Letter to Clients - February 2010 (Final Installment)

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

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

Video Introduction (replay)

This is where we left off in our second installment:

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

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

The Elephant in the Room

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

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

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

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

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

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

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

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

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

WWBD? (What Would Bernanke Do?)

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

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

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

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

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

Starting Over

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

Peter J. Falker, CFA

February 9, 2010

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

Letter to Clients - February 2010 (Second Installment)

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

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

Video Introduction (replay)

Here is where we left off in our first installment:

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

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

The Dollar – Public Enemy Number One

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

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

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

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

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

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

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

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

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

To be continued

Peter J. Falker, CFA

February 4, 2010

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

Letter to Clients - February 2010

Video Introduction

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

Good News is Welcome

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

First, the Conclusion

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

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

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

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

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

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

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

What, me worry?

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

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

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

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

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

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

To be continued

Peter J. Falker, CFA

February 1, 2010

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

Pendulum at the Apex

We bring you this message from the markets:

“The dollar is going away as the world reserve currency. The Federal Reserve is creating another bubble. Treasury bonds are a terrible investment. We are headed for runaway inflation. Gold is going to $2,000. Interest rates will skyrocket. The 10-year U.S. Treasury bond yields only 3.5%, but who wants that? This isn’t going to last; the Chinese won’t stand for it. With the Fed printing $1 Trillion dollars, Fed Funds at 0% and the budget deficit running over $1 Trillion for the next 3 years, we’re not just looking at inflation; we’re looking at hyper-inflation and double digit interest rates. Buy stocks!”

Of course, this is just a rather cynical summary of the somewhat contradictory picture we have seen financial markets craftily drawing up since the gut wrenching lows of March 2009. It is a marketplace with no diversification, little regard for risk-aversion, and a preponderance of highly correlated asset returns. Indeed, with gold recently breaking to new highs, the dollar under consistent pressure, and the Dow inexorably climbing from 6,500 to 10,000 you can actually see some confirmation of these proclamations.

It’s hard to dispute such prognostications. They seem as clear as the housing and tech bubbles look now in hindsight. They seem inevitable. Or do they?

Of course, we don't know what the future holds. There is no crystal ball and nothing in life is certain. If nothing else, the stock market has clearly demonstrated at least that over the past 10 years of negative returns. What is interesting and perhaps more rewarding is to look at the realities of today, not just the expectations and perceptions the markets have of tomorrow. Today there are some important potential inflection points that may reverse trends that have been at work for several decades. The typical Pavlovian response in markets to take risk in the presence of easy money, big government spending, and a declining dollar might be, at the very least, somewhat premature.

It is really astounding that our economy is hardly motivated with interest rates at all time lows. Indeed on many fronts it is not “rates” that are important. Instead, it is the “levels”. The levels of debt are so high and onerous that even historically low interest rates can’t seem to induce further borrowing and consumption. The level of capacity in the economy may be too great to provide significant rates of return on marginal capital investment. The potential rate of growth in GDP is too weak to impact the level of employment. Yes, the recent GDP report showed annualized growth of 3.5% in the 3^rd quarter. However, nearly half of that growth came from auto sales. Will auto sales be sustainable, post Cash for Clunkers, or without government backing for GMAC and Ford Credit to provide auto financing? Another 16% of recent GDP growth came from residential construction, which is only 3% of our overall economy these days. Will the first- time homebuyer tax credit result in sustainable housing construction? If the levels in the economy are misaligned, then the rates of change and return may prove illusory.

The U.S. economy has been expanding for many years, certainly creating wealth along the way, but also propelling our growth with artificially low interest rates and increased leverage when times got tough. It has worked, and the expectation is that it will work again. Many fear it may only work too well and create runaway inflation and unfunded fiscal deficits. But it’s the status quo. Yet, there is an opposite force starting to assert itself, which might give us an indication of the returns we can expect on our investments in the years ahead.

Figure 1. (Click the chart for a larger image.)

An object in motion tends to stay in motion unless acted upon by an opposite force.

This paraphrases what most of us remember from high school physics of Newton’s First Law of Motion, which is also known as Newton’s Law of Inertia, and it actually applies to what we might expect from the economy and asset values for years to come. As the chart above indicates, we may begin to see it in the relationship of increased savings and ownership of risk-free U.S. Treasury bonds. According to Federal Reserve data, the household and non-financial business sectors combined are on track in 2009 to see a reduction in year-end debt levels for the first time since data from the Federal Reserve started in 1946. The average rate of growth in debt levels over that period of time is close to 10% annually. This marks an historic change in behavior. Furthermore, the savings rate has broken a 35 year downtrend that reached a low near 0% in 2005. From the late 1940s to the early 1990s the savings rate was between 6% and 12%, consistently averaging just above 8%. By the middle of this year, for the first time in the past 10 years, the savings rate increased to 5%. If we continue this trend reversal, it is certainly possible an 8% or even 12% savings rate can be achieved. So, what does this mean?

Consider for a moment that credit is tight, the household sector is at record levels of indebtedness at 180% of GDP, and real unemployment (including those who have given up looking for jobs and those reduced to part-time) is frighteningly high at around 17%. Of course people are saving. They need to save in order to protect their personal balance sheets, amid job insecurity, stifling debt levels and the specter of higher taxes. The same goes for corporations and banks, where funding and returns on capital have become more uncertain. Again, given the levels of debt, not the rates, people have little choice but to save and sit on cash. Hence, there is an underlying demand for U.S. dollars and safe, liquid U.S. dollar assets. Only dollars can repay dollar-denominated debt, of which there is 30 times more than actual dollars available. That’s why the dollar appreciated over 25% when the initial and most violent wave of deleveraging occurred in late 2008 and early 2009. It’s also why the Federal Reserve continues to be so aggressive. They understand how scarce dollars are, relative to the amount of debt in the system and the potential for further deleveraging.

Bear with me and consider the numbers to see how this is playing out. It could mark a material change in how we, as a nation, save and invest.

The U.S. has aggregate borrowings of close to $55 Trillion. U.S. Treasury debt owned by the public is just over $7.1 Trillion (and there is another $4.4 Trillion of intergovernmental holdings owned by agencies such as Social Security). In the first quarter of 2009 alone, household ownership of U.S. Treasury bonds increased by an astounding 140%. This represents an increase of $336 billion. We have never seen a quarter-to-quarter increase greater than 30% (occurred in 2004) going back to 1951, as far back as this data goes from the Federal Reserve. Add to this that during the first two quarters of 2009, money- market mutual funds, which many households have ownership in through 401ks or brokerage accounts and is not included in the household data, increased Treasury holdings by almost $400 Billion, an increase of 324%. Certainly much of this results from general risk-aversion. Very similarly, FalkerInvestments transferred client money market assets into a U.S. Treasury money market fund, in late 2007, to avoid risks we could see developing in the asset-backed commercial paper market. When taken together, there is over $700 Billion of additional funds that have been invested in Treasury bonds from these sources over the last two years. They have absorbed 30% of additional publicly held Treasury issues since 2007, yet only account for a combined 15% of all Treasury ownership. Further, consider that the household sector alone only accounts for 8% of all publicly held Treasury debt today, having hit a low of 4% at the end of 2008. As recently as the year 2000, the household sector owned 21% of publicly held Treasury debt and was consistently between 20-30% going back to 1951. At the 20% level today, the household sector would own roughly $1.4 Trillion of the $7.1 trillion of Treasury bonds outstanding. Indeed, we may see those ownership levels again. With disposable personal income today at $10.9 Trillion, if the savings rate reached 12% there would be at least $1.3 Trillion available for investment annually, without considering growth in income. That is almost $1 Trillion more than we are saving today. Certainly, the savings will be spread around, but as households continue feeling the pressure of debt and unemployment, it is very likely that Treasury debt will see a significant continued source of demand, as it is the only legitimate risk-free investment available. You can debate that in the long-run, but for now the U.S. is a long way from any risk of default. When people save against the financial pressures that are mounting, they invest for more certain return and do not speculate. Given the data, we could well be in the early stages of a trend reversal.

Taking a quick tangent from this, everyone seems to be worried about China selling Treasury holdings and their continued willingness to fund our deficits. Mainland China and Hong Kong combined represent the largest foreign investor in U.S. debt with $921 billion of publicly held Treasuries. But also understand that they have their currency pegged to the U.S. dollar, so they have to keep buying dollar assets, favoring Treasuries because they are risk-free. If they don’t keep buying, the Chinese yuan will appreciate, making their exports more expensive and threaten all the capacity they are adding through their own massive stimulus measures. With our trade deficit shrinking, as consumers revert to saving instead of spending money, China’s trade surplus will also shrink, leaving them fewer dollars with which to buy Treasuries. Yet, when considering the numbers from above, it is distinctly possible we don’t need China to buy more of our debt. We could fund our own budget deficits with domestic savings. The whole China concern of today may well be flawed and it is really they who face the more difficult adjustment. If we aren’t willing to underwrite Chinese trade surpluses, as we have for so many years with debt-fueled consumption, they are left with fewer resources to keep their currency and exports cheap, and will have to seek other ways to keep their 1.3 Billion people happy.

Many people would dismiss all this as conjecture, especially those counting on runaway inflation and skyrocketing interest rates, but there is a message here. It is hard to imagine a world so different from what we have become used to. The imbalances in the global economy have been building for a long time and we have now experienced an awakening, with two collapses of asset prices in seven years. It is entirely possible that the opposing force of over-indebtedness will reverse the economic course of the last several decades. It is showing up in the numbers, while the markets, aside from the Treasury market, might not see it yet.

As this relates to our investment strategy, we may have to be willing to accept investment returns over the next several years that are potentially lower than the long-term average. Certainly, the last 10 years have already been well below average. In the midst of deleveraging and increased savings, risk-taking may not be well rewarded and, indeed, risk-aversion will continue to be the surprising beneficiary. Using the changing character of household savings and Treasury ownership as an indication of risk tolerance going forward, we can infer that high-quality investments with a greater certainty for return, both on and of principle, will likely be favored over investments that offer potentially higher rates of return. This is called saving and investing, not borrowing and speculating.

We don’t see such developments as disastrous or necessarily portending another crash. One could argue that it sows the seeds of more balance and stability in the absence of any significant geo-economic or geo-political interference (i.e. trade protectionism and global terrorism, two destabilizing forces that make life all the more uncertain). Economic growth will slow considerably, in part due to Keynes’ paradox of thrift. The Fed’s position on interest rates and monetary policy is likely a symptom of what ails us, not necessarily a catalyst for further imbalances. We would rather see growth in equity prices moderate and have interest rates remain stable. If stocks continue to fly upward, it may likely be on the back of speculation, not on sound value investing. If interest rates begin to move higher as more people are convinced of future inflation and unfunded deficits, then the indebted household and real estate sectors may likely crumple under the pressure.

We need to see moderation and we are investing along those lines. We are not interested in the risk trade or one that assumes the status quo. We are not willing to chase the stock market higher by adding high-beta, speculative growth stocks to our portfolios. We are looking for consistent, more predictable, returns from the stocks and bonds of high-quality companies, and favor a portfolio profile that outperforms markets by being risk-averse, which is characteristic of our past returns.

As always, we own only companies that demonstrate consistent internal rates of return that exceed the cost of capital. That is an irrefutable measure of quality. We are increasingly focused on those companies with the stocks and bonds that offer strong cash flow yields to the investor. Before the markets reached the bottom this year, we allocated up to 25% of our model portfolios to investment-grade bonds with an average annual yield to maturity of 7.5%. We have trimmed several equity positions as they have recovered and started to add more concentration to stocks with dividends in excess of 3%. Our stock holdings represent close to 60% in our model portfolios with any remaining cash immune from market risk and awaiting opportunity in the U.S. Treasury Money Market Fund. For our clients with dedicated bond portfolios, we continue to invest at the best investment-grade bond rates available on the yield curve, favoring maturities under 5 years. If we see long-term rates rise, we will slide our maturities out further on the curve

Again, no one knows what the future holds. The markets, however, seem on the verge of certainty about the future. I would agree that things are better today; we did not go completely over the edge. The market rise is fairly well justified to this point and, frankly, a relief to those of us with stock investments. This may not be “the” moment and maybe the lesson has yet to be learned. But with households losing almost $12 Trillion in financial and housing asset values in two years, representing the biggest percentage drop since the Great Depression, I’m not sure the system can withstand a more obvious lesson. With such deep losses in assets dear to the American household, the widespread public outcry over bailouts, deficits and taxes, combined with the changing nature of savings and investment, there is good reason to believe we are finally changing course.

As always, we welcome your questions and comments. So we can respond directly to anything you might want to offer or ask, rather than sending a comment through this blog, please send an email to Peter@FalkerInvestments.com .

Peter J. Falker, CFA

November 4, 2009

The Big Picture

It’s time for a little economics review. While this risks putting you to sleep, it’s essential that we keep a level and clear perspective on where we are today. We think this is pretty important stuff and we want our clients and interested followers to know how these things affect our current investment strategy.

It’s no secret that the major catalyst for this “Great Recession” was the highly leveraged consumer who mortgaged their future with cheap credit on the back of inflated housing prices. That may risk oversimplifying the problems we are facing and, indeed, the ensuing collapse of credit markets and the dismantling of the banking system created much greater threats to our economy. The general population may never understand how perilously close we were to a calamity worse than the Great Depression, due to a widespread failure of the banking system. As it is, the only evidence of support for the U.S. economy today is coming from massive infusions of liquidity by the Federal Reserve and the supposed ability of the U.S. Government to finance a growing budget deficit; both very controversial actions. The markets have responded to this support and are currently trying to discount an uncertain future. Right now you can find equally compelling arguments for an extremely wide array of potential outcomes. We seem to be riding on a “razor’s edge” of confidence that keeps us on guard and focused on capital preservation and balance in the portfolios. We are much better off than just a few months ago and that alone can inspire markets to move higher if risk appetite increases. However, we still need to keep a grip on reality and weigh the fundamentals.

From a macro-economic perspective, there are three areas that are of particular importance when reading the roadmap to recovery.

1.) The housing market

2.) The health of the largest component of U.S. GDP – the consumer

3.) The prospect for inflation.

While we look at each individual investment in our portfolios based on its own merit, our asset allocation and willingness to take risk largely rests on these big picture factors.

Housing

Figure 1. (Click on chart to enlarge)

Figure 2. (Click on chart to enlarge)

These charts point to some very important progress in the housing market. The first thing to recognize is the improvement in housing supply. Figure 2 shows a massive contraction in building activity represented by building permits, while figure 1 shows a recent downtick in housing inventory (the green line). This is tremendous progress towards flushing out extra supply. If you look very closely at the last data point on each chart you will even see microscopic improvements in demand. Housing permits just moved slightly higher and houses sold (the blue bars in figure 1) have recently moved up. So the housing market may well be improving and that has very significant implications for stability in the banking system. That is undeniably the market at work and certainly a good sign.

Natural rates of supply and demand are highly correlated to population growth but they were most recently skewed by the proliferation of cheap mortgage credit. Since 1960, average building permits have run close to 1.5 million per year. In the period from February 2003 to August 2006, the heart of the housing bubble, average annual permits were running just over 2 million units. In 2005, permits were running close to a 2.2 million annualized rate every month. Given the below average numbers of the last 2 years, the average annual permit rate from February 2003 until now is just over 1.6 million, signaling a reversion to the mean and a more normal environment.

Lingering concerns remain from foreclosure rates that are resulting from what may be the highest rate of unemployment we’ve seen in the last 30 years (currently at 9.5% and rising). The Mortgage Bankers Association recently reported that 1 in 8 of the nation’s home mortgages were behind on their payments in the 1^st quarter. This is the highest rate in 37 years and largely the result of too much debt. When combined with tight credit conditions, the data portends a much slower rebound in housing than has occurred after past recessions, but improvements in supply and demand do indicate that prices may stop going down.

The Consumer

The state of the housing market provides a good lead-in to discussing the state of the consumer. First, let’s take a look at mortgage debt relative to household real estate values.

Figure 3. (Click on chart to enlarge)

What’s important in figure 3 is the skyrocketing loan-to-value ratio (the red line) over the last 3 years. Home mortgage debt has remained close to $10.4 Trillion while housing values have plummeted almost $4 Trillion since 2006. The only ways for loan-to-value to improve is for debt levels to go down or housing values to move up. Even though supply/demand has improved, a meaningful rise in the value of real estate is very limited in the near term, given tight credit and unemployment. Debt levels can only effectively be reduced by asset liquidation or aggressive savings toward future debt reduction. Neither of these support rising real estate values and are likely be dilutive to future household income and equity. Certainly it is helpful that mortgage debt has stopped growing. Refinancing has been very strong as rates are managed lower by the Federal Reserve and lending is subsidized by the government through Fannie Mae and Freddie Mac. We are clearly fighting fire with fire as such policies significantly contributed to the housing bubble in the first place.

Figure 4. (Click on chart to enlarge)

Figure 5. (Click on chart to enlarge)

That leads us to household income statements and the ability of consumers to continue driving the economy higher. As identified in figure 4, U.S. households are well on their way to a higher savings rate. In an environment of high unemployment, record levels of household debt service (18% of personal disposable income), and tight credit, there is virtually no choice but to save. While saving has healthy long-term implications, it makes for very difficult economic growth in the near-term. Add to this that average weekly hours worked, as reported by the U.S. Department of Labor, are at the lowest levels since 1964 (when the data was first compiled) and you can understand how personal income statements are pinched. How does this relate to economic growth? Figure 5 shows that consumption is at record levels near 73% of GDP. However, with consumption coming under pressure because of significantly higher savings rates, it’s easy to see the why GDP growth may be limited over the next several years. In other words, increased saving naturally results in lower consumption, which could keep the economy stagnant for years to come.

Important to understand in all this is that there is a level of production the U.S. economy has to maintain in order to meet the basic needs of a productive and growing population. Lower capacity utilization rates and drastic cutbacks in capital spending have reduced manufacturing inventories by almost 10% from year ago levels while sales have decreased 18%. The decline in sales has recently begun to moderate and may support some GDP growth from inventory restocking. As far as predictions go for the recession ending this year, much of it will be tied to this natural process. For example, Intel Corporation recently excited the markets when they claimed higher sales and margins largely due to inventory restocking by their OEM customers. As we hear this from more businesses, it will be received as relatively good news and indicates we are not going over the cliff as we were in the 1^st quarter. But that is about all it indicates at this point.

Our economy still faces a gap in potential growth as it begins to rely less on a “borrow, import, and spend” model and shifts towards one of “invest, innovate, and export”. Important to note, export oriented economies such as China, face almost the exact opposite challenge, as they will encourage less saving and more consumption. As we see aggressive infrastructure spending and stockpiling of industrial commodities by the Chinese, arguably a significant factor in recent global economic stability, we will learn about their economic viability, as their largest customer (the U.S. consumer) embarks on a fundamental shift in saving behavior.

In all, consumers and households have very difficult issues to confront as the excesses of the past 20 years are corrected. We expect this sector to emerge healthier and more resilient after several more years of adjustment. We also need to monitor how significant headwinds from government policy in the private sector and the prospect of higher taxes will affect future rates of unemployment and income.

Inflation

Possibly the most debated issue among economists today is whether we are headed for inflation or deflation. Milton Friedman is famous for declaring that inflation is always and everywhere a monetary phenomenon. This is a simple concept and given the record increases we’ve seen in money supply it would mean we already have inflation.

Figure 6. (Click on chart to enlarge)

The above chart was originally used in a blog piece written back in November 2008 (click on the link to read that post) and depicts what is called the monetary base. It is often referred to as the Federal Reserve’s balance sheet and reveals the magnitude of the increase in the supply of money. Where is all this money going? The Fed has initiated several unprecedented programs to support liquidity and credit in the economy. For the first time in its history, it is literally functioning today as the lender of last resort to the short-term commercial paper and asset-backed lending markets, as well as backstopping money market mutual funds. It is even buying mortgage debt and U.S Government bonds to keep interest rates low. Without this continuing support, we believe that our economy would have collapsed into a serious depression.

Friedman’s theory may have already proven true, as we do have rampant inflation manifesting in the price of U.S. Treasury bonds, where yields are frustratingly low. In fact, Warren Buffet, in his annual letter to shareholders, stated that the Treasury bond bubble may prove to be just as extraordinary as the dot com and housing bubbles. Consider that while the monetary base has increased, it is only acting as life support and has not encouraged meaningful increases in bank lending or private investment. Money has continued to filter down into excess banking reserves held at the Fed, short-term treasuries, and FDIC insured bank accounts, as consumers, businesses, and banks look to hold cash to stabilize balance sheet capital. The Fed is in the money market every day and Fed Chairman Ben Bernanke has expressed confidence that by targeting only what the credit market needs, they can unwind their balance sheet very quickly, if and when private capital comes back to the market. The problem is that large parts of the credit market, such as asset-backed securitizations, have essentially disappeared and banks are still quite risk averse when deploying capital, so it may be quite some time before private capital reappears in sufficient quantities to make a difference.

Unless liquidity provided by the Fed finds its way into the economy and grows via the multiplier effect of bank lending and investment, we will not see any meaningful rate of inflation in consumer goods or wages. With capacity utilization rates low (68% vs. average 80% since 1980) and unemployment rising, there is very little pricing pressure. Also consider that, according to Federal Reserve data, aggregate debt of the U.S. economy is roughly $56 Trillion, which includes approximately $12 Trillion of U.S. Government debt. As you can see in figure 7 below, that is approaching four times the level of U.S. GDP. By way of comparison, that ratio was only 2 to 1 in 1985. If confidence wanes and deleveraging continues, inflation in the general economy will not develop any time soon. This is where the government stimulus is intended to pick up the slack, why its effectiveness is being debated, and an additional stimulus plan seems likely. We need money in the economy to move toward productive investments and expenditures. If it only transfers to social and corporate welfare (bailouts) and then lays idle in bank accounts and Treasury bonds, we lose the efficient allocation of capital. In this way, some inflation in goods and services will be a welcome sign, indicating the movement of money deeper into the economy. It is only after evidence of a significant economic rebound that we can begin to fret about potential runaway inflation in consumer prices.

Figure 7. (Click on chart to enlarge)

Recently, the Fed has slowed the pace of money growth as it tests the resilience of capital markets. We will keep a close eye on this as an indication of confidence coming back to the market. While deflation, by definition, may not occur because of an expanding money supply, waning confidence could result in declines in asset values and consumer prices, while Treasuries (and quite possibly gold) would strengthen. That would not signal economic recovery and at this point is a compelling variant view as the consensus of many analysts and media pundits seems more focused on hyper-inflation. Judging from the bond market (specifically Treasury bonds), heightened inflation expectations have not been priced in at this point, which suggests the markets are not aligned with popular opinion. This issue is possibly the largest wildcard of all when considering the direction our economy takes.

Investment Implications

When considering everything discussed above, it is reasonable to question whether or not the extreme conditions we are witnessing should portend greater challenges ahead.  Are we really at a breaking point that marks a turn in the global economy and the balance of power?  Are we over or underestimating the potential for debt induced price deflation to accelerate?  Is debt at four times GDP unsustainable?  Certainly at two times GDP it may have looked just as troublesome.  Is consumer spending at 73% of GDP necessarily too high?  Couldn't consumption continue to increase as it has in the past?  Are dramatic declines in U.S. equities and housing prices sufficient to provide reasonable future returns?  The list goes on and we continue to ask ourselves these questions when formulating investment decisions.

In all, the state of the housing market and consumer, when combined with inflation expectations, signals that a significant and healthy correction is running its course, while risk aversion remains very high. We believe the markets have discounted many of the economic challenges we face and could potentially move higher if more positive news develops.  At the same time, we do not like the condition our economy is in to handle any external shocks (of course we are talking mainly about ever present geopolitical threats). Households are still over-burdened with debt, government policies are casting a long shadow on consumer and investor confidence, while monetary policy has introduced unprecedented risks.  There is little value in trying to speculate and predict specific outcomes of the Great Recession. There are simply too many variables to allow for bold predictions, and investors shouldn’t feel anxious to chase returns. There is a growing belief that “it’s different this time” and that we are likely to continue feeling the ramifications of “The Great Recession” for a generation to come.

Given this, our focus at FalkerInvestments is on the objectives of our individual clients and the investment returns required to meet current and future financial needs. The majority of our clients are invested in our model portfolio, which achieves what we think is an appropriate balance of risk and return for long-term compound growth. Within that portfolio, our strategy over the next 6-12 months is to remain balanced with EVA-producing, dividend-paying stocks representing 55-65%, investment-grade bonds 20-30%, and the remainder in the US Treasury Money Market Fund.

We also manage dedicated bond portfolios for some of our clients, in which we hold significant investment-grade fixed income holdings that provide relative stability and modest returns to support their lifestyle. We do not encourage them to look for returns in excess of what they need and can reasonably achieve. We are investing those assets across the yield curve while keeping enough liquidity to invest if rates move higher.

Equities have recovered from declines that occurred earlier in the year and have reversed a small percentage of 2008’s decline. On the whole we see our stocks being close to fair value, given the state of earnings projections, while remaining intact to produce solid returns on capital going forward. We have not attempted to “catch bottoms” or take incalculable risks to ride recent momentum in the markets. We have and will continue to take advantage of the current market rebound to trim positions, where warranted, while maintaining an active list of dividend-paying reinvestment opportunities.

Our bond allocation has done very well and we are actively looking for 6-8% long-term returns in investment-grade bonds, as they become available. In our model portfolio, the maturity schedule is currently under three years with an average yield-to maturity around 8%. The short-term nature of our bond holdings provides us with reinvestment opportunities, should rates move higher from rising expectations of inflation.

It is important to note that cash should not burn a hole in our pockets in times like this. Remember that we are only a few short months removed from what was a potentially devastating collapse in the banking system. Investing is dynamic and, while earning any yield seems desirable over no yield, it is important to consider the value of liquidity and stability that a core cash position provides. Just as banks are sitting on excess reserves to protect capital while waiting for better lending opportunities, the access to stable and liquid cash serves as an effective lever for us to quickly respond to investment opportunities. Our portfolios are designed with a cash component in mind , which is factored into our expectations for return. It has served as an extremely useful asset over the last 12 months by providing reassuring stability in difficult times, while also allowing us to move quickly on specific bond investments. Finding meaningfully better short-term yields today requires losing significant flexibility and certainty of return, the two things cash is meant to provide. If we see any very short-term bond opportunities that strike the right balance, we will pursue them with a percentage of cash that we would otherwise expect to hold in treasury funds during that time period.

So that covers how the macro-economic view is influencing our thinking. Hopefully you’ve made it through without too much head-bobbing. As always, we appreciate your comments or questions. We really are fortunate to communicate with a wide array of very intelligent, informed clients and friends, who provide useful inputs to our thinking.

Peter Falker

July 22, 2009