly in excess of 1% during 2009. This would be the first reduction in private sector debt levels since the 1930s. Also consider that bank lending is down 5% in the last 12 months. During all recessionary periods since the Great Depression, private debt has never contracted. In fact, it was always expanding credit that has jumpstarted recoveries in the past.

This is where I start to worry. You see, Fisher recommended in his book, that “reflation”, brought about by resetting the value of the dollar (devaluing it) could create expectations of the price level rising. This would motivate buyers and investors who had dollars to abandon them in favor of assets and goods before prices rose. It wasn’t until FDR basically took control of the banking and monetary system in 1933, and effectively removed the dollar from the gold standard, that prices started to rise. In effect, this so called quantitative easing is exactly what has lifted the stock market in 2009, and even back in 2003. The only difference, I hasten to add, is that debt levels have only begun to fall and the availability of credit is indeed shrinking, which is very worrisome.

Add to this that consumers are recently showing a change in behavior toward debt reduction and increased savings. Certainly, after losing/under-producing over 10 million jobs over the last 2 years, they have reason to continue that behavior. Consider, for example, that mortgage debt remains unchanged, while home prices have fallen nearly 30%. Not only is the elephant in the room still there, he’s taking up more space than before.

With debt levels relative to GDP in the United States at twice what they were in early 1929, I worry that we face what Fisher referred to as that “hopeless magnitude of debt”. While outside the scope of this writing, this is not just a domestic problem, global sovereign debt concerns are taking the stage in 2010. Again, it matters little what causes debt to unwind, it matters how it proceeds when it does.

WWBD? (What Would Bernanke Do?)

The mere size and duration of Fed and Treasury directed bailouts should give anyone pause to consider why they are so vast and long. The next closest comparison outside the Great Depression is Japan, where deflation persists to this day amid new “threats” to devalue the yen. The Japanese banking system was slow to reduce debts in the early 1990s over fears of insolvency. Similar to the U.S today, Japan slowly shifted private sector debt to government debt. Witness the recent expansion, now with a new provision for unlimited losses, of Fannie Mae and Freddie Mac to further underwrite the housing market. Add to this the purchase by the Federal Reserve of $1.25 Trillion in mortgage-backed securities.

Japanese Government Bonds have recently become cause for concern, even if still not a great risk, as sovereign debts are showing early signs of strain evident in the latest struggles of Greece and Spain. While Japan still enjoys a high standard of living, likely due to their history of maintaining high savings rates, the stock market is but one-third of its 1990 value, in nominal terms. Ben Bernanke, in a 1999 paper which he wrote while still a pure academic at Princeton, blamed the Japanese for not lowering rates to zero immediately and pursuing quantitative easing soon enough in the early 1990s. He states: “Most striking, is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn’t absolutely guaranteed to work. Perhaps it’s time for Rooseveltian resolve in Japan.” As such, that statement provides valuable insight toward understanding the person driving our monetary policy today. The Great Reflation Experiment has been unveiled.

Bernanke, and possibly Greenspan, are likely to go down in history as the first to orchestrate a real economic recovery simply by repeatedly devaluing the dollar, without a decline in the level of outstanding debt. As mentioned earlier, when FDR left the gold standard in 1933, he was starting at much lower absolute levels of debt and GDP. This formed a very important base from which to grow. The economy continued to struggle even then with a low confidence level, but relief was on the horizon as government programs reinforced recovery until World War II finally intervened. In Japan during the 1990s, stubborn to allow debt reduction, the price level remained under pressure as confidence has been repeatedly lost.

While each scenario is somewhat different, they are identical in that a period of inflation resulted in too much debt, which in turn caused great difficulty in resurrecting profitable growth in the economy for years to come.

Today, just as quickly as we reflate, we may well run right back into the wall of debt that repelled us before.

Starting Over

So that brings us back to the beginning of this blog, the conclusion. With an outlook for modest, below average growth in the economy for possibly several years, we stress our high regard for businesses that generate consistent returns on capital and deliver high cash flow yields to investors. Staying alert for reasons to reduce market exposure will remain important. Our number one concern is, as always, protecting the wealth of our clients. We are not predicting a crash and by no means desire that outcome. As we’ve said before, preparing in earnest for a crash can leave you with years of significant missed opportunities. We are simply being careful to safely navigate the challenges that will come to define the era in which we live. (It was worth repeating.)

Peter J. Falker, CFA

February 9, 2010

Thanks for visiting our blog today. Please visit our website at www.FalkerInvestments.com

Letter to Clients - February 2010 (Second Installment)

Note: We are publishing this blog post in three installments this week, because of its length. If you would like to read it in its entirety or send it to a friend, here is a link to a pdf file on Google Docs of the entire article: FI Letter to Clients - February 2010

If you would like to return to the first installment, click here.

Video Introduction (replay)

Here is where we left off in our first installment:

The structural defects that the financial crisis revealed have been there for a long time, and it is hard to reconcile how they existed all this time without being exposed. Similar to balancing on a high wire, all you need is a misstep or a nudge to knock you off. The nudge came in 2008, and the question quickly turned to how far down the safety net was, assuming there would even be one. The net, in the form of massive infusions of dollars from the government, finally appeared and indeed broke the fall.

We are all now enjoying the free flight of a rebound from the high-wire safety net. Certainly, investments held through the crash have recovered significantly, while investments made during the crisis (primarily in corporate bonds) have added considerable value. We could grow complacent and marvel at how conventional wisdom triumphed once again as it “paid to buy pain” at the lows in March of 2009. People who did so feel like heroes. But I’m not impressed. The risks of entering a second Great Depression were real and the fundamentals of those risks remain. The stock market is, indeed, lower than it was 10 years ago, and today we face much greater challenges.

The Dollar – Public Enemy Number One

A strengthening dollar allows us to buy more. That sounds like a good thing. Yet, as holders of dollars benefit from the prospect of buying more goods or stocks in the future, it also has the potential negative consequence of limiting future profits to those that produce or own those goods and stocks. In reality, we would all prefer a stable dollar, one that allows us to work and profit from the value of our talents and skills, while making purchases and investments with the confidence of predictable benefits.

Expectations of cheaper and cheaper dollars were built into the marketplace over many years, leading to widespread inflation in asset prices. This led businesses and consumers to not only spend the dollars they had as the price level rose, but to borrow from others and spend theirs as well. Borrowing money to buy assets that increase in value also has the effect of lowering the relative value of your debt obligations.

The miracle of our fractional reserve banking system, whereby every dollar deposited in a bank is lent out 10 times over, creates an ever expanding supply of credit when fueled by low interest rates (courtesy of the Federal Reserve and possibly a mercantilist Chinese economy – but that’s another topic entirely). Add to that the inventions of modern finance and a rapidly developing market for asset-backed lending, and you have increased the number of arteries that can deliver credit. Eventually credit is not used for sound investment, but it is used freely for consumption and mal-investment.

In reality, people borrowed more and received less in return, as their purchasing power slowly eroded. Eventually, all it takes is an unexpected failure in the system, a so-called “black swan" event, for the process to reverse itself. And when it reverses, the same mechanisms of lending upon lending that propagated the growth of credit in the beginning, similarly accelerate the contraction of credit.

So it is that we had a financial panic and a stock market meltdown beginning in late 2008. Hedge funds were forced to liquidate. The banking system seized up under the pressure of falling asset prices, threatening insolvency, which caused credit flows to come to a halt. The dollar rose by 30% versus major currencies and every day it was gaining in value relative to everything except risk-free government bonds (which have dollar-like characteristics). The value of outstanding debts began to swell relative to the value of plunging asset prices, which in turn motivated further selling. Just as the dollar was devalued, it quickly became overvalued.

The Great Depression era economist Irving Fisher called such changes in the value of the dollar “The Money Illusion”. Inflation leads to an oversupply of credit and a false indication of wealth whereas deflation leads to a lack of credit, choking off capital flows where they are needed, threatening a reduction in the standard of living. Important to understand, the dollar becomes overvalued when hoarding occurs in an unrelenting deflationary spiral. Human assets, our skills and talents to create and add value, eventually become devalued at the expense of a swelling dollar and a lack of capital. (After all, dollar bills are just pieces of paper. They need to be exchanged for something of value.)

Starting in late 2008, as in the Great Depression, we started cutting into the bone. Real value was being destroyed. We were stepping backward in the timeline of progress. People, as clearly identified by the skyrocketing unemployment rate, are increasingly unable to use their skills to provide for their families and contribute to the economy, failing to improve their financial future. Returns on capital are reduced while losses begin to eat away at net worth. A revaluation in the dollar is then appropriate, as fear and hoarding erode real economic growth.

Leading up to the crash in 2008, we had rampant inflation driven by excessive debt. At the bottom we were faced with, and indeed experienced, the debilitating effects of deflation. Correcting inflation is easier, if sometimes painful. Attempting to correct deflation is more difficult and much more painful.

The reason for this is the legacy of debt that the inflationary period leaves behind.

To be continued

Peter J. Falker, CFA

February 4, 2010

Thanks for visiting our blog today. Please visit our website at www.FalkerInvestments.com

Letter to Clients - February 2010

Video Introduction

Note: We are publishing this blog post in three installments this week, because of its length. If you would like to read it in its entirety or send it to a friend, here is a link to a pdf file on Google Docs of the entire article: FI Letter to Clients - February 2010

Good News is Welcome

It should come as no surprise that we are genuinely pleased about the stock market’s performance in 2009. We are also very pleased with the performance of our client investments. What gives us the most satisfaction, however, is the chance to catch our breath and evaluate where we stand. Certainly, at the depths of Dow 6,440.08, on the morning of March 9, 2009, we all needed a break, no matter how much or how little exposure one had to the markets. That was quickly becoming irrelevant. The rate at which we were heading toward a second Great Depression was remarkable, and it is equally remarkable how it has so far been avoided.

First, the Conclusion

With an outlook for modest, below-average growth in the economy, we stress our high regard for businesses that generate consistent returns on invested capital and deliver high cash flow yields to investors. Staying alert for reasons to reduce market exposure will remain important. Our number one concern is, as always, protecting the wealth of our clients. We are not predicting another crash and by no means desire that outcome. As we’ve said before, preparing in earnest for a crash can leave you with years of significant missed opportunities. We are simply being careful to safely navigate the challenges that will come to define the era in which we live.

The market collapses of 2002 and 2008, being so close in proximity, have combined to create a significant inflection point. There are changes occurring in financial behavior that will linger with us for many years, and this greatly influences how we manage our client assets. The stock market over the last decade has produced great gains, only to be overcome by even greater losses. In the years ahead, avoiding loss will gradually replace the pressure to make high returns, which marked the late 1990s and early 2000s. Indeed, that will ultimately serve as a positive for investors just as too much optimism, which leads to complacency, is a negative.

During the last 10 months, we have witnessed an historic swing from pessimism to optimism with the stock market rising 70%. Possibly that optimism today is more appropriately called hope, as many in the economy are clearly worse off than they were just a year ago. I expect that we will bounce between fear and optimism, panic and complacency, in ever shorter cycles, until the excess leverage in our economy is burned off. We are still very much in a transition period toward a more general public acceptance of risk-aversion. Change may already be signaled by a turn in the savings rate, greater household ownership of U.S. Treasury Bonds, and the first signs of deleveraging in the private sector since the 1930s. If these turns continue into trends, risk-aversion will become the norm, which eventually creates better opportunities for more speculative investors.

We like our portfolio of investments right now, and we are making new investments, patiently adding attractive cash yields while selling certain positions that have benefited the most from the rebound in commodity prices. We are always focused on protecting and adding to our clients’ future wealth, even if that means holding higher cash balances for a period of time, as we have for much of 2008 and 2009.

Our investments will increasingly focus on sectors that keep us close to cash. We are talking here about owning companies that serve needs rather than wants in the economy; companies close to their customers’ pocketbooks; companies that give consumers basic necessities (i.e. consumer staples, select utilities), or provide technology to enhance business productivity in an environment of challenging revenue growth. We want to be where dollars need to be spent, and where investors can earn a high proportion of their returns in cash flow from dividends. We will continue to add investment-grade bonds that meet our yield criteria, as we did during the crisis lows. Of course, remember, our overriding discipline is that every company we own creates EVA by generating profits in excess of their cost of capital. There isn’t a better time than now to focus on that quality.

The most important component of our client portfolios is that they remain risk-averse. While this may cause them to lag the market on the way up, if we wake up tomorrow morning to a “black swan” event that again shocks the market into a tailspin, we don’t want to be wishing we had been risk-averse today.

That’s our bottom line. Here are the reasons why.

What, me worry?

Well, to be honest, yes. Understand though, only because it is a big part of our job, and it’s not the same as pessimism.

“Navigating our clients’ assets through this very fluid world, is not about what we want to happen, but what is likely to happen…The financial crisis exposed structural problems that require a structural response…The temptation to relax too early is disastrous.”

- Mohamed El-Erian, CEO of PIMCO January 15, 2010 on CNBC

Managing investments for other people over the last 12 years continually reminds me of the value of having something to worry about. Hopefully, this helps our clients worry less about their investments while giving them more room to improve their careers or better their families. Certainly I am an optimist in life, especially when it comes to raising my kids. (My wife rejects worry in life as “negative energy” and reminds me of that regularly). Yet, a money manager is largely a risk manager. And while risk can measure the likelihood of making money, it more importantly measures the likelihood of losing money. Studies show that the risk of loss is of greater importance than the risk of gain. When you lose what you have, of course you have much less ability to gain it back.

The structural defects that the financial crisis revealed have been there for a long time, and it is hard to reconcile how they existed all this time without being exposed. Similar to balancing on a high wire, all you need is a misstep or a nudge to knock you off. The nudge came in 2008, and the question quickly turned to how far down the safety net was, assuming there would even be one. The net, in the form of massive infusions of dollars from the government, finally appeared and indeed broke the fall.

We are all now enjoying the free flight of a rebound from the high-wire safety net. Certainly, investments held through the crash have recovered significantly, while investments made during the crisis (primarily in corporate bonds) have added considerable value. We could grow complacent and marvel at how conventional wisdom triumphed once again as it “paid to buy pain” at the lows in March of 2009. People who did so feel like heroes. But I’m not impressed. The risks of entering a second Great Depression were real and the fundamentals of those risks remain. The stock market is, indeed, lower than it was 10 years ago, and today we face very significant challenges.

To be continued

Peter J. Falker, CFA

February 1, 2010

Thanks for visiting our blog today. Please visit our website at www.FalkerInvestments.com