Greetings! And Happy Fall! And Happy Veterans' Day! I apologize for the "seventh inning stretch", since the last quarterly Insights publication (end of June).
The Europeans have held 14 “emergency” summits in the last 21 months, and this last one was pretty important - so I wanted to wait until we got something remotely decisive, to digest. And even it left out most of the details...
MIT economist and former chief economist for the IMF, Simon Johnson said (October 23, 2011), "I wonder whether we'll say 2008 wasn't the real crisis - it was a warm-up, but the real crisis was the sovereign debt crisis in Europe." Ouch.
The "international lender of last resort"
"The environment for the international lender of last resort differs from that of the domestic lender in two basic ways - one is that liquidity crises are often associated with changes in exchange rates and the other is that the rule of law is more fragile in the international context. The international lender of last resort also walks a tightrope, in this case between providing liquidity to countries so that unnecessary changes in exchange rates are avoided and minimizing the likelihood that is provision of liquidity would enable a country to postpone significantly the changes in the foreign exchange value of its currency that would be necessary for a return to the equilibrium value." p. 247 - Manias, Panics and Crashes - A History of Financial Crises - Charles Kindleberger
"Either the ECB is enabled to play a more significant lender-of-last resort role and the Eurozone moves closer to an integrated fiscal union (though getting Treaties altered for this in 17 countries will assuredly be a lengthy process) or the Euro experiment will end up being an asterisk just as the Latin Monetary Union, the East African Monetary Union and the Scandinavian Monetary Union all proved to be more than a century ago." November 11, 2011- David Rosenberg.
Their "plan" looks more like this image below to me...
So here goes...
Let's take some time for a laugh (it's good for our health);
Let's take some time to get serious by carefully examining what's going on in the markets, the economy, and how it all impacts you and your family.
Time for a laugh
Going to the Doctor
“My doctor recently told me that jogging could add years to my life. I think he was right. I feel ten years older already.” Milton Berle
"The Pessimist complains about the wind, the Optimist expects it to change and the Realist adjusts his sails." - William Arthur Ward
I would like to say, I have never been as concerned about our country as I am right now. There is a great danger ahead for the American people. The rich and the poor both face serious challenges. The middle class is being demolished.
We are very near having more takers than givers in our society. And this phenomenon is not just here in the United States (by a longshot). It's a global phenomenon.
Time to get serious
A Sense of Peace
Is it possible to have a sense of peace in today's volatile, and I'd say even hostile and confusing investing environment? Yes.
If you've paid any attention to what I've been saying for years now, you've heard me go on and on about the need for income from our investments. Income Now. And Income Later.
"Jack-Why aren't you advising more people to dump their bonds and buy stocks?" (Because yields are going lower and going to stay low for years)... "And why are you using an aircraft carrier to make a point?" (Because they're safe; oh,and they're really cool)...
Only after we secure the income components (Income Now and Income Later), of the retirement plan (the keel of the ship - if you will), should we focus on the capital appreciation (aggressive stocks), component (the flight deck - if you will), of the retirement plan.
“It (a good Navy), is the surest guaranty [for us, a sense] of peace.” President Theodore Roosevelt, December 2nd, 1902, second annual message to Congress.
- How would you feel standing on the deck of CVN 77, the United States Navy's aircraft carrier, on a cool, crisp, clear day, having a cup of coffee or tea after the sunrise?
- Would you have sort of a sense of peace?
- Would you feel fairly confident about where you were headed?
This may sound a bit silly, but please bare with me. If you're not an admirer of naval aviation, like I am, please forgive me. Please pay close attention to the tail-end (the last few seconds of the video clip)...
Parenthetically, that ship is impressive isn't it? It is a tad bit more impressive than the image of the "European-ship", isn't it?
“Structural growth problems in developed economies cannot be solved by a magic penny or a magic trillion dollar bill.” Bill Gross – October 31, 2011
Here are this edition's topics:
World-wide Interest-rate Deflation;
Deflation update (quote);
Increasing savings may nudge U.S., into consumer-led recession;
Volatility and capture (nineteen 3%+/- days 08-09 (peak to trough));
The “super” committee and spending.
1) The E.U. and what's next...
"It (the E.U.), is very complicated...It's hard to do it under one monetary policy and seventeen different flags." Dennis Stattman - Portfolio Mgr., Blackrock Global Allocation - November 2, 2011
"No one should take it for granted that there will be peace and affluence in Europe in the next century. The world is watching Germany and Europe to see if we are ready and able to take responsibility. If the Euro fails, Europe fails." German Chancellor Angela Merkel, October 26, 2011
Wow. The comments from Chancellor Merkel sound serious. Sounds like they'll try to do whatever's possible to save it, eh? Since they've been integrating Europe for 60 years now, it wouldn't be in anyone's best interest to have it dis-integrate in a chaotic manner. The idea that Italy will just allow their rates to go to 7% and stay there and refinance their debt (for any true length of time - in any real quantity), in that environment is silly. It's hard for them to make the math work with their borrowing rate at 1%, much less 7%. Also, S&P made a timing error, but it was prophetic nonetheless, by somehow errantly memo'ing someone that they were lowering France's rating. They will lower France's rating before too long, though. Just let the tape run. You'll see.
If I were to ask you what the biggest economy on the planet is, you'd either say the U.S., or China. It is sort of a trick question because in 2010, the world's biggest economy was the European Union. Question: If the Europeans truly have enough money, (what this bailout really is is a leveraged buyout structure that may be able to have 4-5X leverage, but may need higher optics, we don't really know yet), then why was Sarkozy meeting with the Chinese and the Japanese?
"Now we would like even greater efforts from within the EU and eurozone to ease crisis worries by creating a stronger and more detailed approach." Prime Minister of Japan, Yoshihiko Noda. October 28, 2011.
The Economist may have summed it up best:
"In the light of day, the holes in the rescue plan are plain to see. The scheme is confused and unconvincing. Confused, because its financial engineering is too clever by half and vulnerable to unintended consequences. Unconvincing, because too many details are missing and the scheme is at its core not up to the job of safeguarding the euro. This is the euro-zone's third comprehensive package this year. It is unlikely to be its last."
"We don't know how this works yet." - Angela Merkel
Whoa...that's pretty heavy - not something you want the salesman in the car showroom to say to you as he/she hands you the keys..."We don't know how this works yet"...mmm...
You know - sovereign defaults are typically all or nothing affairs. This term, "haircuts", that the EU has introduced about the Greek debt "plan" - it probably won't fly - the attorneys would tie that deal up in courts for years.
Recapitalizing banks "causes" recessions
The U.S., has already recapitalized our banks. It's a tad bit painful (per the examples we can point to in history (our example in very recent history)). If Merkel gets this the way she wants it, each country (there are 17), will end up recapitalizing its own country's banks and in the process most of the euro area will end up looking like Ireland did - and it went from AAA to BBB (credit rating), as it ultimately had to guarantee its banking system. Ireland had a huge recession, took a massive internal competitive devaluation via large-scale wage cuts (which the Greeks and Italians won't accept since civilization owes them something). Two years of painful adjustments later, Ireland is getting back on its feet again. Ireland is, unfortunately still sort of a mess, but is now much better off because of taking their medicine the hard way and moving on. After a nice jog on a cool, brisk morning, while I was in Manhattan - I sat on a bench looking at where the two World Trade Center towers used to be, and had a wonderful, lengthy conversation with a wealthy Irish businessman who lives in Dublin.
There is NO WAY Europe avoids outright recession. No way. It may be that the Eurozone does not avoid an outright modern-day depression. You can't rule it out.
How much credibility does the EU really deserve? This is the same group that told us that Greece wasn't going to need a bailout. Do we really believe that France warrants a AAA rating when the United States has a AA+ rating? France will be downgraded before too long - why do you think we saw them have an "emergency", meeting over the weekend to cut spending? They know it's coming.
Reasonable questions: Did the announcement of us "bailing out the banks", stops the ensuing recession? No. Do you think it will stop the ensuing European recession? No. The index of business sentiment in Germany fell to its lowest level in 16 months. Germany has a surplus. With all of these fiscally irresponsible countries parasitically attaching themselves to Germany will that last...?...Will the Germans work two years longer than they were planning - in order for the Greeks to retire two years earlier...?...
The situation is different from what we saw in 2009 - back then, for us, the recession was almost done. Now it is just beginning, and this will exert a second-round negative effect. There is an 86% recession-correlation between the U.S., and Europe - meaning that 86% of the time that one is in recession, the other one is, too.
2) Worldwide Interest-rate deflation is going global (already there in many developed countries)...
German and French 10 year bond yields are pointing towards a severe recession
One year ago: 2.51%
One month ago: 3.16%
Euro Zone Area Benchmark Rate
April 1990: 12.84%
Australia, Brazil, South Korea, Russia, India and China have been havens for investors looking for higher yields. That will change.
Australia lowered rates last week and indicated lower interest rates in the future due to slowing growth and slowing inflation.
Yield on Australia 10 year last year: 5.20%
The Brazilians have a massive household balance sheet debt bubble on their hands similar to what the U.S., had/has. Monetary easing on its way and rates will be coming down there.
Russia defaulted on their debt in 1998. Trust them to never do it again when things get rough?
The monetary authority signalled an end to their interest rate tightening cycle on October 25, 2011. Their governing body signalled a bias towards lowering interest rates the same day.
Hard landing, monetary easing and lower rates likely on the way.
3) Deflation update;
"The Fed continues to look at the economy as having deflationary risks rather than looking at the actual inflation that we've been experiencing...I don't think there's a lot more that the Fed can do." - Dennis Stattman - Blackrock - November 2, 2011
4) Increasing savings may nudge U.S., into consumer-led recession;
- The 1990-91 recession was led by commercial real estate
- The 2001 recession was led by capital spending
- The 2008-09 recession was led by housing
- The next recession may be led by the consumer (accounts for 70% of the U.S., economy)
The process of a secular rise in the U.S. personal savings rate and the dampening effect this will have on aggregate demand will be incredibly deflationary for some time.
We had an 8-12% savings rate from the 1950's-the 1970's. It wasn't until the late 1980's that the savings rate dropped down to 7%. In contrast, the savings rate went all the way down to 2% by the time the dot.com bubble boom was in full swing in the late 1990's.
The herd is wrong
The imminent, hyper-inflation prediction with respect to interest rates by most of the economics community call is wrong - short-liquidity-shocks notwithstanding. The prices of certain commodities and certain goods - that's a different story. But with credit collapses, it's different. Bond yields in Euroland in the 6's and 7's cannot stay there - they will HAVE to be manipulated downward. Again, the struggling countries like Italy cannot make the math work at 1%, much less 7%. Rates are going down everywhere.
"The credit collapse of the 1930's around the globe dramatically altered social norms related to consumption, speculation and saving. Those who were adults with families in the 1930's shunned debt and believed in the 'pay-as-you-go' for the rest of their lives." David Rosenberg - October 25, 2011
5) Volatility and Capture
"The safest way to double your money is to fold it over once and put it in your pocket." - Kin Hubbard
I love to watch the planes take off the deck of carriers - love it. We've established that you need a keel first; then you've got something solid on which to build the flight deck.
2008-2009-'esque Volatility on its way as we work through the structural issues
Please remember that there were nineteen 3% +/- sessions from the time Lehman Brothers collapsed in September 2008 to the final low of March 2009. While in Manhattan, I had the privilege of spending some time with Joe Amato, President and Chief Investment Officer of Neuberger Berman (who was head of the investment arm (non-banking unit), of Lehman Brothers. They thought so much of Joe that they asked him to run the firm post-Lehman. He sees the same potential that I see with respect to the negative effects that global deleveraging will likely cause. With all of that volatility, the market still managed to slide more than 50%. I don't believe that a move that severe will necessarily happen to the U.S., equity markets. But earnings look good don't they? Where are they strongest? Overseas. China will land hard and Europe will be miserable. I think that the S&P will test the range of the 900's, which would imply a 30% "haircut", from here. I could be wrong, though. The credit reflation tonic (Q.E.), has been incredibly effective at reflating asset prices thus far. I might add, that equity markets are currently trading under the assumption that QE3 by the Fed is a done deal. I think it is, too - by mid 2012 at the latest.
"Everybody's doing it"...
QE (printing money), is what each and every country on the planet will be forced to do unless they choose to default. Sounds dramatic - but watch it happen...this will indeed increase volatility and thus increase the need to capture gains with respect to capital appreciation strategies.
These F/A 18s and F35s are awesome planes. They are really something. They're state of the art - THE best in technology and sophisticated avionics and they're very, very expensive. So when they take off, you don't want them crashing off the edge of the flight deck. And after a successful sortie, you don't want them crashing. So you capture them.
Capture illustrated: http://baroncapitalmanagement.com/mutual-funds/baron-focused-growth-fund/bfgix/?tab=Performance ), performance analytic...
$100,000 invested in BFGIX (click here), May 31, 1996 would have resulted in $517,530.40 versus $229,309.70 from the Russell 2500 Growth index. Awesome.
Three things to consider here:
a) That's a fifteen-year time period;
b) That performance was acheived during one of the greatest credit expansions in our country's history - it doesn't mean that it can't be repeated, just something to consider;
c) From a risk tolerance standpoint, it may not be appropriate for you even if you have plenty of income from the income component of your retirement plan.
*Also, Baron Funds' Focused Growth Institutional Strategy (fund), actually beat out the Russell 2500 growth index benchmark 90% of the time (ref., aforementioned URL:).
6) The "super" committee and spending;
"The very effort of individuals to lessen the burden of their debts increases it, because of the mass effect to liquidate. The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not righting itself, but is capsizing." Irving Fisher, 1933
Our leadership will not lead. For example, we have a "super" committee that is supposed to come up with a bunch of spending cuts before Thanksgiving. They will most likely fail miserably. That failure is, by design, supposed to cause automatic cuts in 2013. Those cuts will most likely never happen. Congress will most likely find a way to not do them. Our deficit is so out of control that without significant spending cuts/increases in taxes or a combination of the two, the ratings agencies will most likely continue to drop our credit rating as a nation.
Remember I said Bernanke would do some form of QE, but not call it QE? "Operation Twist"...?... Sounds like a James Bond movie or something, but okay...My guess is that before too long you'll see 50 year and 100 year US Treasury bonds being talked about. That's the only way the math works.
"All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment." John Kenneth Galbraith, 1990, A Short History of Financial Euphoria
Thank you very much for your business. I have a great job and you make it possible.
Have a great Thanksgiving with your friends and loved ones and a Merry Christmas as well!
Talk with you soon.
The next edition of Insights will be in March 2012.