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The Wall Street Wish List Edition #10
By Brady Willett & Dr. Todd Alway Wish List 2010, December 28, 2010
The ‘Wish List’ is not direct investment advice: we the producers are private investors, not professional investment advisors.
Please make your own final investment decisions.
1) Wish List Review and Outlook 2) New Research and Selections 3) Conclusion
Anyone anxious to celebrate the latest ‘recovery’ in the world’s largest economy need only remember the last recovery: it was backed by waves of fiscal and monetary stimulus that promoted the formation of unsustainable asset/credit bubbles, which in turn reinforced the reckless borrowing/spending habits of the U.S. consumer. With extraordinary waves of fiscal and monetary stimulus supporting the current recovery ‘unsustainable’ is once again the word of the day. Federal Reserve Chairman, Ben Bernanke, alluded to this word in late 2008:
“To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed's balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way...” Ben Bernanke. December 1, 2008
In the months following the above speech Bernanke cut interest rates to zero percent and added more than a trillion dollars to his pet projects. Returning interest rates to ‘normal levels’ and sculpting a more ‘sustainable’ balance sheet was, and remains, a castle in the sky.
To get an idea of just how large the stimulus/bailout actions of U.S. policy makers have been, in February 2009 it was estimated that the U.S. government (when including the Fed), had committed enough money to solving the financial crisis to pay off more than 90 percent of the nation’s home mortgages. Notwithstanding the rapid rebound in equity prices and Wall Street bonuses (which are now back to pre-crisis levels), these bailout/stimulus measures have yet to have a positive impact on many average homeowners. Rather, as 2009 draws to a close CoreLogic estimates that 10.7 million homeowners are underwater (with an additional 2.3 million an eyelid away from joining them), and that there is currently a backlog or ‘shadow inventory’ of 1.7 million foreclosures. The conclusion to be drawn is that stimulus measures have not been focused on helping the individual so much as the abstract notion of what is good for the financial markets must be good for everyone else.
But ‘everyone else’ is hardly doing as well as Wall Street: food stamp utilization is at record highs, consumer confidence figures are mired below pre-crisis levels (Conference Board), and the U.S. unemployment rate is at 10.2% (17.5% if you look at the U-6, or ‘underemployed’ figure). It is this type of chilling statistic that resonates even as the U.S. posts positive GDP numbers. And as the contradiction between statistical growth and individual decline increases, the word unsustainable rings out…
Against the backdrop of a weak economic recovery patched together by potentially ruinous amounts of monetary and fiscal intervention, few policy makers dare ask the most important question at hand.
Question: What caused the crisis?
At risk of oversimplification, the answer is as follows: Too many bad bets! Wall Street bet that their inventive schemes would enable them to withstand any downturn (and/or that they would be bailed out and not go to jail if they failed), the consumer bet that no amount of debt was too great because housing prices always rise, and policy makers bet that their self-regulation and pro-homeownership policies were wonderful. Everyone bet wrong.
Safe in the knowledge that when too many bad bets go wrong at once a financial calamity quickly erupts, what path have policy makers embarked upon? The path of least resistance, of course.
Bernanke Encourages Gambling
“Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective…the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand.”
Ben Bernanke, December 1, 2008.
The day before Bernanke unleashed the above speech the yield on the 10-year Treasury bond was 3%. 13-sessions later the yield had plummeted to as low as 2.04%. Although Bernanke was only quietly theorizing about what the Fed could do if the last of its interest rate ammo was spent, market participants were listening. As for Bernanke, it can be inferred that he was delighted his words had a direct impact on the supposedly free Treasury market. After all, in the same speech Mr. Bernanke noted the following:
“…last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.”
After exhausting traditional policy measures and increasing the scope of its MBS purchase and TALF programs, on March 18, 2009 Bernanke finally dropped the bomb: the Fed would purchase $300 billion in Treasury securities. The day of this announcement the yield on the 10-year Treasury bond opened at 3% and ended at 2.53% (the largest daily bps decline in the 10-year yield since October 20, 1987). Those that thought the Fed didn’t have the power to influence the massive Treasury market over the short-term were wrong.
Given that Bernanke was ‘encouraged’ by the reduction in mortgage rates following the Fed’s announcement to buy MBS, he must have been downright ecstatic when yields plummeted following the March 18 announcement (not coincidentally, equity market participants were pleased as stocks potentially put in a ‘historic’ bottom during this month). Realizing that Bernanke previously noted “…under a paper-money system, a determined government can always generate higher spending and hence positive inflation”, there was the sense that ‘helicopter Ben’s’ academic theories had been vindicated. After all, asset prices were no longer plummeting, the dollar was falling (quite sharply on March 18), and inflation mongering was on the rise.
In short, TIME’s person of the year, Ben Bernanke, was ‘successful’ insofar as asset prices rebounded. When all seemed lost Bernanke found a way to entice investment capital back into risk. Does it matter that the Fed and U.S. government put an enormous amount of taxpayer funds on the line to achieve their goal of igniting inflation? Does it matter that the price of gold is hitting record highs and that a growing cadre of global policy makers are questioning the dollar’s reserve currency status? The answer to these questions is a firm not really -- at least if you buy into the story that the good times in investmentland will eventually trickle down to ‘everyone else’….
Blame Ben!
Once upon a time Bernanke concluded, with a straight face, that “the net supply of saving in emerging market economies contributed to both the U.S. housing boom and the broader credit boom.” This ‘global savings’ glut defense has been reiterated on cue by countless former and current Fed members in an attempt to evade responsibility for the housing/credit bubble. And each time the phrase is uttered the observer can not help but cringe. Think about it: policy makers failed to regulate the markets and they maintained highly stimulative policies even as asset prices soared and financial institutions acquired greater leverage. Now these same policy makers want to blame a capital influx into Treasuries from emerging markets as a major contributor to the bubbles?
Thankfully, the events since late 2008 have ensured that Bernanke and others will not be able to play the myopic ‘saving glut’ defense after the next crisis. Rather, after bailing out failed enterprises, cutting interest rates to zero percent and promising to keep them there (even as the crisis supposedly subsides), and by intervening directly into the Treasury market, Bernanke has made his own bed. There is in our mind absolutely no way for Bernanke to blame anyone else if he has created an unmitigated financial mess.
Incidentally, while no one expected Bernanke to fully revoke Keynesian economics and embrace the Austrian perspective, he might at the very least have given reflection to the notion that monetary policy has limits; that a sustainable recovery can only arrive once the reckless investment, borrowing, and savings habits that led to the previous crisis have been flushed out of the system. All the evidence suggests that he did not.
From Bailout To Bust?
Before the 2008 financial crisis the very thought of U.S. dollar hegemony abruptly ending was reserved for a tiny group of pessimists commonly referred to by the popular media as crackpots. However, with the onset of the financial crisis previously obscure individuals (like say Dr. Ron Paul) have been thrust onto the limelight to enlighten others on the dying patient that is America. While seemingly unimportant, this trend of ‘crackpots’ turning into legitimate experts represents a major impediment to the process of confidence rebuilding.
More than 6-years ago – in an article entitled ‘Hashimoto Factor’ - we argued that “The U.S. economy and the bubbles inherent to its financial markets are only sustainable so long as foreign capital (and those who control it) is placated.” Not only were very few people discussing the ominous trends in foreign ownership of U.S. assets back then, but fewer still would have cared or understood the topic matter. By way of contrast, in 2009 Saturday Night Live did a skit that depicted President Obama pledging that the U.S. will repay the $800 billion it owes China. As one of the funnier SNL skits, part of the transcript is worthy of reprint.
Announcer: We will now take you live to Beijing for the joint press conference already under way between U.S. President Obama and Chinese President Hu Jintao…
Hu Jintao: You know, as I listen to you, I am noticing that each of your plans to save money involves spending even more money. This does not inspire confidence.
Obama: I assure you, you're going to get your money.
Hu Jintao: Will you kiss me?
Obama: [ confused ] Sorry?
Hu Jintao: Will you kiss me?
Obama: I don't understand.
Hu Jintao: I like to be kissed…when someone is doing sex to me!
The reasons for this abrupt change in the perception of U.S. finances is keenly related to the fact that more people now realize that fiscal and monetary stimulus activities do not create sustainable economic recoveries. For more than a decade analysts and professional economists had faith that U.S. consumers, despite common sense, would perpetually be able to amass more debt and spend well beyond their means. The financial crisis has crushed these delusions. For more than 20-years the U.S. slept safe in the knowledge that its economy was the growth engine of the world, its financial markets were the largest, safest and most sophisticated in the world, and that the U.S. dollar was the glue that held this world together. The financial crisis and policy reactions to it have thrown serious doubt on all of these suppositions.
In 2009 China surpassed the U.S. to become the largest automobile market in the world and Mike Mobius recently estimated that within only 3-years China’s financial markets will be bigger than those in the United States. While not as enamored with the super-growth China theme as many, these and other events do suggest that major changes are afoot; that the U.S. centric world we have known most of our lives is in decline as other growth engines and monetary regimes – or at least the possibility of such – awaken.
Suffice to say, the prospect of the U.S. having to confront its debt largess is on the rise, and the gambles Bernanke’s Fed has taken and encouraged others to take are reflective of desperation. The policy goal of pushing the ‘unsustainable’ U.S. borrow, spend, and speculate model to the extreme has laid the groundwork for the next financial crisis, and it promises to be even more stunning than the last. The only question, at least in our minds, is when.
Complex Questions That Can Not Be Answered
While our role as stock investors is to try and ignore macro themes and dissect individual companies whose success/failure is not necessarily dependent upon what the Fed may or may not do, this approach is proving increasingly difficult. Quite frankly, that the Fed has taken such an active role in so many markets and is pledging to keep interest rates low for the foreseeable future suggests that market participants will continue to flock to risk. That so many of the Fed’s central bank counterparties are also at or near the point of maximum ease also suggests that greater risk taking is the theme of day. Incidentally, the suggestion leading into 2009 was that the world faced the prospect of competitive currency devaluations. The more accurate conclusion leading into 2010 might well be competitive bubble formations.
Along with the problem of trying to decipher unpredictable future swings in investor risk taking, there are many questions worthy of contemplation.
- Has a dollar carry trade helped propel global stock prices higher? If so, is there a risk that when this carry trade unwinds prices will collapse lower?
- Can numerous governments, notably the U.S., Europe, and Japan, continue to borrow obscene amounts of money without interest rates moving higher and/or their sovereign credit ratings moving lower?
- Is a record gold price reflective of rational inflation fears, or is it anticipating that a weakening dollar presages a dollar crisis (or global monetary crisis)? At what point, if any, does gold itself become such a popular destination for speculative investor capital that it represents a bubble?
Answering these and other macro questions is the prerequisite if you plan on latching onto many of the most popular investment themes today. We do not…
We Are Individuals!
The best gauge of investment success is not always the end result, but the process. For example, some individuals became extremely wealthy by handing money to Bernie Madoff - but they lost their fortunes when Madoff’s Ponzi-scheme imploded. Realizing that these investors were not smarter than everyone else when they were making money, the lesson is that every investor should have a good understanding of exactly how they are making/losing money.
In short, those speculators who think that monetary and fiscal forces will ignite a sustainable economic recovery and/or push stock prices higher still, have already failed as investors (this is the case whether they produce short-term gains or not). There is no magic formula when it comes to forecasting stock market performance based upon policy making decisions. Japan is well aware of this and with a lost decade in U.S. equities having already transpired, U.S. investors are learning this as well.
Benjamin Graham once offered “In the short run, the market is a voting machine but in the long run it is a weighing machine.” With participants clearly voting for a big recovery and pricing most stocks beyond our risk threshold, we are left to weigh the implications of policy desperation. Perhaps what can best be said is that where once a savings glut ruled, now a government spending/borrowing glut is threatening to take its place. This new paradigm of risk taking has raised the bubble ante dramatically, with the next major crisis not likely to be about individual companies and markets, but countries and currencies…
Part I – Wish List Review & Outlook
When the first Wish List report was released on December 26, 2000 the benchmark U.S. index, the S&P 500, was at 1,305.95. 9-years later and the S&P 500 is at 1,126.80, or down 13.72% before dividends. There are many analysts - just as there was from 2003-2008 - who claim that you must climb aboard the equities train today because it is leaving the station; that while there is always the risk of losing money in the markets there is even greater risk to your portfolio by not participating in today’s rally. Armed with the devastating losses the markets have produced over the last decade, we would suggest ignoring anyone that offers such a belief.
Our opinion is that if you want to make money in stocks try to select solid companies you understand at attractive market prices. While we have wavered from this stance over the years, we still hold it as a guiding principle. Stocks today have priced in a great recovery that may or may not transpire, and valuations are stretched unless such a recovery does transpire. We are generally bearish on most stocks.
Since December 26, 2008 the ten Wish List companies selected – on an evenly weighted basis - have increased by 33.13% when including dividend payments and before taxes and commissions. During the same time (Dec 26, 2008 – Dec 24, 2009) the Dow Jones Industrial Average gained 24.22%, the S&P 500 gained 29.75%, and the Nasdaq gained 49.89% (to end only 55% below its all time high set in 2000). Using 2009 as the reference the Wish List outperformed the S&P 500 benchmark by a very small margin when including dividends. .
On an annualized basis the total return of the Wish List since inception is currently 18.5%, while on an average annualized basis the return has been 13.46% over the last 9-years.
We continue to believe that owning gold is an excellent way to hedge against a weakening U.S. dollar. We have favored gold (not necessarily gold stocks) since the first Wish List in 2000. The primary short-term danger we see with gold is the threat of global policy makers reigning in their stimulus activities. For example, if the U.S. Federal Reserve is raising interest rates by the end of 2010 and reducing the size of its balance sheet, there is the distinct possibility that gold could move significantly lower.
With that said, gold is not a 1-trick pony: there is the possibility that regardless of what the Fed may or may not do over the short-term, precious metals will benefit as central banks purchase more of the metal for reserve diversification, and investors continue to purchase precious metals in an anticipation of the next crisis. We envision gold trading at significantly higher (USD) prices in the future, although the timetable for further gains can not be known.
We will refrain from speculating on whether or not purchasing (more) gold is a safe idea right now with the metal trading near all-time highs. We will update our precious metals opinions online if they change.
Below is an alphabetical recap of the 8 companies that remain on the Wish List (loss/gains take into account dividend historical dividend payments)
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