Broker Check

2011-2015 The Fork in the Road

June 24, 2011



I hope that all is well in your life and that you are finding satisfaction in it.  The wise King Solomon once wrote, "A person can do nothing better than to eat and drink and find satisfaction in their work."  I hope that no matter what sort of work (or rest), you're up to, I hope that you're finding satisfaction in it. 

And as the legendary golfer, Ben Hogan, once said, "As you walk down the fairway of life you must smell the roses, for you only get to play one round."  A cousin of mine, who has severe cancer, recently reminded me of the need to "smell the roses".  You pay attention to people that have that perspective - they tend to be a little more keenly aware of what really matters.


As investors, let's continue to use this framework (below), as a filter and as a grid to run the financial media that we consume, the rumors we hear from investment professionals, friends, views from economists, and any thoughts we may have about the status of the economy, the stock market, interest rates, our portfolios, and other investment decisions that may arise.

"The Detection of Change

Because the detection of change is such a key element in security analysis, the analyst devotes a great deal of time thinking about change and its causes.  Some leading questions are:

  • How long can this go on?
  • What factors will most likely change the trend?
  • What is the status of each of those factors?
  • What evidence of change should one look for?
  • Where can one find such evidence that will tell when a causal factor or event is coming into play?"

(from Fifth Edition, Graham and Dodd's - Security Analysis)

2011 (YTD)

Early in the year, we invested a lot of cash on hand into municipal bonds that had been beaten up badly in Q4 2010.  We've trimmed a number of equity holdings and have continued to pursue [click here] the bond theme  under the premise that lower and lower rates will continue for years to come. 

This is an extremely unpopular view.  Many people don't want to hear me bring it up ever again.  We've been extremely selective and patient in our bond-buying so as to try to capture as much yield for clients as possible without taking on too much undue risk. 

We've recently added a small position in the Japan Nikkei index for three reasons:  First, due to the historically low valuation on a price to book basis; second, the recent correction due to the tsunami (now we have more certainty in terms of being able to quantify the economic impact - i.e., the amount of time needed to bring Toyota plants back online, etc.), and thirdly, since the end of 2005, we've seen companies there actually begin to borrow again after 15 years of cleaning up company balance sheets by paying down debt. 

We are also adding to the Blackrock Global Allocation [click here] position  for certain portfolios. At this time, I believe that hiring the team at BlackRock Global Allocation, and investing in the U.S. based multinationals that sell to emerging economies like China, India, Brazil, etc., is the most prudent position.  Going back to the detection of change points above, should we really be betting the farm on straight-line, linear growth in China?

Very recently, we have been taking advantage of the increase in corporate bond spreads buying industrial companies such as Sealed Air, Teekay Shippers, Vulcan Materials, Navistar, as well as Weyerhauser.  The move in oil prices pushed the prices of some of these short-intermediate term bonds down to an attractive entry point allowing us to capture more of the 5.65-7.25% per year yield that we're seeking. 

Additionally, we're having conversations with clients asking them to consider repositioning a portion of their IRA's/SEP IRA's (or even establishing new accounts with after-tax money in certain cases), into 8% cumulative, pension-like fixed indexed annuities, some of which are scheduled to see a rate-drop to 7% after September 30, 2011.

2011-2015 The Fork in the Road

The view below of the fork in the road, I believe, illustrates the current viewpoint for presidents of companies, economists, public policymakers, and also for investors - whether they be in Athens, Greece; Trenton, New Jersey; Washington, D.C., Berlin, Brussels, Tokyo, Toronto, Brasilia, Los Angeles, Lisbon, Atlanta, Sydney, Beijing, or anywhere else for that matter.

When you come to a fork in the road, unless you immediately pull your car over to evaluate your options, you are rarely afforded the luxury of time and thus the choice of being patient and deliberate versus being instinctively decisive...  Would you say that's correct...?...

"Truly successful decision making relies on a balance between deliberate and instinctive thinking."  Malcolm GladwellBlink:  The Power of Thinking Without Thinking 2005

We are going to examine seven (current), forks in the road:

1) Bond yields going lower (still - and staying low for a long time), due to deleveraging - don't miss this;

2) The United States and China - their own separate fork in the road;

3) Bernanke's fork in the road (note: Professor Cochrane article);

4) The fork in the road you face as an investor;

5) The patience versus 'wanting it now' fork in the road;

6) Debt ceiling issue not a done deal - and could turn out to be a big deal;

7) Role of government going forward


1) Bond yields going lower and staying low for a long time

"I think the thrust of 'extended period' is that we believe we're at least two or three meetings away from taking any further action [raising interest rates].  And I emphasize at least.  But depending on how the economy evolves, and inflation and unemployment, it could be, you know, significantly longer."  Fed Chairman Benanke - June 2011 

Seen any signs that read this way at local banks?

"Yes, we're lending!"

"Come on in, we're lending!"

"Come on in and talk with us about our super low rates!"

 Guess what?  NO ONE CARES!  It's called deleveraging!  No one wants more debt.

"When the private sector is paying down debt with zero percent interest rates, it tells you just how sick the private sector is." - Richard Koo - Chief Economist - Nomura Research Institute - and author of Balance Sheet Recession - quote is excerpt from video (below).

I firmly believe that this book, and Richard Koo's work on balance sheet recessions, will turn out to be some of the most influential work for the 2011-2015 time period - right at the top.  

His analysis of how the GDP in aggregage in Japan over the twenty year time period has actually managed to increase is good work.  Though they managed this increase and didn't suffer a massive drop as in the Great Depression is maybe one of the most noteworthy achievements of the policy.  Even though it's not been as bad as it could've been, it's hard for me to see how successful the Japanese have been (given how messed up things have been/are), with the debt so high and the savings rate so low and the following headlines from the June 15, 2011 "Japan Today", newspaper (online version):

Let's look at headlines from newspapers in Tokyo on tax-day (in the U.S.), June 15, 2011:

  From Japan Today – website - June 15, 2011 - "The number of welfare recipients [national total] for March [*before the Tsunami],is almost equivalent to the record monthly average...close to the record-high mark seen in the aftermath of WWII."

"Losses caused by bank robberies already exceed [we're not even halfway through the year as of June 15'th], last year's (2010), total."

Applications for workers' comp due to mental stress hit record high (breaking record 2 years in a row - not just tsunami-related).

BOJ (Bank of Japan), further eases monetary policy to boost economy - to keep interest rates between 0 and 0.1%.  [Tsunami-related - but note, the term "keep", that indicates that monetary policy was ultra-accomodative even before the tsunami].


"In the past five years, private sector loans have deflated by $1.9 trillion.  Public sector assisted credit has surged by a similar amount".  Haver Analytics.

The only trending (non-statistical outlier (blip)), area within credit markets expanding has been in the area of assisted student loans.  Over the past three years, they have soared by $250 billion.

The Japanese 10 year JGB bond yield is, as I write this, 1.068%!  Our 10 year U.S. treasury bond yield is 3.1%!  If Gary Shilling is right, and we see a 2% yield on the ten year, and I believe he is right, our yields will go lower and they will trade in a trading band in a low range for YEARS!


2) The U.S., and China are each at a Fork in the Road

"By three methods we may learn wisdom:  First by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest."  Confucius

The two major economic actors on the planet, The United States and China (who are, economically, inextricably tied, I'd argue), are both, each, at their own respective fork in the road.

Let me explain:

  1) The United States of America can choose:

    a) To travel down the road towards a Japan-esque (circa., 1990), destination on the map;

    b) To travel down the road towards a Canada-esque (circa., 1998), destination on the map;

  2) China will either:

    a) Suffer a hard landing;

    b) Or avoid a hard landing by orchestrating a soft landing.

Google map U.S., to Japan

We're already pretty far down that road already, in my opinion, but we still have time to turn around.  Low interest rates for a long time (due to credit contraction - a result of overborrowing both by the government and private sectors), very slow growth domestically, a system dependent upon monetary stimulus and an awkward, unhealthy banking system, a tax system that is broken, more government regulation of markets and less free-markets.  Don't be caught off guard - the numbers coming out of Japan in the months ahead are going to look awesome - be reminded, though, that their stock market was at 34,000 twenty years ago and it's currently ~10,000.  And they've worked their excesses out whereas we've just gotten started.

Google map U.S., to Canada

Before ~1998, Canada spent like a drunken sailor - much like the U.S.  Canada ~ 1998 cut spending on entitlement programs, right-sided spending in many, many areas, discouraged real estate speculation by no longer allowing interest expense on debt to be deducted from taxes, and many, many other structural reforms.  As a result, their banks are among the most pristine on the planet, and the need for government bailouts is just not necessary.  But, they had some serious growth pains for 7-8 years.  It was tough.  But they are reaping the rewards presently of being responsible.

China's Fork in the Road

So, in the United States, the term has been for money managers, "Don't fight the Fed."  It now seems to be extended to include "Don't fight the Communist Party."  This group in China has an interesting form of legitimacy - as long as they grow, they stay in power.  Think they'll do whatever it takes to stay in power?  Remember, there are 400 million people in the cities in China that are participating in the growth there.  But there are 800 million people within the interior of China that are not participating much at all.  Can there really be straight line growth there with no hiccups?  How sustainable is that deal?  Should we consider being just a little bit patient?

Please pay attention to this recent article on China June 23rd article in The Economist on China

3) Bernanke's fork in the road;  (note:  Professor Cochrane article and Graph)...*

QE5 - let's not even, for a second, debate whether or not Bernanke and Co., will do QE3 or not.  If he feels he has to, he will.  Really.  Some form of it is maybe a done deal.  It may be soon and it may not be for a few years.  In Japan, the big chunks of intervention came several years apart - once in 1991 and again in 1998.  Richard Koo's book conclusively proves that were it not for massive monetary and fiscal policy accommodation, Japan's GDP would have collapsed much like what we saw in the 1930's in the United States.  Bernanke and folks know it. 

Bernanke June 2011:

"We do have a number of ways of acting.  None of them are without risks and costs.  We could, for example, do more securities purchases and structure them in different ways.  We could cut the interest on excess reserves that we pay to banks.  And as was suggested by an earlier question, actually Jon's question about giving guidance on the balance sheet or perhaps even giving a fixed date, you know, to define the extended period, those are ways that we could ease further if needed.  But, of course, all of these things are somewhat untested.  They have their own costs.  But we'd be prepared to take additional action, obviously, if conditions warranted."

After I finished Koo's book, I realized that Obama and Bernanke, in their initial QE1 response, could've actually done much, much, more.  The Chinese did much more and they have not been unscathed by the financial crisis, but they've held up extraordinarily well to date (though they've got a major bubble on their hands - and know it).

Please read Professor Cochrane's recent article Professor Cochrane Article - Fed doing nothing with all of this

What if interest rates go higher?

"The United States will spend approximately $440 billion this year, in interest expense alone, on our debt.  Before 2008, we never had a deficit that amounted to more than $440 billion in a given year.  So, if the interest rate on that debt were to increase by say, only 1%, we would be having to spend $140 billion more each period on interest expense alone." - Laurence Fink - Chairman and CEO BlackRock (company that is the manager of more U.S. Treasury bonds that any other money manager on the planet) - April 2011 - Bloomberg TV. 

What I think Bernanke will do

It is this reason that Ben Bernanke will put some sort of ceiling on select interest rates - and I think it will happen before 2015.  Because again, by 2015, if massive, significant cuts are not made to our spending, if you add the costs of Medicare, Social Security, Medicaid, and just the interest on our debt, that's over 92% of our entire annual budget.  The Treasury department can't afford for rates to go higher...make sense?

The lion's share of our debt matures in the next five years.  Bernanke and team will not 'kick the can', as he's been accused of doing to date - they will lift an enormous pile with a crane and scatter it a great distance into the future.  They are going to have to do some form of this.  The math and the calendar suggest there are no other alternatives.

4) The fork in the road you face as an investor

You've been fortunate enough to create some wealth for yourself and your family, now you're at a fork in the road as to what to do with it...

Question:  Ever instinctively noticed a "Con-Way", tractor trailer on the road? 

Did you know that you can instinctively invest in the company's stock, symbol CNW, today (June 24, 2011), priced at $37 per share (notably, as with many stocks, six and a half years ago, the stock was priced at roughly $50 per share), and hope that at the end of six and a half years that the stock is at or above $46.62 and sell your stock on January 15'th, 2018, exactly, and capture approximately 32.5% cumulative return? 

Cumulative returns that protect

Or, did you know, that you could deliberately invest in their Senior Bonds BBB- (Investment Grade rated by S&P), that would pay you 5%, each and every year, for six and a half years (how boring is that, I mean come on?), and be looking at a 32.5% gross cumulative return? 

Or, what if you were really good and you put together a basket of mutual funds and the collection, in aggregate, did very well most years but of the seven time intervals (six and a half years), experienced two rough periods> illustrated:

+10% (Year 1), +10% (Year 2), +10% (Year 3), -20% (Year 4), +10% (Year 5), +10% (Year 6), -10% (Year 7 (Year 7 is only 6 months)) = Gross Cumulative Return of 20% versus 32.5% with the aforementioned bond.

Clearly, you can be deliberate and invest in stocks and that can many times make a lot of sense for your particular situation.  But I would argue that until you secure your income for now and income for later, placing a great deal of your wealth into a capital appreciation strategy without considering the income stream that you may derive from it, is not wise.

This is not just an income shop here.  We like stocks, too.  It's just that, the income theme is strong here. 

Enough about bonds already! 

Why do you think I've been so evangelistic about bonds over the past five years?  It's not been because I've been trying to argue that bonds are better than stocks or that the timing of my call is surgical and perfect and that your entry and exit point will allow you to trade for huge profits and then get back into stocks.  It's not even that I have anything great to add to the gross weight of financial press that's readily available.  It's been because exceptional rates of return with safe/relatively safe investments are vanishing.  When you own a mutual fund, you don't see it.  When you sit in my seat, you see it.  Here's an example:

On January 13, 2009, a client purchased a (three year bond), BBB- rated, Alcoa, Senior Bond,maturing January 15, 2012 paying 7% per year (YTM - Yield to Maturity).  If I want to invest in that same issuer of bonds, with the similar length of time until the bonds mature, my yield (YTM - Yield to Maturity), will only be 1.7%.

See the difference?  Three year bond at 7% per year versus 1.7% per year.

Investors are in denial

We're 31 months into zero percent interest rate policy deal with no real end in sight (determined not by opinion, but by excerpts from Fed Chairman Bernanke's speeches), and we're not even a little bit like (I'm not trying to say we're precisely like), Japan?  Okay...  Sounds like a tad of denial to me.

If I'm right about the overall direction of interest rates and the implications for bond yields, you are running out of opportunities to purchase solid bonds at reasonable (based on past historic U.S., fixed income measures), rates of return.  The math overwhelmingly affirms this thesis.

What now?

Instead of the Alcoa bond for three years, how about we consider an Owens Illinois (began in 1903), (glass bottle manufacturer with business all over the world), six and a half year senior bond for 6.4% per year?  Sound reasonable?

Please remember, the S&P 500 is flat compared to twelve and a half years ago.  Is it reasonable to consider the possibility that it will be no higher in six and a half years?

And what I'm going to tell you is, things are not as they seem...the fundamentals in our economy and the economies of other countries due to excessive leverage and the serious need for structural reform, are not good.  This is NOT a normal cycle.  Trust me.

Artificial intelligence

Before 2015, unless Bernanke and team pull off one of the most creative feats in modern history, we are going to enter into a separate and new recession that will be real.  The "recovery", that we've seen off the lows from 2009 has been mostly artificial.  No matter what Wall Street wants you to believe. 

This deal is unfortunately playing out exactly like I thought it would.  In the back of my mind, though, I sort of didn't believe my own prognostication about bond yields, the capital markets, the economy and the similarities between our situation after 2007 and Japan's situation after 1990.  If you are concerned about the state of things - you should be. 

5) The patience versus 'wanting it now' fork in the road;

A client of mine recently said to me, "Jack, I don't understand why everybody doesn't invest this way."  To her point, insurance companies do.  When I was a kid I thought that banks had "all" (I know, it's a relative term), the money.  Insurance companies have quite a bit of money.  I recently had the privilege of spending some time with the chief investment officer of an insurance company who manages his company's $26 billion bond portfolio, and after we discussed at length, many of their bond positions, one of the impressions I formed of this person was that he was very patient.  Despite my comment above that the insurance companies have quite a bit of money, many insurance companies needed TARP bailout funds at the peak of the last crisis.  This company did not.

It's a funny thing - patience:

Children want things now:  "But I want dessert now!"  "Are we there yet?"  "Now can we open our presents?"  In contrast, as we get older we learn to wait.  Medical students wait through training.  Parents wait in hopes that the prodigal will return.  We wait for what is worth waiting for, and in the process we learn patience.

As investors, let's be patient.

6) Debt ceiling issue not a done deal - and could turn out to be a big deal;

"Expect theatrics" - stated a Washington, D.C., Public Policy expert on a recent conference call (June 28'th, 2011), I listened in on. Treasury officials are ill-suited to make changes to Treasury auction schedules this soon and to consider changes in finances.  S&P and Moody's would most likely lower the U.S. sovereign debt rating from AAA to AA if the Treasury delayed an interest payment.  Some foreign central banks are restricted and are only allowed to hold AAA rated debt on their books. 

Nobody knows how this would affect the bond markets.  U.S. Treasury debt is THE starting point for evaluating risk-free assets.  Volatility would most definitely create opportunity - not just in bonds, but also in stocks. 

Another President's Day weekend 2008?  

Some time during this Fork in the Road period (2011-2015), we'll see another liquidity crisis, I believe.  One of the simple, country boy explanations is that:  it will happen again, because everybody says that 2008 will never happen again; and because we've not fixed things yet, we've just postponed fixing them. In 2008, the liquidity crisis (President's Day weekend, 2008), created awesome opportunities for bond investors and anything similar would create a similar opportunity for bond investors.  The same would hold true for money that should be allocated into stocks.

Enjoy Mr. Lindsey's recent article on the state of the deficit - Article Lawrence Lindsey - Deficit

If we had a spike in Treasury rates, we'd get a follow-through and a spike in mortgage rates which would fully derail the anemic housing recovery we have.  There are no contingency plans at the U.S. Treasury in place to deploy if an agreement to lift the debt ceiling is not reached.  It is unlikely, unless some major momentum begins to build, that this will get resolved before the deadline.  In other words, they'll be cramming for the final exam in the wee hours of the night rather than putting the time in way in advance.

7) The role of government (in the future)

"We (as Americans), are all going to have to adjust our expectations as to what government can and will do for us in the future." - Dennis Stattman - Senior Portfolio Manager - BlackRock Global Allocation Strategy - June 28, 2011

The United States has the only growing population as far as developed countries are concerned.  We are a country of entrepreneurs and we have the best and brightest minds in the world.  We are about to undergo significant structural change that will take time and the effectiveness of our political system to deal with problems is going to be tested.  Decisiveness will be tested.  Leadership will be stress-tested.  We have opportunities to export again, to develop new technologies, and we have the ability to choose how we use energy and healthcare - these choices will entail risk, however. 

Since 2007, the percentage of government transfer payments (which means how many cents of every income dollar comes from the government versus production), has gone from 14% to 18%.  This is unsustainable.

"The government's purse has been a tonic for corporate profits since that time [2007-2011], but that's coming to an end." - Dennis Stattman - Senior Portfolio Manager - BlackRock Global Allocation Strategy - June 28, 2011

Whew!  That's a lot of words! Closing...

Smell the roses

I hope that you are able to get some time exercising outdoors and do like my cousin says and "smell the roses", over the next several weeks.

"In every walk with nature one receives far more than he seeks." John Muir

I am very thankful to you and your family that you entrust us to help you organize your family's financial affairs and to help you make wise investment decisions.  It's something that I do not take lightly at all. 

I sincerely hope that you and your family and friends have a splendid and wonderful remainder of the summer!

Talk with you soon.



Enjoy KAL cartoon from The Economist