What We Expect in 2014

After the huge market recovery we saw in 2013, it seems unlikely that we will see a repeat performance in 2014.  What seems more probable is that we will see corrections and rallies around current market levels and, given the expected continued recovery of the U.S. economy from six years of recessionary and deflationary conditions, at least some positive overall movement in the markets.  In other words, the equity markets will probably be up in 2014, in response to improving economic conditions and corporate profits, but not nearly as much as they were last year.  By the same token, we would expect the bond markets to be down, as long-term interest rates begin to rise, in response to the Federal Reserve’s gradual pull-back of its historical quantitative easing posture.

The Federal Reserve had a very big impact on both the U.S. economy and the equity and bond markets in 2013.  The magnitude of the Fed’s actions over the past five years is quite remarkable.  When the financial crisis hit in 2008, the Fed’s balance sheet stood at a fairly normal level of about $800 billion.  It is now five times as large at nearly $4 trillion.  This is the result of successive rounds of “quantitative easing” (QE), in which the Fed has bought U.S. Treasury bonds and mortgage backed securities, which has had the effect of both monetizing the federal deficit and flooding the country with newly created dollars .  In its latest QE round, which began in September 2012, the Fed has bought $85 billion in bonds per month, an annualized rate of over $1 trillion.  Just now they have started to “taper” this program with the potential of ending it before year-end.  Where did all this money go?  While it’s impossible to say exactly, some of it went into the housing market to fund mortgages, but a very large portion of it has certainly found its way into the equity markets, thus driving up stocks.

It is remarkable that this vast creation of money has not caused inflation (i.e. too much money chasing too few goods).  This would indicate that, without the Fed’s ultra-liberal posturing, the economy might well have fallen into a deflationary spiral in the last couple of years, which would have had a very negative effect on the world economy and equity markets.

The trick, then, will be for the Fed to begin pulling back on quantitative easing in 2014 without negatively affecting the U.S. economy and equity markets.  There will be a lot of anticipation, which is likely to result in some degree of market correction, as we go through the year.

It is our intention to stay invested throughout the coming months and look for opportunities to deploy additional capital.  Here is what we said a year ago in “The Case for Stocks in 2013”, which bears repeating as we begin this new year:

“When all is said and done, the shares of strong, undervalued companies are perennially the best investments.  And that’s exactly what we have said and done for years.  We look for companies that create economic value by perennially producing returns on invested capital that exceed their costs of capital and look to buy them when they are undervalued.  Buying and holding stocks has been difficult, at times, in the last 10-12 years but, during that long and sometimes unsettled period, it has been, and continues to be, the right way to invest.”

The key word above is “undervalued”.  While we have all enjoyed the run-up in equity prices of the last year, it is hard to find  good companies, i.e., those without “issues”, that are not at least fully valued in this market.  It’s been quite a few years since we have seen this kind of situation, but history teaches that corrections are always in the wings in this scenario.  So the question is not if a correction will come, it is what will cause it and when.  Given the huge reliance of the economy and equity markets on the Fed’s QE strategy, as important as it has been, it seems likely that the Fed’s exit strategy and how it is executed by the new Fed chair, Janet Yellen, could be the likely source of concerns in the market over the next 12 months.  The other imponderable, of course is the geopolitical situation, terrorism etc., which is always on our radar screen.

So, we will watch, wait and analyze.  We have quite a few names we would like to own, in addition to our current portfolio so, when the time comes to deploy additional capital, we are ready. 

Happy New Year!

Jack and Peter Falker

January 10, 2014

The Case for Stocks in 2013

Happy New Year everyone!

Time Magazine’s cover story, in their November 26, 2012, issue proclaimed, in huge, bold-faced type:  “WHY STOCKS ARE DEAD (And Bonds Are Deader)”.  Headlines like that scare a lot of people, especially when they are being bombarded from all sides with doomsday articles on the so-called “fiscal cliff” and all the dire things that were going to happen when we were supposedly going over it.

If, as Time proclaimed, bonds are even deader than stocks, how are we supposed to invest our money?  Are we to leave it in cash with money market yields at essentially zero?  Well, you had to read all the way to the fourth-page ending of the article to learn that the protagonists of the story, Bill Gross and Mohamed El-Erian of PIMCO Investments, are buying blue-chip stocks rather than bonds (their primary business).  According to El-Erian and Gross: “Blue chips have become the new bonds.  Multinational franchise firms… can spread risk around the world while delivering a 3% inflation-beating dividend…. Well-capitalized growing firms that are undervalued because they are in beleaguered markets are also smart plays.”  So, the conclusion of the Time article is the exact opposite of the bold-faced headline.

When all is said and done, the shares of strong, undervalued companies are perennially the best investments.  And that’s exactly what we have said and done for years.  We look for companies that create economic value by perennially producing returns on invested capital that exceed their costs of capital and look to buy them when they are undervalued.  Buying and holding stocks has been difficult, at times, in the last 10-12 years but, during that long and sometimes unsettled period, it has been, and continues to be, the right way to invest.

In the context of the daily news cycle, it is good to step back and remember where we are economically at the moment.  In their 2009 book “This Time is Different”, Reinhart and Rogoff demonstrated statistically that financial-panic induced recessions historically have a long tail of approximately seven years.  Beginning in late 2007, we have just been through the worst financial panic since the great depression, so statistically we should not expect our difficult economic conditions to fully abate until sometime in 2014 or 2015.  And that’s about how it feels.  Unemployment is gradually improving, but it looks like it will remain high for several years to come.  The housing market, while a bit better, is still soft.  Automotive and retail sales remain slow and inflation is non-existent, at times bordering on deflation.  Households continue to relentlessly pay down their debt, which is theoretically a good thing but, when you’re paying down debt, you put off major purchases, such as cars and houses for several years (perhaps to 2014 or 2015).  So, while corporate profits are gradually improving, it is unlikely that they will become really robust for several years to come.  In the meantime, shares of good companies can be expected to remain reasonably stable and dividends should generally be secure, as the economy continues to slowly improve.

Finally, as we have expected for several months, the United States did not go over the fiscal cliff, despite the horrid prognostications of the national (and international) press.  Of course, much more remains to be done in cutting spending to reduce the deficit, so we can expect a lot of political posturing and nay-saying throughout the coming year.  Nonetheless, everyone should keep in mind that the United States of America is not having any problem funding its debt obligations at historically low interest rates.  That is primarily because the debt of the United States is safer by far than the sovereign debt of any other country in the world.  So, we are not Greece (or Italy or Spain) and debt Armageddon is not upon us just yet, despite the cries of the far right during our recently concluded presidential campaign.

In conclusion, here is the last paragraph of our blog two years ago, at the end of December 2010:

We are avoiding market-timing, looking instead to “draw our own line” that wavers less than the markets. We do this by investing only where we see value and value-creation for the long-term, sometimes regardless of the level of the stock market. As frustrating as the past decade has been, that strategy has worked for us and resulted in better returns than the market over time. Making predictions about future stock market values can be eternally futile. We will stick with what we know and pursue our strategy of creating wealth and preserving capital by investing in companies that consistently create value for shareholders.

Ditto!

Happy New Year,

Jack and Peter Falker

January 4, 2013

Market and Strategy Update

As all of our clients know well, we have been very conservative in our market allocations since the financial crisis began in 2008, choosing the path of protecting capital and focusing on dividend income. That served us well over the last several years, allowing us to avoid much of the extreme market volatility. But we have always considered that position to be temporary. Our longer-term objective is to find value opportunities across the entire market, without a bias toward any particular industry or economic sector.  Given the current dynamics of the markets and global economy, we are making this transition gradually.

The second quarter was the polar opposite of the first quarter from both a market and economic perspective.  The best performing economic sectors in the first quarter became the worst performers in the second.   The European situation flared up again and the U.S. economy has been stagnant.  We are starting to see the impact on earnings expectations from the European troubles.  As a result of slowing growth around the world, particularly in China, oil prices have eased significantly, relieving some concerns about rising input costs and inflation. 

In relative terms, the U.S. economy has emerged as the winner.  Banks are far more resilient from a capital adequacy perspective and the housing market has stabilized.  This has removed concerns of possible systemic banking failure such as we faced in 2008-09.  Besides the effect of recession in Europe, uncertainties over our future government policy and leadership likely pose the most significant risk to the economy today.  Perhaps not so much the policy itself, but the uncertainty of what those policies will be.  With the so-called “fiscal cliff” looming and the elections in November, we will start to see more clarity on policy direction.

In response to slower growth, central banks are further pursuing easy monetary policy and leaders in Europe are again taking steps to fight their debt crisis.  Importantly, because of so many disappointments from such policy makers in the recent past, we think investors are increasingly more skeptical.  Such skepticism can be an important ingredient for a healthier investment environment.  The markets have been routinely buoyed by persistent hope and optimism.  That one-sided mentality has made it difficult for value investors to frame longer-term return expectations. 

In light of that development, we have continued to gradually diversify the equity portfolio, as we discussed in this blog in April.  With these steps to be more fully invested, however, comes greater market risk and we have not been immune from the decline in the market during the second quarter, most notably in several financial, materials and consumer discretionary stocks. However, we continue to be heavily weighted in the consumer staples sector (almost double the market weighting), where dividends are higher and earnings have been strong.  That continues to benefit us, as the sector is currently trading at its highest level since 1995.  So, as we have become more diversified, our equity performance in the second quarter was quite similar to the overall market. 

We plan to own about 40 companies in economically diverse sectors for the equity portfolio.  Our primary focus remains on companies that are generating good Returns on Capital and EVA, while trading at relatively attractive valuations.  We are not market timing or expecting short-term trading profits.  Not all of our investments will meet our expectations, so we are always considering necessary adjustments.  At any given time we are evaluating the prospects of roughly 120 companies that meet our basic criteria.  Historical analysis shows that a disciplined strategy of owning value-creating companies at relatively low valuations, outperforms the market over time.  As we move away from our very conservative sector allocation of the past two years and become more fully invested, we would expect our portfolios to reflect similar out-performance patterns.

Thanks for your continued trust.  Please let us know if you have questions.

The Falkers

Market and Strategy Update

Stock Market Slogan...Print, Baby, Print

First, let’s explain some of what is behind the recent market rally. Perhaps the most important factor in the stock market’s rise this year has to do with recent actions by the European Central Bank (ECB). In December, amidst a brewing economic and banking crisis, the ECB offered European banks the opportunity to borrow unlimited amounts of money for 3 years at an interest rate of 1%. The reason for this Long Term Refinancing Operation (LTRO) was clear. Fears of insolvency, resulting from concentrated investments in potentially bad debt from certain European countries, had closed access to the credit markets for many European banks. Where no money could be found, the ECB turned on the printing press.

What the ECB did is important. In both Europe and the United States, central banks continue to fill the void in credit markets as the world economy recoils from a massive debt bubble. Perhaps in the short-term, by taking financial collapse off the table, we are better off. Even though the US stock market had zero return last year, the Federal Reserve’s launch of QE 2 in August of 2010 provided a powerful rally from that point until May of 2011. That rally was very similar in cause, magnitude, and character to the current rally.

Clearly central banks are buying time for policy makers to adapt and economies to adjust. Yet, it is necessary to remain aware of how much support is provided by their actions. The Federal Reserve has injected more than $2.5 Trillion into U.S. Treasuries and Mortgage Backed Securities since 2008. With LTRO alone, the ECB provided almost $700 Billion to support European banks.

As a result, the equity markets, which were starting to price in financial meltdown in Europe, are now pricing in a more optimistic view. Expectations have quickly turned positive with bullish sentiment of stock market forecasters approaching historically high levels. We have seen a significant rally in “low-quality”, beaten-down stocks, as they recover from last year’s lows. While those stocks have led the market, there has been a broad advance in US equity indexes, supported in part by decent economic data in the US.

With expectations for support from global central banks every time a problem appears, it seems likely that markets could hold up reasonably well this year. However, we would like nothing more than for the economy and market to move away from a dependence on easy money. While central banks have made it clear they will continue pursuing easy monetary policy, perhaps the only thing to get in their way will be politics. With the U.S. election straight ahead, their job could become more complicated. While the Obama administration might benefit from the Fed’s proactive policy supporting the stock market this year, Romney has already indicated that he is not in favor of reappointing Fed Chairman Ben Bernanke.

Taken in full context, we understand and appreciate the market rise this year. As always, it is good to consider both sides of the coin. Apparently Goldman Sachs does. Goldman’s Chief Global Equity Strategist recently issued a research piece (close to the recent market high) saying that now is the best time to own stocks in a generation. At the same time their Chief US Equity Strategist has a year-end target for the market about 11% below where it currently trades. Let’s just say cognitive dissonance has become a common psychological condition for any investor these days.

The Apple Effect

We would be remiss if we didn’t address one of the more remarkable impacts on the market: Apple.

Consider that the Dow Jones Industrial Average of 30 stocks was up about 7.5% to end the first quarter, while the S&P 500 was up nearly 12%. Also by comparison, FalkerInvestments’ equities were up about 7.5% year-to-date. Now consider that neither the DJIA nor FalkerInvestments hold Apple stock, while it is the largest component of the S&P 500. Looking at the table below, you can see that one stock, Apple, accounted for 15% of the total return of the S&P 500 Index in the first quarter! (click chart to make it bigger)

I don’t know the history, but this sounds like some kind of record. Anyway, the obvious question is: why don’t we own Apple? The simple answer is that it just doesn’t fit into our model. Clearly from an EVA perspective, it is one of the best value creators the world has ever seen in such a short period of time (their long-term history isn’t so great). However, from a valuation perspective it’s just too expensive. That may sound ridiculous with the stock up 54% in just 3 months (was it cheap 3 months ago?). But then also consider what the market underestimated then, it might be overestimating now. While not thought to be overvalued by most investors who own the stock, much of Apple’s value depends on keeping up a relatively torrid growth rate for such a large company. Who are we to doubt that Apple can continue with its recently stellar track record? (We love our i-Phones too). At the moment, Apple fits somewhere between a growth stock and value stock. Even though what they have been able to accomplish seems obvious now, it has been a speculative stock the whole time. While it’s unlikely Apple will fit our value model anytime soon, we keep a close eye on how it performs, because it just might dictate the next move in the market.

Strategy Update

Here’s an update on what we’re doing. As we said in our year-end blog post, after twelve months of zero return in the stock market, investors had generally become risk-averse and pessimistic. Entering this year we were making plans to start broadening out the portfolio, becoming more economically diversified and less defensive. As our clients are well aware, given the tumultuous and somewhat unprecedented economic events that have unfolded globally since 2008, we had chosen the path of protecting capital and focusing on dividend income. That served us well last year, providing positive returns and avoiding much of the extreme market volatility. But we have always considered that position to be temporary. Our longer-term objective is to find value opportunities across the entire market, without a bias toward any particular industry or economic sector.

We have started to execute that plan, but have adjusted our timing somewhat with the market surge. We have increased our overall market exposure (i.e. reduced our cash position) by only a few percentage points, mainly focusing on becoming more diversified. By means of explanation, consider our investments in Consumer Staples and Utilities, two of the best performing sectors in the market last year (Utilities were the best performing sector). In percentage terms, our client portfolios were roughly 20% and 14% invested in Consumer Staples and Utilities, respectively. That compares to their weights in the S&P 500 of roughly 11% and 3.5%. Much of that overweight position was afforded by our underweight positions in Financials and Industrials, two of the worst performing sectors last year, Financials being the worst. Again, with Europe’s banking system looking vulnerable to a very severe economic crisis, we avoided the chance that insolvency “over there” could impact the financial system here.

So, as one might expect with the current rally, the first quarter has seen a complete reversal of fortune for those sectors, with Utilities the worst performer and Financials one of the best (as you can see from the chart above). Therefore, our transition, while well planned, has slowed somewhat as we are, in simple terms, reluctant to “buy higher and sell lower”. However, we have made significant progress finding what we consider to be compelling values in sectors where we have been underweight. Given the strength in the market, a few of those stocks have already exceeded our expectations. While not a topic for this blog, we will relay our thoughts on new holdings during client meetings and occasional blog updates.

We will continue trimming back our exposure to the Utilities and Consumer Staples sectors as we seek value opportunities in other sectors. How much we continue to reduce our absolute cash position will be somewhat dependent on market corrections. As we gradually transition the portfolio, our goal is to own around 40 stocks that together represent all 10 economic sectors of the market. At any given time we are considering roughly 120 companies that meet our basic criteria of generating EVA while trading at relatively low valuations. Historical analysis clearly proves that a disciplined strategy of owning value-creating companies at relatively low valuations outperforms the market.

Thanks for reading. Let us know if you have any questions.

Peter and Jack

April 9, 2012

From 2011 into 2012

FalkerInvestments’ investment strategy performed well in 2011, with equity returns of 7%, on average, as compared to flat price performance of the S&P 500 index. Our overall portfolios, which hold a mix of equities and bonds and were over-weighted toward cash during the year (depending on the risk tolerance of each client), also outperformed the S&P 500 benchmark. We are pleased with this performance given the high level of portfolio insurance afforded by our cash position during a turbulent year.

Europe’s sovereign debt problems dominated market psychology for most of 2011. The United States experienced a weak economic recovery, which was enough to at least partially offset concerns about Europe, and resulted in the S&P 500 Index ending the year almost exactly where it began, the first time that had happened in 64 years.

As we enter 2012, we will likely see a continued slow economic recovery in the United States. This is the result of several factors, including tight credit conditions in the private sector, limited fiscal stimulus due to growing levels of U.S. Government debt, and continued uncertainty about future government policy (e.g., financial regulation, taxes). At least one certainty has been the unprecedented support from the Federal Reserve. Given current conditions, the Fed has committed to a zero interest rate policy into 2013.

Unless some extraneous geopolitical or “black swan” event intervenes, it seems probable that the U.S. equity markets could increase moderately in 2012, treating Europe’s deepening recession only in terms of how it affects U.S. corporate earnings. Because U.S. financial institutions are intertwined in Europe’s affairs, they are the ones most likely to be affected, while multi-national industrial companies will fall back on their U.S. and non-European businesses.

We expect to capitalize on the good performance of our EVA-based equity strategy in 2012 by deploying a greater proportion of our client capital toward dividend-paying, value-creating equities, for those clients whose risk tolerance calls for equity investments. We think the valuation of the market, after zero appreciation in the past 12 months, now has a fair amount of risk-aversion embedded in it. This may well provide for a better-performing equity market in 2012 and, accordingly, we began this week to deploy at least some of our cash position toward high-quality stocks.

As always, we will be watchful of world economic and geo-political conditions, as well as being very selective about what we do. We are, however, encouraged by broader acceptance of these challenging conditions by investors and policy makers alike. Two years ago in this blog we spoke about an expected transition in the markets from excessive risk-taking to one of risk-aversion. That transition is underway and beginning to provide opportunity.

Thanks for your continued trust.

Jack and Peter Falker

January 6, 2012

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.

(See: http://falkerinvestments.blogspot.com/2008/09/breaking-buck-08-not.html)

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

A Few Thoughts

Since our last blog posting on August 2^nd, 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 2^nd 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

Policy Makers to the Rescue

Rewind

Last year, at this time, the stock market was struggling under the weight of worsening economic news. On August 27^th 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 29^th 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

Deflation and Ham ‘n Eggs

On February 2^nd, 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

Too Conservative?

Is it possible to be too conservative in the face of all that is going on in the world right now, both economically and geopolitically? We don’t think so.

During the last year, we have patiently developed a portfolio designed to bring consistent, compounding returns over several years. We have focused on dividend yield and capital preservation, as we carefully invest our cash position. Through the first eight months of 2010, the market was extremely volatile (remember the “flash crash” in May?), while our portfolios held steady, maintaining a sizable advantage in returns. Ironically, right about the time we started seeing widespread value in the stock market, the Federal Reserve hit the panic button in the face of a softening economy, to ward off deflation. The “Bernanke Playbook”, about which we’ve previously written, is in full effect and lifting the stock market. While we benefit from this increase, our conservative strategy (which incorporates both stocks and bonds) is naturally slower to respond than the overall stock market, at least for the moment.

Get With the Program

The Fed’s current, extreme and historic quantitative easing effort (QE2) to buy newly issued, longer-term government bonds is an attempt to raise inflation expectations and lift asset prices, in particular equities (yes, they actually said that). The thinking goes like this: lower the longer-term cost of capital, making current equity valuations look attractive. By bringing investors into the equity markets, companies can access capital on better terms (e.g. the General Motors IPO). That, of course, assumes there is an abundance of viable capital projects that can return in excess of this lowered cost of equity. If so, then you get immediate job creation as capital spending increases.

The question is, when this explicit subsidy to the cost of capital is removed (through future Fed tightening), are those newly formed investments sustainable? Furthermore, the unintended consequences of inadvertently financing subpar “investments” (i.e. housing) can have dramatic consequences. An increase in equity values supports greater amounts of debt. If equity values falter, the debt becomes highly onerous.

The first round of Fed quantitative easing (QE1) in 2009 was probably effective in preventing a liquidity crisis from exacerbating an already deepening insolvency crisis. Now, with an extra $600 Billion promised over the next six months, coupled with a lenient tax policy, you can see that our country’s monetary and fiscal leaders have implemented an all out go-for-growth (go-for-broke?) strategy. While all of this might create growth, we remain skeptical that it will create sustainable value. For now the stock market has taken the bait and gone higher. However, bond yields have also gone higher, giving a confusing signal about expectations for growth, inflation, and future unfunded deficits. To what extent will the Fed tolerate such rate increases before embarking on another round of bond purchases?

That said, there are signs of stability in the economy and we are encouraged to see the productive spirit of the private sector deliver profits. Unemployment is still high and likely to grow, but new jobs are usually seen late in a recovery. The banks appear stabilized, although a persistent decline in real estate prices keeps them in capital preservation mode. Right now the stock, bond, and commodity markets appear certain that the economy will grow unabated, given the aid of massive stimulus.

What Happened to The Road Not Taken?

I shall be telling this with a sigh

Somewhere ages and ages hence:

Two roads diverged in a wood, and I--

I took the one less traveled by,

And that has made all the difference.

-Robert Frost, The Road Not Taken

Certainty in the market makes us wary. Such confidence emanates from what has become Wall Street’s Golden Rule: “Don’t Fight the Fed”. Oddly enough, for the past 12 years, the exact opposite would have been more rewarding. Perhaps that rule should be rephrased: “Get Rich or Die Trying”. That doesn’t sound quite as appealing. Needless to say, Wall Street is feeling bullish these days. We’ve seen this road before.

The list of headwinds to economic recovery is long. But that is not what primarily concerns us. Most of them are well known to investors already. We are concerned with the risk of government policies preventing the market from functioning efficiently. For example, we are encouraged by the pace of domestic private sector deleveraging (whether through default or pay down) and the concurrent increase in personal savings. Such headwinds to growth will eventually become tailwinds. Our greater concern is whether productive, market-clearing processes are interrupted by potentially false perceptions created by chronic money printing and stimulus spending. Rising asset prices without wealth creation leads to debt/payment obligations with no collateral value. Again, we’ve been down this road before.

Feeling Like a Contrarian

At least for the moment, our year-to-date equity performance trails the market, as investors have ramped up their risk-appetite. Yet, we are very confident in maintaining our conservative position. Even though we wrote about the potential for QE2 this summer, perhaps we mistakenly believed the political fallout over printing money would have short-circuited its occurrence. Or perhaps that story has yet to be told. There’s nothing like a political vacuum, created by an election season, to give the Fed free reign. Either way, since we ourselves cannot print money, we choose to stick with prudent capital management on behalf of our clients. We are moving down the road we want to take, looking for consistent, compounding returns.

We are avoiding market-timing, looking instead to “draw our own line” that wavers less than the markets. We do this by investing only where we see value and value-creation for the long-term, sometimes regardless of the level of the stock market. As frustrating as the past decade has been, that strategy has worked for us and resulted in consistently better returns than the market over time. Making predictions about future stock market values can be eternally futile. We will stick with what we know and pursue our strategy of creating wealth and preserving capital by investing in companies that consistently create value for shareholders.

Hopefully we have been able to clarify what’s going on in the economy and the markets, here at the end of 2010.

Holiday greetings to all,

Peter and Jack Falker

December 20, 2010

Confronting the Boogieman (or Why the U.S. Economy Isn't Growing)

Concern over deflation has started going mainstream. This is not a simple concept to embrace, especially with the backdrop of an easy Fed and massive government spending. But that is the paradox of easy money in an era of over-indebtedness. Identifying why this is happening allows us to formulate a sensible, constructive investment strategy during this very unusual time.

With confidence weak and high levels of debt to income, easy money does not prevent dollar hoarding and debt reduction. People are not induced to take risk or borrow money, even with very low yields on savings. This puts downward pressure on the demand for goods, services, and investment, resulting in an embedded deflationary bias in pricing. That includes both consumer prices and nominal interest rates.

Deflation is the scourge of central bankers, rendering them useless (which they probably are anyway) as society embarks on a rational policy of saving and reducing debt. In previous blog posts I have mentioned Ben Bernanke’s 1999 paper entitled “Japanese Monetary Policy: A Case of Self-Induced Paralysis”, which lobbed hefty criticism at Japanese policy-makers for being too rigid during their decade-long battle with deflation (that’s now two decades and counting). I highly recommend reading the section “How to Get Out of a Liquidity Trap” starting on page 14. Call it the Bernanke Playbook.

Here is a link to the pdf file of that paper if you are interested.

This type of hubris keeps us thinking that simply the “right” monetary policy, or even the right policy-maker can fix our problems. Markets spin with talk of the Fed initiating what is dubbed QE 2 (the first quantitative easing was the $1.25 Trillion purchase of mortgage-backed bonds), a sort of monetary nuclear option to obliterate the threat of deflation. Recently the Fed announced they will use the receipt of interest and principle from their mortgage portfolio to buy U.S. Government bonds to maintain the size of their balance sheet. While not at a full court press as of yet, the Bernanke Playbook is getting more attention. (see it referenced here in Paul Krugman's blog)

The Bernanke Playbook has not been fully initiated yet, likely because it is too politically challenging for the Fed to engage any further in the outright purchase of Treasury bonds or pursue more unconventional asset purchases. They are letting the economy bleed out as many bad credits as possible, while staying very accommodating to prevent a liquidity crisis that could boil over into further insolvency.

But why then is the economy so sluggish, and why is job creation missing? Remember something I mentioned in a previous blog post: Every recession since WWII has been accompanied by growth in private sector credit. If we are confused by the current progress of recovery, it is because we are simply not wired for this environment. It’s very hard to grow when credit is contracting.

All questions regarding tax policy, capital spending, jobs, bank lending, etc. have more or less to do with this largely unprecedented reduction in private sector debt, or deleveraging, in a consumption driven economy.

Interestingly though, the process of saving more and reducing debt is extremely rational and almost too much for us to handle. Strategic default and foreclosure, for example, while ethically disturbing, is very rational behavior, given the structure of housing finance and mortgage contracts in this country.

So what is the endgame here? In truth, the end will justify the means as less leverage and more equity in the economy decrease risk and increase future wealth creation. However, the means carry all the risk and that is our primary concern. At the top of the list is whether private sector credit is simply transferred and concentrated within the government. That will only increase the risk of a systemic breakdown (e.g., a failed Treasury auction) in the future. We need to see total debt levels, i.e., private and public debt, reduced. If that results in sluggish growth and a long trough in this depression-like environment, so be it. Be conservative and patient in your investments.

This is what we are closely watching. Deleveraging is the “boogieman”, striking fear into the hearts of central bankers and policy makers, because it can spiral into deflation, potentially unrestrained by any policy initiative.

Below are some numbers and more pictures to help explain what is happening. I intended to publish this earlier in the summer, when the Fed released the data, but the next set of numbers is not released until September 17^th anyway. That will update us for the 2^nd quarter, but I think these numbers tell the story.

Out of roughly $55 Trillion in total outstanding U.S. debt:

Total U.S. debt reduction in 2009: $201 Billion

Total U.S. debt reduction Q1 2010: $260 Billion (5.1 X the run rate of 2009)

Household sector debt reduction 2009: $240 Billion

Household sector debt reduction Q1 2010: $98 Billion (1.6X the run rate of 2009)

Financial sector debt reduction 2009: $1.5 Trillion

Financial sector debt reduction Q1 2010: $646 Billion (1.7X the run rate of 2009)

State and Federal debt INCREASE 2009: $1.5 Trillion

State and Federal debt INCREASE Q1 2010: $506 Billion (1.3 X the run rate of 2009)

It is also interesting to note that debt reduction in the small business sector since the beginning of 2009 has been entirely offset by increases in debt financing done at the large company level. The banks are not increasing lending to small businesses, but the capital markets are open to companies with access. In other words, easy money is not trickling down to where it needs to go.

It’s also important to highlight that total debt is declining (government borrowing is not keeping pace with the private sector reduction), albeit at a very slow rate. That is a good thing from my point of view and we need to keep a close eye on that. We are also watching the transfer of mortgage debt financing to the balance sheet of GSEs. Here I am talking about the increase in debt levels for Fannie Mae and Freddie Mac since they were placed into the conservatorship of the Federal Housing Finance Agency in 2008. The once assumed guarantee of the Federal Government is now explicit. This is where the risk from consolidating debt at the government level is most concerning.

Now some pictures and notes.

People are simultaneously saving more....

and reducing debt....

In addition to reducing debt, households have gone from being net sellers of Treasuries two years ago, to buying almost 20% of new issuance in the 12 months ending in Q1 2010. Some may argue with the wisdom of buying Treasuries, given current interest rates and deficits, but clearly the household sector is trying to save without adding risk. From the late 1940s to the late 1990s, the household sector owned between 20% and 30% of publicly held Treasury debt. Today it owns about 10%, up from 4% in 2008. Could the household sector be the new marginal buyer, replacing foreign capital? Consider that potential trend, given how low interest rates are today.

Bank credit, the lifeline of small businesses, is shrinking.

As deposit growth is a function of credit expansion, we would expect deposits to start shrinking as bank credit continues to contract. Notice that deposit growth turned negative somewhere between 1992 and 1995. However, it was not preceded by a contraction in credit. What happened is money temporarily moved out of the deposit base into the broader economy, providing fuel for a capital spending boom that resulted in the tech mania of the late 1990s. The chart below, depicting the velocity of money (representing how quickly money is circulating in the economy), clearly shows this.

The other side of this “rainbow” is signaling exactly the opposite effect of the mid-1990s, as money is leaving the wider economy through deleveraging. Money (read credit) that was once flying around the economy is coming home to roost in the form of excess reserves at the Fed. Advocates of hard money expect to find their pot of gold at the end of this rainbow to keep money supply growth under control in the future. While not an advocate of the gold standard or the Federal Reserve for that matter, Milton Friedman said in an August 2006 interview that only a major financial catastrophe could bring about a radical change in how monetary policy is administered, so as to reduce the risk of policy mistakes. He died less than three months after that interview, on the eve of just such a crisis.

And to sum it all up....

That little downturn at the top is what we have to show for our efforts, but at least it’s going in the right direction. Confirmation that we had too much debt lies in the fact that debt levels are starting to fall, seen in the chart above relating total debt to national income. Remember, growth will make this line fall even further. If we reach a point of sustainable debt levels, possibly we will see that growth.

Clearly, deleveraging can explain, in large part, why the current recovery is so weak and ripe for a prolonged recession. But is that something to fear?

As I said before, the process itself carries all the risk, as any shock or further loss of confidence (no jobs, further debt trouble in Europe or Japan, war etc.) could quickly intensify debt reduction, as the private sector could go beyond saving excess income and into asset liquidation. On the other hand, if the so-called “bad” credits (such as credit used for consumption and sour real estate investments) can bleed-off without causing a disorderly unwind of the entire debt structure, the economy and markets will eventually face less risk and a more robust future.

Confronting the Boogieman

So we have a rare, so-called outlier, event taking place right in front of our eyes, i.e., the deleveraging of the U.S. economy. We know from history that events thought to be statistically improbable are by far the most consequential when they occur. The obvious reason for this is that society doesn’t prepare for what is mistakenly thought to be highly unlikely. That makes sense, but financial and social matters tend to ignore probabilities. If you see something coming, but do nothing about it, it is irresponsible. In other words, don’t just lie in fear of the boogieman. Confront him.

Here’s how we are confronting him. We are intensely focused on our EVA strategy, which is vitally important in today’s world (a subject for an upcoming blog). Our equity holdings have been outpacing the market lately while overall returns are somewhat moderated by our sizable bond and cash positions (i.e., we don’t go down as much and we don’t go up as much). We are ahead of the overall market in our model portfolio year-to-date because we are doing more with less by holding cash. We are more protected, taking much less risk by being 50-55% invested in the stock market, but good performance in that select group of EVA-producing equities is driving solid returns overall. The cash position is an intentional allocation aimed at protecting capital, as the risks of deflation and falling asset prices loom large. It is not a permanent condition for us, but we need to see this “once in a century” type event play out. Certainly with the upcoming elections in November, which may prove volatile, this is a good time to stay patient and conservative.

Please let me know if you have any questions or comments by visiting our website at www.FalkerInvestments.com

Peter J. Falker, CFA

8/24/2010