Compass October 2010

In this issue:

Compass is the quarterly newsletter of Creekside Partners. All information is obtained from sources deemed to be reliable, but is not guaranteed as to accuracy. Nothing in this newsletter should be construed as financial or investment advice to any reader. All material herein is the copyright of Creekside Partners.

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Does the Winner Really Win? A race to the bottom usually ends up there.

Remember Sizzler?

The restaurant chain that opened in 1958 started an arms race with its casual-dining competitors in the mid-1980s to offer ever more food at evercheaper prices. The salad bar turned into an allyou- can eat buffet. More diners, paying less money, eating more food. Competitors responded in kind. In response, Sizzler began to cut its overall food quality. After a while, the appeal of all-you-can-eat of a mediocre menu began to wane and the chain’s customers moved on down the road. Chapter 11 followed and over half the locations never reopened. A number of open-buffet chains went the same way.

The world’s developed nations are engaged in a similar “race to the bottom” with their currencies. Everybody wants to have the cheapest currency. One nation’s currency is priced in terms of other nations’ currency. If you want yours cheaper, somebody else’s has to get more expensive. Since they also want theirs cheaper, they make the same moves you do. And so it goes, spiraling down until high inflation brings out the populace carrying pitchforks and pikes.

By lowering currency prices, nations hope to stimulate their economies by growing exports. Exports would grow since that nation’s goods will appear cheaper to foreign buyers. If the dollar falls 10% versus the Euro, a $1 million Caterpillar tractor will be 10% cheaper to a European buyer, versus a tractor made in Europe. More American goods flow to Europe.

Naturally, European policy-makers have an interest in seeing goods (and services) flow the other way. So they take steps to reverse that currency movement.

The steps that are taken are not complicated. The central bank goes out into the financial markets and starts buying up assets, bonds in nearly every case. Central banks prefer to buy government bonds (so as to have high-quality collateral for their currency), but they don’t get so picky in times of trouble. Our own central bank bought the defaulted remnants of Bear Stearns and AIG, along with a trillion or so of bad mortgage bonds.

The central bank pays for these bonds by essentially printing money. When the Fed buys a block of bonds from Goldman Sachs, Goldman naturally wants to get paid. When it asks for payment, the Fed just says, “Here you go,” and the money is magically in Goldman’s account at the Fed. You might ask, “Where did the Fed get the money?,” and we might respond, “Do you ask the Easter Bunny such questions?”

This process is euphemistically known as “quantitative easing,” and we’ve been talking about it since early 2009. One of us (Ashburn) was on CNBC a couple of days after Bernanke’s Jackson Hole speech in August where he hinted at once again ramping up the quantitative easing machine. This past week, central banks around the developed world began to take steps to get out ahead of Bernanke on this race to the bottom. As the Wall Street Journal headline put it, “Central Banks Open Spigot.”

All of these central banks are doing this for the same reason: to stimulate their own economies and soak up unemployment. The trick to it working is the same trick used when managing an all-you-can-eat restaurant: out-cheapen your competitors and hope you make it up in volume. I suspect that Sizzler initially saw a bump in revenues (analogous to a bump in GDP). In time, competitors would match prices; customers would begin to figure out what was going on; and the race to the bottom was in full swing. And we know where it ended up: if something can’t go on forever, it won’t.

The world’s central banks are engaged in just such a race. The race can’t go on forever, and nobody can really win it. When it stops, economies will find themselves with either a failed competition (employment didn’t improve) or a nasty hangover after celebrating their “victory” — in the form of an exploding money supply (and inflation).

And this is where investors need to decide just who they are and what they care about. And it comes down to this:

  • Do you care about being right in the short term? Or…
  • Do you care about being right in the longer term?

To be right in the short-term, you need to make investment decisions that are time sensitive. You need to be a trader — knowing what to buy, when to buy it, and — most importantly — when to sell it. Back in the late 1990’s, “everybody” just knew that the dot-com bubble couldn’t last. But “everybody” just knew they could time their exit just right. Likewise with the housing bubble.

We’re not suggesting there is an incipient bubble building now, but the principles apply.

In the short-term, central bank buying of bonds on a large scale serves to prop up the bond (and stock) markets with an artificial bid. Investors become comfortable with making aggressive bets on longerdated securities, such as stocks, long-term bonds and even REITs. In the short term, this is sensible since the Fed has said, “Don’t worry. We’ll take care of you.”

When the central banks pull their standing “buy” orders out of the markets, we expect the markets to react badly. In the summers of 1987 and 1994, the Fed pulled its buy order abruptly and interest rates rose several hundred basis points and major stock corrections ensued.

To buy long bonds and stocks in the current environment is to ignore fundamental principles of valuation. The per-share earnings of stocks has fully recovered to levels consistent with long-term GDP growth1. If earnings are back to long-term trends, then long-term price/earnings ratios should apply. And they don’t — stocks are currently trading about 15% above sensible long-term P/E ratios.

So then…why buy more stocks now? Because you might figure that other investors will continue to be enamored of the Fed’s paternal promise to bail them out, and they’ll keep driving up stocks. It’s a shortsighted decision and you are welcome to make it if you are smarter and more nimble than the rest of the market.

We care more about being right 4-5 years from now. That longer and wider time horizon frees us from the trader mentality. It allows us to focus on the timeless analysis of valuation. Stock indices will always revert to some modest multiple of the long-term earnings capacity of the companies making up the index. That multiple is in the 17-18 range, in our opinion. (They are currently trading at a multiple of about 21.)

Turning to the bond market, again we think about valuation. We don’t need to guess at the “earnings” from a bond — the earnings rate is printed right on it. What we need to be concerned with is inflation, since, unlike company earnings, the bond’s annual payment will not rise with inflation. If a bond pays us 2.5% and inflation is 4%, we lost 1.5% per year while we held the bond. Our value analysis of bonds consists of comparing today’s bond yields to our longer-term inflation expectations. By that measure, the government bond market is wildly overvalued.

If the Fed is successful in participating in the race to the bottom, it will continue to bloat its balance sheet and, eventually, the money supply. Higher inflation is a certainty. We don’t know the timing of that shift. As value investors, we don’t have to get the timing right — we are investing to be right 5 years from now, not necessarily right every step along the way.

Our current tactics are to underweight the stock market, keep bond maturities short and hold a little energy and natural resources. We will be content to watch this destructive little race from the sidelinesand get back in the game when it’s over.

Rick Ashburn & Andy Hempeck

1 As an aside – keep in mind that earnings per share can not, will not, and never have grown faster than GDP over extended periods. It’s pretty much a mathematical impossibility. In fact, a dirty little secret of investing is that earnings per share have grown at a significantly slowerrate than the broader economy for more than a century. Economy grows ~3.25%; EPS grows ~1.8%. On a per share basis (the only basis that matters to you and me), publicly traded companies don’t even keep up with basic economic growth,.

Major Asset Classes Valuation

Economic Factors
Headwind or Tailwind?

Inflation. Inflationary pressures remain low only in the short term. Those pressures are most assuredly higher if we look out past the end of our noses.

Employment growth is nil; millions of people want jobs they can’t find; millions more are working part-time; millions more have given up for now and are “sitting this one out.” Industrial capacity utilization rates are above their 2008-09 lows, but are actually down in the year ended August 2010. The current figure of 74.7% should be compared to the 1981 recessionary low of 76.8%. We’re supposed to be climbing out of a recession, but we’re still worse off than the low of 1981! In that era, inflation peaked with capacity utilization rates in the 84-88% range. We’re a long way from that sort of pressure on our industries to crank out more goods with fewer resources.

We do not anticipate any significant inflation in the (very) near-term. However, the Fed will eventually get what it wants, and what it wants is inflation. 20 years of 4% inflation pays off more than half of today’s national debt. And that, my friends, will ultimately be the choice of policy makers from all political stripes. The monetarist/Austrian School economic theorists can wring their hands in anguish in ivory towers all they like, but voters ultimately force politicians to be practical. Voters want the easy way out, and mild persistent inflation is the easy way out.

Since our appearance on CNBC when we warned of the Fed’s eagerness to create money and buy bonds, they have ramped up their rhetoric in preparation of doing just that. Short-term: no inflation. Longer-term: brace yourselves.

Bond Interest Rates. Longer-term bonds continue to perform strongly (yields low and getting lower). We moved into shorter maturities in Q4 2009, bringing our average maturity down around 2 years. Even without inflation, long bond rates are in trouble. As is the usual plan in such an environment, we have to be patient and earn measly shortterm interest rates and then pounce when long bond rates are high enough to compensate us for our long-term inflation outlook.

Corporate Earnings. Earnings recovery has flattened, but at a level consistent with a fully recovered economy (yes, really). Companies are profitable but are “hitting the wall” on eeking more productivity out of existing staffing. Top-line revenues (“sales”) remain stagnant.

Companies seem reluctant to hire or expand. We can’t say we blame them since households remain strapped and scared.

Real Estate. Housing remains in bad shape. In many parts of the country, house prices still don’t fit into a genuine healthy long-term household financial plan. History and math tell us that a household should spend no more than 2.5 to 3 times its annual income on a house and still have enough lifetime earnings left over to put kids through college/ trade school and save for retirement. In California, the median home price is still about 5 times the median household income — despite the spectacular drop in home prices.

Yield Curve Shape. The shape of the yield curve is defined by how much rates rise as we move from shortterm rates (e.g., money markets) out to longer term rates such as 5– and 10-year bonds. We lamented the flatness of the yield curve back in early 2007, arguing that a flat yield curve is a precursor to economic slowdown (hardly anyone believed us!). Now we have a steep yield curve again — the essential ingredient to productive business investment and a growing economy. An upward-sloping yield curve is the mother’s milk of capitalism.

Placing Gold in Context

Obviously gold has been in the headlines a lot lately and we watch this precious metal on a regular basis. My brother in-law (who enjoys speculating) recently sold an American Eagle Gold Bullion coin for a nice profit. The transaction piqued my interest and caused me to dive into the numbers further and get a better handle on this precious metal that has been a news and market favorite as of late.

According to the World Gold Council, the total global gold ever mined is approximately 168,000 tons (32,000 ounces in a ton). Gold is trading at $1,347 per ounce as of October 6, 2010. That puts the total global value of gold at a bit over 7.1 trillion US dollars. According to the USGS global mining is producing an additional 2200 tons per year. These are not trivial numbers, but should gold be a big part of your investment portfolio?

Many people will tell you gold is an inflation hedge or a hedge against the dollar weakening, but unless you are willing to make a significant allocation in your portfolio, say in the neighborhood of 30%, gold is not truly a hedge. Most investors buying Gold ETF’s or Gold mutual funds are only speculating on its future price. We would not be surprised to see gold head higher from today’s levels and we would not be surprised to see it sell off either.

World Gold Holdings, 2008 (Source: World Gold Council)

Type of Holding Percentage Approx. 2010 Dollars
Jewelry 52% $3.7 trillion
Central Banks 18% $1.2 trillion
Investment (bars, coins, etc.) 16% $1.1 trillion
Industrial 12% $0.853 trillion
Unaccounted 2% $0.142 trillion

The global stock market value is in the neighborhood of $50 trillion. Imagine for a moment that global investors decided to move a mere 10% of their asset allocation from stocks to gold. That’s 5 trillion dollars moving into gold — more than the total amount ever produced in history in the hands of investors and central banks. That’s more than 50 times the total annual new production of gold.

This highlights the precariousness of extending microeconomic principles out to a grander scale. If a few of us buy gold, the price might move smoothly at the margin, just as economic theory suggests. But if lots of people are suddenly chasing after (or selling into) a fixed amount of the stuff, prices will not behave nicely. The market will exhibit what the “chaos theory” mathematicians call non-linearity. Normal price movements might be likened to a path of stepping stones meandering around a pond. They might or might not be heading where you want to go, but at least each stone is right in front of the last one.

When markets behave non-linearly (or, chaotically), you might suddenly find that the next stepping stone is 20 feet off to your left and the only way to move forward is to take a bath.

History can tell us a great deal and the lesson to be learned is that, historically, gold has been used as jewelry. If you truly believe it is going higher then buy your significant other a nice piece of gold jewelry and you will be in a win a win situation.

Andy Hempeck

2010 Year to Date Index Returns

Large-Cap U.S. Stocks

Small-Cap U.S. Stocks

Foreign Stocks (Developed)

Emerging Market Stocks

REITs

High-Yield Bonds

High-Grade Bonds

Inflation

(year-over-year Aug 31)

3.79%

10.53%

&nbsp1.07%

13.07%

19.44%

10.38%

7.88%

+1.15%

Wherever applicable, we use the returns on Vanguard Index Funds as the benchmark figures for various asset classes.

Readers wishing to review the actual performance record of a composite of our client portfolios should call or email us at info@creeksidepartners.com.