Monday, November 21, 2011

Eurozone Issues

It seems increasingly likely that there will be at least one sovereign debt default in the Eurozone over the next several weeks and that, as a result, there will likely be some change in the composition of the 17 Eurozone countries using the euro as their common currency.

These Reuters quotes from the last week seem indicative:

Angela Merkel told her Christian Democrat party that: “Europe is in one of its toughest hours, perhaps its toughest hour since World War Two.” She said further that she feared Europe would fail if the euro failed and vowed to do anything to stop this from happening.

"In another conference, Merkel said “Europe's plight was now so ‘unpleasant’ that deep structural reforms were needed quickly, warning the rest of the world would not wait.”

"She called for changes in EU treaties after French President Nicolas Sarkozy advocated a two-speed Europe in which euro zone countries accelerate and deepen integration while an expanding group outside the currency bloc stayed more loosely connected -- a signal that some members may have to quit the euro if the entire structure is not to crumble.”

Also, European Central Bank (ECB) board member Peter Praet said it is not the role of the ECB to intervene “when there are fundamental doubts about the sustainability of some countries”, and outgoing ECB chief economist Juergen Stark rejected calls for the ECB to act as lender of last resort like the U.S. Federal Reserve or the Bank of England.

If the ECB is not to be the lender of last resort, such as our Fed, and the German people are to be heard politically, it seems clear that a Greek default is virtually inevitable, and that Italy and Spain, which are much too large to be saved by intervention, could easily follow, creating a severe crisis in the European banking system, which holds the greatest percentage of Eurozone sovereign debt.

How Does That Affect Us?

We can see day-to-day what Eurozone machinations do to our stock markets, which are acting a lot like they did in the 1930s, except that this time they are mostly reacting to the Eurozone’s problems (and now the failure of our own “supercommittee”). That raises the question of just how big a problem a major financial crisis in Europe is for U.S. businesses. Without a doubt, major U.S. banking institutions would be directly affected, depending on their actual exposure to European sovereign debt and the extent of their role as counterparties in derivative transactions. This would likely be quite large, but not nearly as big an issue as our own sub-prime mortgage scandal, which came close to burying several of our big financial institutions in 2008 and 2009, and has still not been resolved. Nonetheless, added to the problems these financial companies already have, it is likely to produce losses in the billions, but probably would not present existential issues (such as Lehman and AIG in 2008).

There is also recent concern that several large money market funds in the U.S., which hold significant amounts of Eurozone sovereign debt, could suffer losses, which would result in the “breaking the buck” scenario, which we wrote about in 2008. What this means is that investors in these funds would find that, not only do these funds cease to produce any current yield, but actually would become worth less than the dollars invested in them. All of our client cash has been invested in U.S. Treasury money market funds since 2008, in order to protect ourselves from this scenario, which begins to look more likely in 2012 than it did in 2008.


As for multinational U.S. manufacturing companies, a crisis in the Eurozone creates the potential for reductions in sales and earnings. Companies with extensive sales in Europe, such as consumer and auto companies, can be expected to suffer earnings reductions and possible foreign exchange losses, depending on the relative strength of the euro vs. the dollar. For example, a weak euro would result in European goods becoming less expensive in dollars (e.g. European cars) and vice versa, which would be negative for the U.S. balance of payments and companies manufacturing goods for export to Europe. Again, these potential losses would not threaten the survival of the kind of manufacturing companies that interest us, i.e. EVA companies that generate internal rates of return on capital that exceed their costs of capital (but they could create interesting buying opportunities).

Because of the Eurozone threat and the yet to be fully resolved mortgage crisis in the U.S., we have continued to steer clear of owning large banks and investment banking institutions in our client portfolios. Our financial exposures are with Berkshire Hathaway through their insurance businesses, and with General Electric, through their GE Capital subsidiary, which, while still suffering from loan losses incurred in the last several years, is a relatively healthy company overall.

FalkerInvestments’ equity portfolios are largely invested in U.S. multinational consumer non-durable, energy, and technology companies, most of which pay good dividends. Plus, we have significant holdings of strong electric and natural gas utilities, all of which pay good dividends. We also have a small automotive holding, Ford, with the expectation that they should benefit more than any other world auto company in an economic recovery, when it comes. Before the U.S. financial crisis, Ford was the only U.S. auto company producing EVA and, of course did not require a government bail-out or bankruptcy.

Because of our belief that Europe’s problems and the obvious fiscal challenges here at home will keep market volatility high, we still maintain significant holdings of bonds and U.S. Treasury money market funds, which provide our clients with good insulation from most world events. These funds are ear-marked for investments in equities, when we believe the opportunities are right.

As we constantly review our portfolios in light of what is happening in the world around us, we continue to conclude that we are comfortable being positioned as we are. Our equity holdings have outperformed the market this year as investors have sought safety in the type of conservative, dividend paying stocks we hold. That could change, of course, if everything gets better all at once, but somehow we don’t think that’s going to happen right away.

As always, we value your observations and questions.

Thank you for your continued trust.

Jack and Peter Falker

November 21, 2011

Tuesday, August 09, 2011

A Few Thoughts

Since our last blog posting on August 2nd, global equity markets have undergone a remarkable sell-off and have now retraced most of the gains made after Ben Bernanke hinted at QE2 about one year ago. Given the risks to the economy that we have discussed in past blog posts, perhaps these levels in the market are more reasonable and offer a healthier investment environment for the future. However, such a sell-off is disconcerting and requires our full attention.

While the failures of political leaders in Washington and the actions of Standard & Poor’s in downgrading United States sovereign debt would seem to be the immediate causes, the markets may be more influenced at this moment by the potential collapse of the Euro-zone and the likelihood of a Lehman-like systemic failure of the European financial system. The effects of such a failure on the U.S. financial system, while believed to be less severe than the financial crisis of 2008, are still relatively unknown.

The sell-off over the last few days has been swift and relentless. It is easy to surmise that one or possibly several significant funds or financial institutions may be under duress and undergoing a liquidation. There is no news of that at this point, but perhaps we will learn more when markets find new support levels. Also, we can’t forget the potential for computer or “machine” trading, which accounts for a significant amount of daily volume, to create volatility. While the decline in equity markets that started three months ago has legitimate fundamental reasons, forced or automatic selling over the last few days may be creating distortions to prices.

At this point our equity holdings are faring better than the market, as expected, and, of course, our cash and bonds are stable. Given our still-sizable cash position, we are looking at several, strong, dividend-paying EVA companies we would like to either buy initially, or add to existing positions. However, we are in no rush to “buy the dip” at this point.

Repeating the conclusion of our August 2nd blog:

We have been consistent in our message for the last several years, avoiding the impulse to anticipate every up or down move in the market based on the next government policy. We are working very hard to remain alert to potential downside risks while prudently investing our clients in the best, low-risk, wealth producing companies we can find. We continue to invest in EVA-producing companies with strong balance sheets and good dividends. We are being extremely careful to protect our client assets and continue to provide thoughtful insight via our fiduciary duty as investment advisors.

Stay tuned; and thank you for your continuing confidence.

Peter and Jack Falker

Tuesday, August 02, 2011

Policy Makers to the Rescue


Last year, at this time, the stock market was struggling under the weight of worsening economic news. On August 27th 2010, Ben Bernanke, Chairman of the Federal Reserve, gave a speech at an annual central bank symposium in Jackson Hole, Wyoming, hinting at his willingness to initiate what we have referred to in this blog as “The Bernanke Playbook”. (Recall that this refers to a paper he wrote as an academic, criticizing the monetary policy of the Japanese during the 1990s and providing his own policy prescriptions.) His speech introduced what became known as QE2 (the second round of quantitative easing) in which the Fed would buy $600 Billion of long-term US Treasury Bonds in an attempt to stimulate the economy.

Three days later the stock market embarked on a furious rally that topped out on April 29th of this year. The market took the bait and gambled that QE2 would spark a sustainable recovery in the economy.

Last week we found out that the annualized growth rate in the economy for the first 6 months of 2011 was 0.8%. By some economists’ estimates, this is less than half of what is required to simply maintain current employment levels. Other very recent economic reports show that the economy is weaker than many would have expected. Needless to say, QE2 has fallen short of expectations. Today the market closed below where it started the year.

The silver lining here is that corporate profits have remained quite strong, due largely to productivity gains. Of course, productivity means doing more with relatively less (i.e. fewer employees). And there’s the rub. How long can corporate profitability withstand the effects of a weak job market? Given the recent economic data, we may soon find out. Importantly, even with the amount of discord among policy makers in Washington, corporate managers are performing exceedingly well in creating value for shareholders.

As for our portfolio strategy, back when Bernanke embarked on QE2 last fall, we maintained our conservative position (as we wrote in this blog in December). We did not believe that QE2 would really fix what ails the economy and lead to a sustainable recovery. What seemed like a very contrarian position then, appears to be the consensus now, as the market recoils from recent economic news. Our efforts have been to invest in lower risk, high-quality companies, with good dividends that, as always, generate EVA. We have conserved cash to be ready when opportunity arises and protect capital. In a volatile world, we have tried to be stable and consistent.

Another Leap of Faith?

While the Fed may distort asset prices, (like making the stock market go up just by saying they will print money) we are not taking issue with the Fed’s willingness to help; they are using every tool made available to them. Without their initial response in 2008, things would have been far worse. Even Bernanke has learned to sympathize with his own plight. At a recent press conference, a Japanese reporter specifically asked him whether he still agreed with the paper he wrote criticizing Japanese monetary policy, while still a professor at Princeton. Bernanke’s answer: “Well, I’m a bit more sympathetic to central bankers now than I was 10 years ago.”

Add this to President Obama’s recent comments about last year’s stimulus package that “shovel-ready wasn’t as shovel-ready as we expected” and you get the sense that policy makers are disoriented. Washington has lately been caught up in talking points and ideology with complete disregard for the tremendous risks they are adding to the economic recovery. However, this doesn’t come as a complete surprise. The country is divided, as demonstrated by the last election. In a way, they are doing what they were elected to do.

We do, however, take issue with investors blindly assuming that our economic problems can simply be overcome by government policy. Every new policy prescription from Washington appears only to be a red herring, diverting attention from the issues and giving investors hope without justification. Just look at the jubilant response of the stock market after the Fed committed to QE2. Or after the elections when the Bush Tax cuts were extended and payroll taxes were reduced. As if one more round of printing money is the solution. As if tax cuts will suddenly invigorate growth. As if spending cuts will put us on the path to stability. As if more government spending will create jobs. As if raising the debt ceiling will create more certainty. While several policies may be necessary at different times, investors have seemed intent on believing the solution is simply a matter of the next policy fix.

In what feels like a scene from the movie Groundhog Day, traders and investors are again anxiously awaiting Bernanke’s upcoming appearance at Jackson Hole later this month for hints of QE3, as the economy weakens. As if…well you get the picture.

Working Through It

We continue to think the world is upside down for policy makers, making them ineffective in overcoming the historic deleveraging occurring in many developed countries of the world. It takes cooperation, coordination, and communication. We have very little of that right now, which is a startling parallel to the 1930s. In Europe it is even more complicated.

There simply is no easy fix. In their landmark book, “This Time is Different”, Carmen Reinhart and Kenneth Rogoff describe the history of financial panic induced recessions (or depressions). Given history, one could expect a seven year period, or “tail”, after the initial shock, until a sustainable recovery begins. During those years, a multitude of policy risks exist with growth taking place in fits and starts. We are almost halfway there.

The irony of the title, and stated purpose of the book, is that it really is no different now than it ever was. Simply, our lifetime experience in relation to a much longer economic history is different. Rogoff and Reinhart show us that this has been happening for 800 years. We can only accept where we are and work through it.

While our politicians fail to inspire us, corporate managers have been brilliant. Dealing with vast political and economic uncertainties coming from Europe, China, and the U.S., they continue to do their part to create value for shareholders. While some pundits, and even members of Congress, proclaim that the U.S. is bankrupt, they fail to recognize the real value that exists in the private sector, regardless of how broken government has become. There is no doubt that policy risk will remain a drag on economic growth and missteps at the government level could have profound consequences. Business owners and managers are very well aware of these issues, yet they continue to look for ways to grow and prosper. We hear this from the management of companies we invest in and we hear it from our own clients, most of whom are making their own business decisions every day. This is what keeps us optimistic and what generally gives the equity market underlying support. The U.S. economy, built on free-market principles and entrepreneurial aspiration, is very much a going concern.

Repeating Ourselves

For investors it takes patience and a dedicated strategy. We have been consistent in our message for the last several years, avoiding the impulse to anticipate every up or down move in the market based on the next government policy. We are working very hard to remain alert to potential downside risks while prudently investing our clients in the best, low-risk, wealth producing companies we can find. We continue to invest in EVA-producing companies with strong balance sheets and good dividends. We are being extremely careful to protect our client assets and continue to provide thoughtful insight via our fiduciary duty as investment advisors.

Our basic goal during this period of elevated uncertainty is to earn a more consistent and predictable return than the market. We believe this is in the best interest of our clients’ ability to preserve and grow their wealth.

Thank you for your continued trust.

Peter and Jack Falker

August 2, 2011

Friday, February 04, 2011

Deflation and Ham ‘n Eggs

On February 2nd, Peter Falker, CFA, gave a presentation titled “Debt Deflation and Quantitative Easing” to the Ham ‘n Eggs Club, a business professionals' group that meets weekly at the Edina Country Club.

Peter drew on the writings of Irving Fisher, a 1930s-era economist, who correctly identified the economic symptoms that created the deflationary environment of the Great Depression. He went on to show, by the use of a series of charts and graphs, that those same symptoms exist in the United States economy today.

He quoted Fisher from a 1933 statement that “It is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”

Peter went on to show that this is precisely what the Federal Reserve is doing today with “Quantitative Easing”, which is the largest inflation of the U.S. money supply in history. Since 2008, the Fed has expanded the monetary base by over $1.25 trillion, with the stated purpose of reflating the price level, i.e., literally creating inflation to offset deflation.

He quoted the “Bernanke Playbook” from a 1999 article written by Ben Bernanke, while he was an economics professor at Princeton, calling for Japan to deal with their own deflationary symptoms in the following way:

  1. Maintain a zero level of interest rates and a stated inflation target.
  2. Depreciate the currency through large scale open-market sales.
  3. Initiate a “helicopter drop” of newly printed money to domestic households.
  4. Buy government and corporate bonds, commercial paper, etc.

While Japan has pursued aggressive monetary policy since 1989, incorporating much of what Bernanke advocated, it has not stopped the deflationary tendencies in that economy. Because of its unstable condition, Japan has remained highly sensitive to negative global economic events. While not a perfect comparison to the U.S., it is important to understand the Japanese experience in the context of current monetary policy in the U.S.

Peter concluded his presentation by pointing out that, while the U.S. stock market has appreciated 20 percent since the Fed’s announcement of its latest round of quantitative easing (QE2), the lasting impression left by debt deflation leaves the economy vulnerable to external economic shocks.

To view Peter’s entire presentation click here:

Peter Falker's Ham 'n Eggs Presentation