CHINA

Aside from grazing the subject in previous posts, I have refrained from directly addressing China and the inherent economic issues. We are by no means experts on China, and the implication of Chinese economic policy is not usually a factor in building our client portfolios. However, the macroeconomic (big issues) world we live in today, requires more thought on subjects like this than at any other time since we started managing investments. We have also been asked our opinion on China in many conversations with investors and friends. So here is my opinion, and I will try to keep this within the specific context of our investment principles. There are many issues that contribute to a well rounded analysis, but my focus here is on that of price.

The Divinity of Price

Our investment strategy, focused on EVA-producing businesses, favors markets that are generally unencumbered and free to translate value through price. The goods and services of the businesses we invest in should be priced to reflect the inputs of labor, capital investment (that includes the cost of capital), and any value that a business creates in excess of these inputs. That extra value is known to us as economic profit and is what ultimately drives capital allocation in the market. Investors will seek out those businesses that consistently deliver economic profit. Equally important is that investors abandon those that destroy value.

Of course, there are factors that interfere with an efficient pricing mechanism, such as uncertainty over changing tax policy and regulation, among many others. For the most part, however, the capital market allows for value-creators to be rewarded and value-destroyers to be punished. It differentiates the good and bad stuff, allowing for both success and failure. Obviously I could launch into a discussion here of the consequences of the bank and auto bailouts of 2008 and how that doesn’t fit this model at all, but I’m trying to stick to the subject here. We clearly understand and are troubled that free-market principles are quickly abandoned when the going gets tough. Stock market returns over the past 15 years and, in turn, our investment returns have been, at times, driven by the forces of market manipulation and intervention.

So, very simply, anytime a pricing mechanism is controlled or distorted, the ability to correctly translate value breaks down entirely. The history of global trade and economics is full of pricing distortions. The driving force is always political and self-serving. So let’s be clear about our politics. The U.S. is a market-based, democratic country legislated by Democrats, Republicans, and a few Libertarians, while China is a centrally-planned economy with a single party government run by the Communist Party of China (CPC).

I don’t have to go much further for you to understand my point, but it should be abundantly clear that the two ideologies approach economics and markets from very different points of view. However, tinkering with market prices is tempting for both. International trade utilizes a natural pricing mechanism in currency exchange rates. Those rates are meant to translate the value of inputs from one economy to the other. China’s policy of a fixed peg of the Renminbi to the dollar is simply a price control. Price controls obstruct free markets. China creates seemingly endless GDP growth, yet without a real price, they likely destroy value and hide losses.

The Yin Grows

Why do the Chinese engage in such overt market manipulation? Some might argue that the Chinese have gone a long way to accepting market principles. I just want to get right at the core of the issue here, knowing we can rationalize or qualify this endlessly. The Chinese are, by definition, Communists. The CPC explicitly uses Marxism as one of its guiding principles. After all, Marx literally wrote the book on communism. In the Communist Manifesto there are statements that reject free trade and free markets. Marx also recognized that capitalism does not tolerate over-capacity. Persistent over-capacity drives returns below the cost of capital to the point of loss. Capitalism and free markets thrive on allowing failure so capital is redirected away from non-productive uses. China is the poster child of over-capacity in today’s world, building vacant cities in anticipation of future growth (Read this article in FT about Chenggong. See this video about Ordos City).

The wealth of the working class in China is suppressed and controlled by an overwhelmingly dominant single party political system, for the (supposed) eventual benefit of the whole. In the short-term, the benefits are disproportionately endowed on exporting industries and state-owned enterprises. The working class absorbs the short-term economic loss for the benefit of increasing total employment. By pressing continually on with investment in more and more capacity, China slowly transfers the means of production away from other countries. On the global stage, this is a power play, leveraging off an economic model of large trade surpluses to gain economic influence in the world.

The Yang Shrinks

The U.S. fell into the trap, with little pause or consideration of the consequences. Lured by a price too good to pass up, the U.S. has repeatedly justified manufacturing and consumption decisions. We fooled ourselves, living in an economy where price supposedly reflects value and aggregates all inputs, we rationalized that China just has access to more resources, more people, enjoying comparative advantages. With unemployment at low levels in the U.S. for many years, largely because asset prices and lending were supported by loose monetary policy, we hardly noticed the growing consequences. (Thanks to our own price fixers at the Federal Reserve – for a better look at that I recommend reading William Fleckenstein’s book “Greenspan’s Bubbles”).

Here we sit with 17% under/unemployment, structurally impaired from years of misallocated capital. Small businesses have little access to capital and banks are not increasing lending. Consumers have pulled back and everyone is yelling about deficits and healthcare. (By the way, the next great misallocation of capital is well underway in healthcare. It is by far the fastest growing component of consumption expenditures AND employment). I am at least encouraged that the political debate in this country is raging. People are paying attention. The fix may well be in on our side of the equation, with much work left to be done.

Yin Must Equal Yang

Welcome to the consequence phase. Too little too late for debate on the subject of currency manipulation, in my mind. The die is cast and we now find ourselves at the end of the debt rope. In order to run persistent trade deficits while maintaining high levels of employment, we have been borrowing in the pursuit of prosperity. How convenient for the Chinese to have been the natural source for much of that credit. Not convenient at all really. It is by design. They seem to have bought into the story as well. As hedge fund manager Hugh Hendry describes it, it’s as if Bernie Madoff was in charge of U.S. GDP accounting and China was the largest investor. The worst thing then for China is a derailment of the U.S. growth story as promised, especially in the form of a banking crisis. As the U.S. hits the debt ceiling, no longer able to borrow excessively as markets deny a further misallocation of capital, growth is short-circuited. China (and other surplus countries like Germany in Europe) must naturally face the consequences as well.

Bubble Hunting

Is China a bubble? I’ve read many who think so, such as Jim Chanos and Hugh Hendry, and they sound very compelling (read Chanos’ thoughts, read Hendry’s thoughts). But I don’t analyze China for investment purposes, have never been there, and I don’t have good insight on the numbers. What I can say, is that manipulating price prevents the market from purging losses. This type of price fixing is meant to rig a country for GDP growth and employment, not value creation. That is similar to how we ended up with the Dot Com and housing bubbles, as the price of money was set by the Federal Reserve to prevent the loss of jobs and GDP growth. In the end, we destroyed value, eventually reflected in falling asset prices. If China is in a bubble of some kind, without free market mechanisms, they may well blow hot air longer than we expect.

China Is As China Does

Financial headlines are ablaze that China must float the Renminbi now. No one seemed to care much until it all went wrong. It’s gone wrong, but there is no value in blaming China. We have been willing participants believing that prices reflected value. Now we confront the circumstances of having reached our borrowing limits and looking for retribution. Retribution, according to many in Congress, comes in the form of trade barriers. So, in essence, instead of manipulating price, we suspend pricing entirely. Let’s only hope this stays within the bounds of a diplomatic resolution. (Follow this link to find Taiwan on Google Maps).

My belief is that China holds the Renminbi peg (or close to it) beyond any pressure applied from the U.S. That circumstance will only serve to enforce the necessary process of deleveraging and the incipient deflationary forces in the U.S. With or without trade barriers, the U.S. must reign in debt and start saving more. Any radical adjustments in policy at this point would likely spark greater uncertainty and exacerbate that process.

This continues to favor our aversion to general equity market risk and keeps us close to “dollar” assets. Within equities, that requires larger holdings in defensive stocks such as consumer staples and very select utilities that pay above market dividend yields. We have continued to hold the high quality corporate bonds we purchased in late 2008 and early 2009. We also hold a fairly high cash position that protects against adverse market reactions. It also gives us flexibility to exploit investment opportunities that will be present as market volatility is likely to continue.

Fighting Words?

One last, rather well known quote from Communism’s founding father. Whether this is relevant or perhaps even prophetic, we might need to reconcile what it means in today’s world.

“Freeman and slave, patrician and plebian, lord and serf, guild-master and journeyman, in a word, oppressor and oppressed, stood in constant opposition to one another, carried on an uninterrupted, now hidden, now open fight, a fight that each time ended, either in a revolutionary reconstitution of society at large, or in the common ruin of the contending classes.”

-Karl Marx, The Communist Manifesto, 1848

Consider this as the China story continues to unfold on the global stage.

Peter J. Falker, CFA

March 22, 2010

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

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