Tuesday, February 09, 2010

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 20th, 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


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