The news of the day was that JP Morgan Chase, held in esteem by many as the pre-eminent mega-bank, had sorely miscalculated and lost a couple of billion dollars or so on what was characterized as a “hedge.”  These guys were reputed to be the best and the brightest.  If this was a hedge, where are the offsetting profits?

This debacle was not the work of a single rogue trader.  Allegedly, the decisions were made in the Chief Investment Office.

Late in the day, Fitch downgraded its ratings on the bank’s long-term debt and indicated that all the bank’s debt was on credit watch negative.  The ratings agency indicated that the magnitude of the loss implies a lack of liquidity.  Fitch also stated that the complexity of the bank’s operations makes it difficult to assess risk exposure.

Onerous as a multi-billion dollar loss might be to the House of Morgan, by itself it won’t threaten the bank or the banking system.  Two important questions present themselves, however.  1) Is this a stand-alone sour derivative trade or–according to the cockroach theory–having seen one, can we assume that there are many still to appear? And 2) Could this be a common trade in the banking industry, which might fall apart at other giant banks as well, cummulatively causing risk to the system?

Common sense dictates we should not have to worry about such questions.  No bank should be so large that it could threaten the financial system and, therefore, be too big to fail.

My March 30th entry on this site recounted several quoted sections from the Dallas Fed’s annual letter in which Dallas regional President Richard Fisher argued powerfully and convincingly against allowing any bank to be too big to fail.  In light of this most recent example of giant errors from giant banks, more taxpayers must demand that we not be held liable ever again for bailing out mega-banks that are allowed to speculate to the degree that they obviously continue to do.  I urge you to read my March 30th entry, “A Powerful Ally Against Too Big To Fail.”

One quote from that Dallas Fed report underlines the scope of the danger that we narrowly escaped just a few years ago.  “The term ‘too big to fail’ disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.”

That government assistance either comes out of your pockets and mine or those of our grandchildren or their grandchildren.  Notwithstanding how much of that assistance has been recovered this time through the continuing largesse of essentially free money from the Fed, it must never occur again.

Much of this week has been spent in preparation for our client seminar next week, leaving me no time to write a new entry for the blog.  Instead, I am reprising the first major piece I wrote warning about a coming top to the stock market rally of the 1980s and 1990s.  We sent it to clients as our year end letter in January 1999, almost exactly one year before the stock market peaked and prices plummeted by almost 50% on the S&P 500 and almost 80% on the NASDAQ Composite.  Prices today are still more than 10% and 40% respectively below the 2000 peaks in those two indexes.

We titled the report The Fiduciary’s Dilemma.  We had alluded to the growing debt crisis in prior reports, and it became a more frequent topic as the debt mountain continued to grow.  In this particular report, however, we focused on evidence that extreme valuations had created a condition of extreme long-term risk for all equity holders.  While today’s conditions are different in many respects from those of thirteen years ago, there are many lessons to take from the experiences of that earlier era.  Had investors properly heeded them, their portfolios would almost invariably be healthier today.

While this piece is long, I hope you’ll find it an interesting and educational trip back in time.

Quarterly Report
January 1999

The Fiduciary’s Dilemma

The fiduciary with responsibility over any institutional investment portfolio is confronted with the most perplexing conundrum of his/her career.  Interest rates on long term bonds, at just a bit over 5%, are near their low yields of the past 30 years.  Rates on shorter, less volatile fixed income securities are even lower.  In an era in which double-digit returns from common stocks have become commonplace, there is little attraction to the fixed income sector.  Because historically outsized returns have accrued to common stocks almost every year for more than a decade and a half, most fiduciaries have known no other environment during their periods of responsibility over these institutional assets.  On the surface, the investment answer is obvious.  Buy stocks and enjoy the ride to ever-higher portfolio values.  After all, the long-term statistics all verify the wisdom of that course of action, and the analysts and strategists profiled on TV’s business and general news shows urge you toward that path every day.  The conundrum arises, however, for fiduciaries that know more than just the financial headlines.  To participate in stocks at these market levels requires fiduciaries to pay far more for ownership than at any prior time in U.S. history.  And unbroken precedent teaches the fiduciary that even when fervor for overpriced stocks has been far less euphoric than it is today, major losses of portfolio value have preceded any long term increase.  What’s a fiduciary to do?

A great many factors shape the environment in which common stocks rise or fall: interest rates in this country and around the world, current business conditions domestically and internationally and investors’ outlooks for such conditions in the quarters and years ahead, current corporate profits and their prospects for growth or decline, the current and potential returns on competing non-stock investments, the supply of money being pumped into the system, and the level of investor confidence in the prospects for future stock profits.  Some of these factors are currently positive, some negative.  Let me summarize the condition of each of these variables.

Interest rates both in the United States and in most of the major industrial countries around the world are very low by the standards of recent decades.  Some of the former Asian tiger countries and a number in Latin America which are struggling to defend their currencies are in stark contrast with rates well up into double digits.  Slowing business conditions in the U.S. will continue to put downward pressure on domestic interest rates as we head into 1999.  A possible wildcard in the U.S. interest rate picture, however, would be the repatriation of capital by Japanese or European investors.  Both are holders of very large quantities of U.S. debt in the form of bonds.  Should either contingent, either because of the need to shore up Japanese yen-denominated investments or because of a desire to diversify into new Euro-denominated securities, pull substantial funds from U.S. investments, our interest rates could spike upward, driving bond prices down.

U.S. business conditions remain relatively healthy. Fed Chairman Alan Greenspan has warned, however, that it is unlikely that the United States will remain an island of prosperity in an unhealthy international environment.  A serious recession still claims most of Asia with only a few glimmers of hope in selected Asian economies.  The 500-pound gorilla remains Japan.  There are faint signs of a few economic upticks there, but some analysts attribute those to the recent outburst of government spending which cannot be sustained.  Japanese banks remain in serious condition with the amount of acknowledged bad loans growing by the week.  The Japanese economy has been weak for nearly a decade, and most analysts expect that it is at least a few years away from a significant recovery.  In Latin America, Brazil has recently devalued its currency, and there is no certainty that it will not be repeated.  Despite the $41 billion rescue effort being undertaken by the International Monetary Fund, questions still exist about whether Brazil will be able to repay its debts in 1999.  As the economic engine of Latin America, continuing economic travail in Brazil would inevitably infect the rest of the region with serious consequences to companies that export there.  The Canadian economy remains less than vibrant, and Europe is slowing.  In the eighth year of the current business advance, it is questionable whether the U.S. can grow much longer with overall world business slowing.  When looking several years down the line it is important to realize that even the most optimistic economists see the U.S. Gross Domestic Product growing significantly less than it did in the earlier decades of this century.  That is typical of mature economies.  They tend to grow less rapidly than young, emerging economies.  This should be a sobering realization to all who ignore history in the belief that the Internet and high speed computing make this an investment environment in the United States unlike all earlier ones.  No matter how much innovation occurs in the United States, there is a wide world of eager, sophisticated business people ready and willing to compete away any excess profit advantage that exists here.  The U.S. cannot protect such an advantage for long.  That is the flip side of instantaneous data transfer and globalization of business.  These factors considered, it becomes clear why Chairman Greenspan cautions that we will not long remain an island of prosperity.

U.S. corporate profits have stagnated in 1997 and 1998.  After very strong corporate earnings growth from 1992 through 1996, earnings have barely budged since then.  Standard and Poor’s reported that the growth in earnings in the S&P 500 companies was 2.6% in 1997.  They estimate that 1998′s final figures will show a decline of 1.5% in S&P 500 earnings.  In each of the past two years investment analysts, an inherently optimistic crowd, forecast earnings growth near 20%.  That group remains optimistic for 1999 as well, although their enthusiasm has been slightly muted because of the experience of the past two years.  In fact, in a recent study Value Line reported that its analysts have made upward revisions of their earnings estimates on 89 of the stocks that they follow and downward revisions on 394.  That is the largest disparity since early 1991 when the United States was in recession.  In Value Line’s 30 years of experience, they have found that revisions in either direction tend to be followed by future adjustments in the same direction.  In other words, initial revisions tend to be understated.  This bodes ill for the earnings forecasts for 1999.  For the time being at least investors are paying scant attention to corporate earnings.

The dividend yield on the stocks in the S&P 500 is 1.3%.  If a broader base of stocks were considered, the yield would be even lower.  Obviously today’s stock investors are not buying primarily to get the dividend.  They are counting on substantial capital appreciation to justify their purchases.  That expectation has been rewarded like never before over the past decade and a half.  Will it continue in the years ahead?  Throughout most of this century the average total return on common stock has been about 10% per year.  That return has come on average from approximately a 4% dividend and a 6% capital appreciation.  The yield on high-grade bonds has generally been in the neighborhood of 150% of common stock dividends, or about 6%.  Today, stock dividend yields are so low that high-grade bonds yield over four times the amount of the common stock dividend.  In past decades even approaching that disparity between stock and bond yields has led to significant declines in stock prices.  Over time investors also compare stock yields with the yields on non-security investments.  Real estate has traditionally been a competing asset class to common stocks.  Commercial real estate, residential real estate and raw land have all proved more or less attractive in different time periods.  With dividend yields so low, virtually any income producing real estate is today offering a greater return than common stocks.  The only advantage to stocks in the years immediately ahead would come if their capital gains outstripped the increases in real estate prices.  Real estate in most parts of the country is far less overvalued than are common stocks.

The rapid increase in the supply of money is one of the primary causes of the continuation of this great bull market.  Perhaps afraid of the disinflationary and deflationary forces apparent around the globe, the Federal Reserve has been pumping money into the system very aggressively over the past year with the rate increasing in the most recent quarter.  When such money cannot find a good business purpose, and many companies have pulled back on their capital spending, it often finds its way into stocks and bonds.  Because the U.S. has not been experiencing any significant inflation, the Fed has been able to lower interest rates and pump plenty of money into the system.  Chairman Greenspan and other members of the Fed’s Board of Governors continue, however, to issue warnings about the potential for an increase in inflation.  They know that these loose money practices have traditionally led to inflation.  Should inflationary trends surface, the Fed would almost certainly tighten the money supply and raise short-term rates.  That would be a very difficult environment for common stocks, even if they were not more overvalued than ever before.

The single most important reason for the continuation of this greatest of all U.S. bull markets is the massive levels of confidence that investors have that stock buying presents no long term risk.  On the contrary, today’s stock buyers, according to recent surveys, believe that they will reap rewards near 20% per year for the next decade or longer.  Such levels of confidence are rare in U.S. history and have only occurred after many years of almost uninterrupted stock market gains.  In the past, such levels of enthusiasm for stocks, never as great as today’s, have marked market peaks, not periods preceding continuing market advances.  Such periods have also been characterized by dramatic excesses and the belief that such behavior was not really excessive.  Today we have the example of the Internet stocks, which have clearly become a bubble sector.  Prices have been pushed way beyond the realm of reality.  For example, America Online has a market capitalization of about $80 billion with 1998 earnings of $230 million.  Amazon.com, the online bookseller, which may or may not ever make any money, reached a market capitalization just a few weeks ago of over $30 billion. That’s worth more than the country of Norway.  Yahoo, with a market capitalization a few weeks ago of $44 billion and 1998 earnings of about $45 million, is worth more than all the stocks on the Singapore stock exchange.  These companies and others in the same industry have all been founded in the past several years.  The industry’s technology is evolving, and no one knows what the industry will look like five years from now, much less over the long term.  Very likely the leaders of this industry ten years from now are not even on our radar screens yet.  Many of today’s hottest companies will likely never make a profit and will fade from the scene in the years ahead.  That notwithstanding, nearly $250 billion of investor money is in these stocks today.  It is pure speculation that many professionals are masquerading as investment.

Some argue that while they don’t know which Internet companies will be the long-term leaders, it is prudent to participate in the group even at these extreme prices because it is the wave if the future. That echoes the claims of decades past about stocks in a variety of emerging industries. In the late 19th century, investors thought they had a sure thing with the advent of electricity. We hear talk about the Internet as a reason for looking at this as a new era justifying new investment principles and standards. Imagine how much more dramatically people’s lives were changed by the widespread introduction of electricity. Most of the advances of the twentieth century were made possible through the use of electricity. At different times the spread of rail transportation and the advent of automobile and air transportation shrunk the size of our country and our globe, facilitating the movement of people and goods. The development of telephone technology and the spread of its use fostered instant communication across the globe. The developments in medicine and biotechnology lengthened lifetimes and the quality of life. The invention of the computer and the development of its technology have changed the face of business, the pace of knowledge development, and in many respects our ways of life. Each in its own time was a reason offered by optimistic investors as justification for looking upon that period as a new era making outmoded past market and economic principles. Amazingly, the time-tested measures of value have survived these and all other societal changes of lesser magnitude over the past century. That unwavering consistency should lead any good student of market history to look askance at the new era claim that “It’s different this time.” That becomes an even more obvious conclusion when we realize that the screaming overvaluations in the U.S. stock market in January 1999 are not mirrored very widely. Severe overvaluation is, for the most part, limited to a relatively small number of western stock markets. Formerly dramatically overvalued Asian and Latin stock markets have been smashed to fractions of their former highs. Real estate in the United States and elsewhere around the world, which exhibited extreme valuations in some areas, was severely cut in price from the extremes. At different times and in different sectors various types of art and other collectibles have seen the bottom fall out of their markets. A few western stock markets are among the relatively few areas that have so far resisted revaluations to more historically normal levels. Despite the near reverence in which are held Alan Greenspan and his fellow Federal Reserve governors, U.S. investors have disregarded their repeated warnings of “irrational exuberance” and insufficient earnings to justify today’s stock prices. Investors are basically disregarding anything that could disrupt the party.

It is important to recognize what stock buyers are paying today. The S&P 500 is selling at about 33 times its 1998 earnings. Since its beginning, that index has sold on average at just over 14 times its earnings. The S&P 500 is selling at more than 75 times the dividends being paid out by those 500 companies. Historically the stocks in the index have sold at about 26 times what they have paid out. The industrial stocks in the S&P are now selling at over 5 ½ times their book values. Over the past 71 years those stocks have sold on average at 1.9 times their book values. Throughout this century stocks have routinely sold above and below their long-term average valuations, although never more above than they are today. Invariably they have reverted to their long-term mean levels of valuation. Almost certainly they will again, whether quickly or in the years ahead. If the Dow Jones Industrial Average instantly reverted to its normal valuation levels, it would have to fall into a range between about 3100 to 4100. From 9200, where it rests today, a decline to that range would necessitate losses ranging from 55% to 66%. Many today see such a decline as inconceivable. In the United States we have only three instances in this century in which investor sentiment has even approached today’s unprecedented euphoria for stocks: in the late 1920′s, the late 1930′s and the late 1960′s. The ultimate price declines from the market highs that accompanied these peaks of investor sentiment were 89%, 52% and 45% respectively. More recently the runaway Japanese stock market that peaked in the late 1980′s reached a low last year 67% below its high of nearly a decade earlier. We have not one precedent in any major industrial country’s 20th century stock market history of a severely overvalued market avoiding a major loss (usually over a period of several years) before ultimately advancing on a more sustainable basis. Perhaps even more disheartening, the recovery periods to the former high prices have been discouragingly long, 25, 12 and 16 years respectively in the United States. It has been over nine years since the most recent peak in the Japanese market, and Japanese stock prices are still 63% below those former highs.

Many of today’s investors anticipate that they would simply ride out any decline. They profess a long-term orientation, and many see any decline as an opportunity to buy more stocks. If markets continue up in future decades as they have in the past that is a sound plan. Unfortunately, even the soundest plans can be confounded by highly fallible human beings. By way of most recent example, fiduciaries should review the responses of their board members after the brief but sharp market crash in 1987. Many fiduciaries were very reluctant to recommit money to stocks after stock prices fell 36% in less than two months in late 1987. That is consistent with what fiduciaries have done after every sharp market decline, especially when the price decline has taken over a year or more. The tendency to avoid stocks becomes stronger the longer a decline lasts. From personal experience I can vouch for the difficulty of convincing fiduciaries to commit significant portions of portfolios to common stocks after the markets have been non-productive for years. For the entire decade from the mid 1970′s to the mid 1980′s, the price to earnings ratio on the S&P 500 ranged from about seven to thirteen times earnings compared to today’s 33 ratio. Despite stocks selling at extremely cheap prices for an entire decade, almost nobody wanted to own them. Of course, investors who accumulated large amounts of cheap stock while it was on the bargain table ultimately reaped high rewards when those stocks eventually reverted to and beyond historically normal higher valuations. Unlike the behavior of potential investors in that decade of ultra cheap stock prices, today’s investors can’t get enough stock despite the fact that it is more expensive than at any prior time in U.S. history. Before the decade of the 1990′s, investors who purchased stock at below normal valuation levels have always had significant profits five and ten years later. Conversely, investors who have purchased stock near overvaluation extremes have always shown net losses five and ten years later.

For all their long-term predictive properties, valuation measures are not precise short-term forecasters. Investor sentiment can carry a market from one extreme to an even greater one, especially if augmented by infusions of additionally liquidity. The markets behavior in the past quarter is an excellent example of that. When cumulative world problems led the market to its early October lows, the Federal Reserve came to the rescue with three cuts in short-term interest rates, and they revved up the money supply. That rekindled investor enthusiasm to recent unprecedented heights. The world’s financial problems have not disappeared, however, and corporate earnings are now slowing or declining in most of the world. While the Federal Reserve could still reduce rates again, pressures could arise in 1999 that might lead to a Fed tightening.

A very important short-term consideration is the technical condition of the market. While the major stock averages are currently at or near their all time highs, they have been led there by a disproportionately small number of companies. Because the S&P 500 and the NASDAQ are capitalization-weighted indexes, the price performance of the largest companies is far more important than the price performance of average sized companies. In 1998 the S&P 500 was up 28.6%, despite the fact that roughly two-thirds of the stocks showed a loss for the year and the average stock declined by 4% in 1998. The index showed such dramatic gains while most stocks were down because of the spectacular performance of large stocks such as Dell Computer (+248%), EMC Corp (+210%), Lucent Technologies (+175%), Ascend Communications (+168%), and Cisco Systems (+150%). With Price/Earnings ratios of 97,78,60,75 and 80 respectively, these stocks were obviously the provinces of traders and longer-term buyers willing to suspend belief in the need for visible earnings. No value stock buyers true to a value orientation (like Marathon) could touch stocks at valuations like that. In such an environment growth stock managers will certainly outperform value managers who stay true to their time tested disciplines. It is instructive to note that growth stock managers always outperform value managers in the periods just before major market tops. It is also important to recognize that the vast bulk of the pioneer leaders in the industries discussed earlier as society changers in the past century (electricity, railroads, automobiles, air transport, telephones, biotechnology and computer technology) either went out of business or suffered major stock price collapses after the period of initial euphoria. That fate may befall most or all of today’s Internet leaders. Apropos of 1998′s market leaders, which are all in the high tech sector, it is important to know what has happened to the high tech market leaders of the past. Twice before, from the late 1960′s to the early 1970′s then again in the early to mid 1980′s, computer technology grabbed the investing public’s attention, and the prices of these stocks skyrocketed. In a fascinating study of the leading two to three dozen firms from those eras, Marc Faber published results in Barron’s that showed the average loss of the leading tech stocks to be about 85% from their highs to their lows in each era. While the growth stock tech jockeys are riding high right now, they will almost certainly experience the down side of the roller coaster in the quarters somewhere ahead.  Such declines have been gut wrenching in past bear markets.

While trying to make short-term market calls is a perilous business, there are ominous signs today. It is rare that major investment indexes rise very long once the majority of stocks start to decline. While the market averages are currently near their highs, more stocks have declined than have risen since April 1998. That is a pattern that has preceded most stock market peaks throughout history. The analogy Wall Street has used for decades for this condition is that of the generals leading and the troops not following. It is considered an ominous condition usually masked by the highly favorable publicity accorded the market leaders. That is exactly what the market is experiencing today.

This brings us back to the fiduciary’s dilemma.  Should (s)he either stay committed or become more committed to common stocks which have been an unrelenting engine of asset growth virtually without interruption for more than a decade and a half?  Or, conversely, should the fiduciary keep minimal exposure to common stocks in recognition that in no major stock market in this century have common stocks reached levels even close to current valuations without suffering serious losses, some of which have lasted for a decade or more?  If the latter choice is made and the markets continue to climb in the year ahead, there will be inevitable regret that opportunity for profit will have been foregone.  If fiduciaries choose the former course, which is the advice of the majority of today’s market analysts, and the markets ultimately do what they have always done, the portfolio will experience significant losses that may not be recovered for years.  An even bigger danger would be that current or successor fiduciaries might lessen the exposure to common stocks after major losses, which is what fiduciaries have done after every major market decline in this century, thereby fully realizing the losses and lessening the potential for future recovery.  The lesson of history is clear, but throughout history the majority of fiduciaries have consistently chosen to follow more popular current sentiment, rejecting historic precedent.  At every major market top and bottom throughout the century, however, following the popular belief proved wrong and historical precedent reasserted itself.  It does create quite a conundrum.

Many themes for these blog posts come from friends’ and clients’ questions.  This week two friends asked about prospects for generating more income.  We’ve written on this topic before, but in an extremely low interest rate environment, further analysis seems appropriate.

A starting point in any discussion should be recognition that you can almost always find greater yield.  Most recently, you could have bought a one-year government bond with the promise of more than 100% return on your money. Unfortunately, the government was Greece just prior to its recent default. That example is extreme, obviously, but the underlying principle is important to recognize.  At least with respect to publicly traded securities, there’s no such thing as a free lunch.  No issuer of securities will gratuitously offer more yield than necessary to find buyers.  If any security provides a better than market average yield, you can count on the fact that a buyer will be assuming greater than market average risk.  Don’t for a minute believe that your research has uncovered an underappreciated opportunity.  Recognize that you are competing for yield against the wealthiest, most powerful financial entities in the world.  Not that such entities don’t make occasional giant mistakes, but it’s rarely because they didn’t know about an opportunity that you found.

If that principle is true, what accounts for worldwide financial giants pouring unprecedented amounts of money into securities yielding effectively zero and losing money after inflation?  A prime example this week came from Germany, where the two-year government note was sold at a majestic yield of 0.089%.  In other words, investors were willing to loan money to Germany for two years for a mere $890 per million per year, the lowest return in the euro-era.  These investors didn’t overlook the alternatives.  Their behavior is simply a quintessential example of investors concentrating on the return of their money rather than the return on their money.

While some do, most investors don’t look first to equities when looking to boost yield. In fact, high dividend-paying stocks have become a popular theme in recent quarters.  But such stocks are far from risk-free.  While a meaningful dividend can provide a helpful buffer when markets are not advancing, we urge investors not to ignore price fluctuations.  Utilities, typically payers of substantial dividends, provide a clear example of how a quest for yield can be penalized in weak market environments.  From its peak in 2000, the Dow Jones Utility Index fell over 60% in less than two years.  No amount of income can compensate for such a precipitous decline.  While that index’s nearly 50% decline in 2008 was a bit less severe, it certainly defeated the purpose for those who bought supposedly conservative income producers when the broader stock market looked toppy.  More than four years later, the index is still far below its 2008 peak.

Far more typical for investors looking to boost yield is a turn to bonds.  Bonds have, in fact, been a sound–if only moderately profitable–investment over most of the past decade.  Unfortunately, most bond yields are at or near hundred year lows, which makes future profit potential problematic at best.  Any rise in interest rates will take away the yield and very possibly turn total return negative.

The Federal Reserve’s reduction of short-term yields to virtually zero was designed to force yield seekers out into riskier investments.  Many have ventured into municipal bonds, high yield (junk) bonds and emerging market debt.  So far, those approaches have justified the risks assumed.  Future profits become increasingly improbable, however, with rates as compressed as they have become.  The erudite James Grant, publisher of Grant’s Interest Rate Observer, has spoken and written eloquently and often against the Fed’s financial repression.  He argues that Fed actions have created mispricing across a broad array of assets.  When investors are desperate for yield, they have a strong tendency to accept the most attractive alternative, even if it falls far short of its historic value.

It is important to recognize that total return is as critical for bonds as it is with utilities.  Simply holding bonds to maturity can be destructive to wealth if inflation rises appreciably in the interim.  Emerging market bonds have always been volatile, and each carries its own country-specific risks.  High yield (junk) bonds currently appear particularly attractive relative to government and agency bonds with minimal yields.  Newcomers to the high yield arena should recognize that investor fear can be destructive to junk bond prices.  From late-2007 to early-2009 the IShares High Yield Corporate Bond Index fell by more than 40% and today sits about 15% below its earlier peak.  It’s also worth recognizing that when economic times get tough, junk bonds default at uncomfortably high rates.  Even municipal bonds, looked upon by many as extremely safe, have experienced substantial volatility in recent years.  In 2008, when there was fear that many municipalities would be unable to meet all their obligations, the average municipal bond dropped in price by 17%.  Just over a year ago, muni bonds suffered another double-digit price decline.  At such price troughs, the news is invariably bleak, and many sell with losses.  Furthermore, if prospects for other assets look more attractive, sales at losses might be necessary to raise capital.

As was the case after equity investors had experienced the 50% decline from the turn of the century into early-2003, people are turning again to real estate.  The rationale for most is different today, however, from that of eight to ten years ago.  In the earlier instance, real estate, fueled by cheap and easily available money, was soaring.  Heavy leverage was multiplying profits.  People were leaving their jobs to become condo-flippers, reminiscent of the earlier era of day traders who similarly sought the path to easy riches during the dot.com bubble.  Once chastened, real estate investors are today a more sober group, seeking yield through more conservative investments.  Others are buying up foreclosures or otherwise available properties at prices far below their peaks of a few years ago.  These investments may prove profitable, but they are probably not as low risk as they appear on the surface.

The common assumption among those turning again to real estate is that the crisis has ended and that, even if progress remains slow, we have lived through the worst.  For the good of the United States, we have to hope that to be the case.  Stock market behavior over the past decade, however, should give pause to those with a high degree of confidence that risks to newly deployed real estate capital are minimal.

Following the nearly 50% stock market decline from 2000 to 2002-03 (nearly 80% for the Nasdaq), investors began to pour money again into stocks as prices began to rise, the Fed remained accommodative and the worst seemed to be in the rear view mirror.  Traumatic as the market collapse had been, investors reflected back on the prior two decades in which buying every major market decline proved profitable.  They resolved not to lose sight of the rewards that accrued to those who were willing to buy into the early stage of each new bull market.  For some reason, however, this time was different.  Those who got back into equities after the 2003 bottom saw all of those profits and more taken away in the second market collapse from 2007 to 2009.  What they did not recognize was that we had entered a long weak cycle in 2000 similar to three predecessors in the twentieth century, the last of which was from 1966 to 1982.  In each of those instances, it had taken three or more major stock market declines to wipe away the excesses of the prior long strong cycle.  Premature buyers had profits unceremoniously taken away.  Investors couldn’t buy profitably for the long term until those excesses were expunged.

The very real danger for today’s real estate investors is that they could experience a similar fate.  The debt excesses of the prior long strong cycle have not only not been eliminated, they have been exacerbated in many major sectors.  It is likely that real estate investors are subject today to the same macro concerns and considerations that affect stock market investors.  While it is true that all real estate is local, the past decade has demonstrated conclusively that macro factors affecting the broad U.S. or world economies can put extreme pressure on local real estate.  With several major countries throughout the world (including the U.S.) in severe debt distress, a disorderly unraveling of that debt could quickly envelop most of the world in another significant recession.  As fragile as our domestic recovery has been, such an event could again wreak havoc on both residential and commercial real estate.  As illiquid as most real estate is, it would be difficult to adjust quickly to such a changed economic environment.

Some advisors have recently recommended annuities as an approach to raising client income. That approach could make sense if interest rates stay low for many years.  Buyers should recognize, however, that annuity rates reflect current interest rates and are near historic lows.  Should severe inflation result over the next several years in response to the flood of new money flowing out of the world’s central banks, returns on current annuities may fail dismally to keep pace with the cost of living.  And if punishing economic outcomes occur because the debt crisis unravels, some of the most impacted firms will be those financial organizations that offer annuities.  It is imprudent to put more money in an annuity than you would be willing to invest in a bond issued by the same company.  Financial firms have been known to fail.

It is possible, though not likely, that governments and central banks may succeed in solving the world’s debt crisis by issuing far more debt.  If they fail, however, the penalties on those who stretch for yield could be severe.

Unpalatable as patience is, it is likely to be the most profitable prescription in the long run.  In an unstable economic situation, it is unlikely that interest rates will stay low for long.  Rather than putting money in potentially mispriced assets, you will almost certainly be better served in the years ahead by preserving capital, accepting low-risk returns in the near term and keeping assets liquid to take advantage of prices that could be extremely volatile for many years.

For more than a quarter century, we have urged investors to maintain a high degree of portfolio flexibility. With countries and banks around the world currently on the edge of insolvency, that message has never been more important. Since Y2K, investors with traditionally structured portfolios containing relatively fixed allocations to stocks and bonds have not fared well. Despite two rallies of more than 100% each, the S&P 500 has returned a mere 1.35% per year since the market peak in 2000, a dozen years ago. Despite not participating heavily in those strong up phases, Mission’s clients have seen portfolio values rise by 70% century-to-date before fees, which vary based on portfolio size. In addition to long-term portfolio performance advantage, clients have benefitted by being able to sleep soundly. Their portfolios earned positive returns in eleven of the twelve completed years of the 21st century. Only a loss of less than 1% in 2008 marred an unblemished record. With the S&P 500 dropping by 37% in that ill-fated year, few lamented a fractional loss. We anticipate that our flexible asset allocation approach will continue to provide great benefit in the years ahead with massive uncertainty affecting world economies and virtually every investment asset class.

Investors’ attention has become focused on the powerful rally that started in October and turned 2011 from a weak year into one with a 2.1% positive return for the S&P 500. That equity strength continued into the New Year and has prompted in many investors the kind of enthusiasm earlier exhibited during the dot.com boom that ended the 1990s and the housing bubble rally that peaked in 2007. As is the case today, the Federal Reserve was the great facilitator of those earlier booms. We find ourselves again in a familiar position urging caution, as we did in those two prior instances of financial excess. Long-term clients, readers and attendees at our seminars since the late-1990s have heard our warnings about unsustainable debt burdens. While the Fed and other central banks around the world have supported periodic stock market rallies by printing money, those positive effects have not been permanent, and central banks have had to resort to repeated printing to prevent economic collapse. Each episode increases already dangerous debt levels for today’s population and makes the burden on future generations ever more onerous.

Despite the greatest flood of rescue money in history, world economic recoveries have been muted at best. Europe may already have fallen back into recession. The U.S. recovery is the weakest in the post-war era. Japan can’t seem to get out of its two-decade-long funk. Even the BRICs (Brazil, Russia, India, China) are slowing perceptibly. Whole countries have had to be bailed out. Now comes Spain with Italy waiting in the wings. Can central bankers continue to pull financial rabbits out of their hats? Will investors maintain their faith that these masters of the improbable will be able to solve crises of excessive debt by creating ever more debt? Or will they be seen eventually to resemble the wizard behind the curtain in the Wizard of Oz?

Cracks in that edifice of investor faith are becoming more apparent. Notwithstanding unlimited loans to European banks to shore up their shaky balance sheets and to enable them to buy otherwise hard-to-sell sovereign bonds, interest rates on Spanish and Italian debt are rising ominously once again. Perhaps investors are beginning to doubt the efficacy of European central bankers’ attempts to solve sovereign debt problems that are probably unsolvable.

I have written frequently about the comprehensive studies that Carmen Reinhart and Ken Rogoff have profiled in This Time Is Different. In analyzing 800 years of financial crises, they describe a common phenomenon they refer to as the moment at which markets go “bang.” That moment refers to the point at which borrowers can no longer borrow at reasonable interest rates, because potential lenders doubt they will be repaid. We witnessed this event most recently in Greece. When the “bang” occurs, interest rates skyrocket, and funding markets essentially shut down. As rates on Spanish and Italian debt rise, investors have every reason to ask why, if those countries are unable to pay the interest and principal on existing debt, there should be confidence that they will be able to repay even greater levels of debt in the future.

Money is starting to flee the endangered countries in Europe. Foreign investors are selling an increasing amount of those sovereign bonds. Governments are barring withdrawals of capital from countries and are prohibiting cash transactions above relatively small levels to make the transfer of large amounts of money difficult. These are symptoms of countries whose citizens fear default and currency devaluation.

So far, such worries are not typical in the United States. In fact, faith persists that Chairman Bernanke has the resolve and the power to keep our securities markets healthy. While that conviction could be well founded, I believe it unlikely. The mantra “Don’t fight the Fed” is well known and, more often than not, sound. Following it slavishly, however, would have periodically led to spectacular losses. It is important to remember that the Fed was aggressively dropping interest rates throughout the 2007-09 stock market collapse, when the S&P 500 declined by 57%. Today people are focusing on the Fed’s successful actions from 2009 to present. The resulting stock market rally, however, has not even brought prices back to the levels of five years ago. Investors who followed the Fed throughout that period are still under water, and, by historical standards, this rally is long in the tooth.

Mission has discussed at length our belief that the long weak cycle that began in 2000 likely has several years to run. That period will probably encompass both rising and falling markets but with a downward bias that will work against a traditional buy and hold approach, as has been the case century-to-date. We anticipate that flexibility and liquidity will be rewarded as volatility powerfully influences all asset classes.

We are attempting to maximize risk-free returns in today’s difficult, high priced environment. With the plethora of stress points throughout the world’s economies, however, we expect that patience will provide numerous opportunities over the months and years ahead to add stocks, bonds, gold and possibly non-U.S. dollar denominated assets at prices that will prove very profitable over the long term.

Employment data colored the news again this week. Markets opened the week reacting to Good Friday’s disappointing announcement that a mere 120,000 new jobs had been created in March, roughly half the anticipated total. On Thursday, the Labor Department reported that 380,000 people filed initial claims for state unemployment benefits and that the prior week’s total had been revised up by an additional 10,000. Such data are notoriously subject to revision, so these disappointing numbers could yet be tempered in subsequent reports. On the other hand, they were supported by the National Federation of Independent Business’s Small Business Economic Trends data that “indicate growing weakness in the job market and portend a rising unemployment rate.”

The concentration of news items about unemployment brought to mind a blog entry that I wrote nearly two years ago in August, 2010, entitled “Keep Your Job.” The point there was that economic, market and employment conditions were likely to remain so uncertain that a predictable paycheck was the most prudent safeguard. Except for those wealthy beyond the need to worry about income, maintaining that paycheck remains the best advice.

Stock dividends are extremely low, yet common stocks have provided an excellent return if one focuses solely on the past three years. Dangerous conditions, however, have penalized stockholders intermittently to such a degree that equity prices are no better today than they were in 1999. Some of those conditions–like excessive debt–are even more perilous now than they were a decade or more ago. Bonds have benefitted from direct purchases by the Federal Reserve in unprecedented amounts, and interest rates are near all-time lows. If rates rise in the years ahead, bondholders could endure significant losses. Returns on safe, short-term investments, of course, continue to yield virtually nothing. Investment income is hard to come by.

Glusken Sheff economist David Rosenberg made some interesting observations this week while commenting on recent employment statistics. He noted that: “…those over 55 years old have seen their employment ranks expand four million since the Great Recession began while the job level for everyone else has fallen eight million. The older folks are coming back into the labor market and at lower wages than they retired previously since they are desperate for jobs as they need the income as an antidote to their lost wealth from two asset bubbles bursting less than a decade apart.”

In his current Weekly Market Comment, the insightful John Hussman noted that in the post-recession period since mid-2009 total U.S. non-farm payrolls have grown by 2.0 or 2.3 million jobs, depending on the survey used. Workers in the 55 and over category, however, have added just over three million jobs. That leaves workers in all other age categories losing from 700,000 to one million jobs. The employment picture remains precarious.

Compounding uncertainty in the investment markets is the question of whether we are likely to experience inflation or deflation in the years ahead. Clearly, Fed Chairman Ben Bernanke has vowed that we will not experience deflation on his watch. Toward that end, he has bent every effort to ward off deflationary forces through money printing. The logical ultimate consequence of such a course is inflation. At the moment, neither inflation nor deflation is a major problem, but that could turn quickly in either direction for a variety of reasons. For the most part, the most effective defenses against inflation or deflation are dramatically opposite from one another. Investors are as likely to make the wrong choices as the right ones. If you’re still in a position to make an employment choice, keep your job and the predictable income stream that comes with it, at least until the investment landscape clears.

The equity markets this week revealed how dependent they have become on the free flow of newly printed money. When the most recently released Federal Reserve minutes indicated declining support for another round of quantitative easing, stock prices fell sharply on increased volume. Ironically, the potential for no further monetary stimulus trumped the Fed’s acknowledgement of slight improvement in the U.S. economy’s sluggish recovery. This development reverses the past few years’ scenario in which economic malaise has been rewarded by higher stock prices, because such sluggishness promised additional direct Fed interference.

Over the past few weeks, James Grant, an eloquent writer of several books and the insightful Grant’s Interest Rate Observer and an ardent proponent of free markets, has made several guest appearances on financial television. In each, he decried the Fed’s blatant and persistent “market manipulation.” He characterizes these Fed actions as “terribly dangerous.” Among other concerns, Grant sees the Fed “manipulating perceptions of risk.” In an era of financial repression, retirees need far more cash than ever prior to leaving the workforce. With yields on secure financial assets driven close to zero by Fed actions, those in need of income have been driven, in accord with Fed intent, to riskier assets. Grant contends that the effect of these Fed manipulations has been to make higher yield markets–like junk bonds and distressed debt–appear far stronger than they really are, which is especially dangerous to less experienced investors. He sees Fed actions as dulling the risk sensors of the entire marketplace.

Grant argues that, besides distorting markets and individual investments, policymakers are prolonging the consequences of the last recession. Fed Chairman Bernanke, an acknowledged expert on the Great Depression of the 1930s, is using examples of mistakes from that horrific economic episode as his rationale for repressive interest rates and huge budget deficits. Grant suggests that the depression of 1920-21 could be a more prudent example from which to draw potential central bank policy prescriptions. He points out that, in that instance, the economy fell off a cliff with GDP declining by more than 20%. In contrast to actions taken in the depression that followed a decade later, in the ‘20s the Treasury balanced the budget, the Fed raised interest rates and the economy recovered. Within one year unemployment fell back to just 3%.

Bernanke has chosen the far more perilous path of financial repression and massive budget deficits with no guarantee that it will work. Grant proposes that the Fed let capitalism work. He sneers at a group of “mandarins” central planning our economy and our markets.

I am very much in agreement with Grant’s positions and have argued long and loud against such central bank intervention. By all accounts, Chairman Bernanke is an intelligent, well-intentioned man, who has studied past financial and economic problems in detail. He has used his position, however, to make the biggest financial bet ever, spawning great risk of unintended consequences. If he is wrong, he will go down in history as possibly the worst central banker ever. And generations to come may have to bear the burden of his folly.

To view James Grant’s recent TV interviews, see below:

March 7 CNBC

March 13 Bloomberg

March 29 CNBC

Clients and others who have attended our seminars and read our publications know that we have for years railed against the existence of “too big to fail” (TBTF) financial institutions.  Since the 2008 near-meltdown of the financial system, world governments and central banks have unrelentingly kept alive even the most moribund of the world’s big banks.

In the majority of developed countries, there exists an article of faith that life as we know it cannot survive without resident financial giants in robust condition.  In recent years, that conviction has resulted in multi-billion dollar rescues and the availability of a flood of nearly free money with which to bolster balance sheets and income statements.  Senior executives in these government-supported enterprises have rewarded themselves with pay packages unknown through history but to kleptomaniacal dictators or founders of vast corporate empires.  Besides providing relatively pedestrian traditional banking services, these entities have made their mega-bucks by structuring and peddling securities, some of which were instrumental in triggering recent financial crises.  Such inequity has to be particularly galling to people whose efforts are providing real benefit to humanity.

Finally emerges an ironic but powerful ally in the fight against TBTF.  The Federal Reserve Bank of Dallas devotes its 2011 Annual Report to that end.  Titled “Choosing the Road to Prosperity: Why We Must End Too Big To Fail – Now,” the report presents a cogent, straightforward argument against the existence of giant banks.

Reading the entire report will serve up the meat of the argument, but the following quotes will offer some of the flavor.

In his introductory letter, Dallas Fed President Richard Fisher made the following points:

“More than half of banking industry assets are on the books of just five institutions.  The top 10 banks now account for 61 percent of commercial banking assets, substantially more than the 26 percent of only 20 years ago; their combined assets equate to half of our nation’s GDP.”

“In addition to remaining a lingering threat to financial stability, these megabanks significantly hamper the Federal Reserve’s ability to properly conduct monetary policy.  They were a primary culprit in magnifying the financial crisis, and their presence continues to play an important role in prolonging our economic malaise.”

“The lackluster nature of the recovery is certainly the byproduct of the debt-infused boom that preceded the Great Recession.…”

“The TBTF institutions that amplified and prolonged the recent financial crisis remain a hindrance to full economic recovery and to the very ideal of American capitalism.  It is imperative that we end TBTF.  In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response.”

Harvey Rosenblum, the Dallas Fed’s executive vice president and director of research, wrote the body of the report.  Several of his contentions follow.

“As a nation, we face a distinct choice.  We can perpetuate too big to fail, with its inequities and dangers, or we can end it.  Eliminating TBTF won’t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance.”

“If allowed to remain unchecked, these entities will continue posing a clear and present danger to the U.S. economy.”

“Moral hazard reinforces complacency.  Moral hazard describes the danger that protection against losses encourages riskier behavior.  Government rescues of troubled financial institutions encourage banks and their creditors to take greater risks, knowing they’ll reap the rewards if things turn out well, but will be shielded from losses if things sour.”

“The Fed kept interest rates too low for too long, contributing to the speculative binge in housing and pushing investors toward higher yields in riskier markets.  Congress pushed Fannie Mae and Freddie Mac, the de facto government-backed mortgage giants, to become the largest buyers of these specious mortgage products.  Hindsight leaves us to wondering what financial gurus and policymakers could have been thinking.”

“Mammoth institutions were built on a foundation of leverage, sometimes misleading regulators and investors through the use of off-balance-sheet financing.  Equity’s share of assets dwindled as banks borrowed to the hilt to chase the easy profits in new, complex and risky financial instruments.  Their balance sheets deteriorated–too little capital, too much debt, too much risk.”  (What would the Dallas Fed say about the Fed’s own balance sheet?)

“With size came complexity.…Complexity magnifies the opportunities for obfuscation.…They pushed the limits of regulatory ambiguity and lax enforcement.  They carried greater risk and overestimated their ability to manage it.”

“The term TBTF disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.”

“While reducing the interest burden for borrowers, monetary policy in recent years has had a punishing impact on savers, particularly those dependent on shrinking interest payments.”

“The machinery of monetary policy hasn’t worked well in the current recovery.  The primary reason: TBTF financial institutions.  Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.”

“The rationale for providing public funds to TBTF banks was preserving the financial system and staving off an even worse recession.  The episode had its downside because most Americans came away from the financial crisis believing that economic policy favors the big and well-connected.  They saw a topsy-turvy world that rewarded many of the largest financial institutions, banks and nonbanks alike, that lost risky bets and drove the economy into a ditch.  These events left a residue of distrust for the government, the banking system, the Fed and capitalism itself.”

“Capitalism…requires maintaining a level playing field.  The privatization of profits and socialization of losses is completely unacceptable.  TBTF undermines equal treatment, reinforcing the perception of a system tilted in favor of the rich and powerful.”

“[T]he country must find a way to ensure that taxpayers won’t be on the hook for another massive bailout.”

“It could be argued that zero interest rates are taxing savers to pay for the recapitalization of the TBTF banks whose dire problems brought about the calamity that created the original need for the zero interest rate policy.”

“Disciplining the management of big banks, just as happens at smaller banks, would reassure a public angry with those whose reckless decisions necessitated government assistance.”

“Big banks often follow parallel business strategies and hold similar assets.  In hard times, odds are that several big financial institutions will get into trouble at the same time.  Liquid assets are a lot less liquid if these institutions try to sell them at the same time.  A nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme.  In all likelihood, TBTF could again become TMTF–too many to fail, as happened in 2008.”

“The TBTF survivors of the financial crisis look a lot like they did in 2008.  They maintain corporate cultures based on the short-term incentives of fees and bonuses derived from increased oligopoly power.  They remain difficult to control because they have the lawyers and the money to resist the pressures of federal regulation.  Just as important, their significant presence in dozens of states confers enormous political clout in their quest to refocus banking statutes and regulatory enforcement to their advantage.  The Dallas Fed has advocated the ultimate solution for TBTF–breaking up the nation’s biggest banks into smaller units.”

“[T]he big financial institutions will dig in to contest any breakups.  Taking apart the big banks isn’t costless.  But it is the least costly alternative, and it trumps the status quo.”

“Greater stability in the financial sector begins when TBTF ends and the assumption of government rescue is driven from the marketplace.”

Former European Central Bank executive board member Otmar Issing in Financial Times, January 20, 2012, adds: “The problem of ‘too big to fail’ has made society–more precisely, the taxpayers–hostage to the survival of individual financial institutions.

“As a result, the basis of free markets has been shaken.…Thus, ‘too big to fail’ not only undermines a fundamental principle of market economies but also a principle of societies in which individuals are responsible for their actions.”

Let’s hope these influential voices get the ball rolling quickly and effectively before taxpayers are again put on the hook to bail out another megabank.

We’re living in an era of make believe.  With the acceptance of newly issued Greek bonds, holders of that nation’s debt are making believe that Greece is still a solvent country and will someday pay its debts.  To get to that point, bondholders around the world had to make believe that they “voluntarily” forgave an estimated 79% of the money Greece owed to them.

Now we have to make believe that many of the European banks that hold the debt of Greece and such other strong sovereign credits as Portugal, Italy and Spain really hold assets worth what they’re valued to be on the banks’ books.  Perhaps concerned that such a financial fiction was too much of a stretch, the European Central Bank twice in the last few months loaned Eurozone banks as much money as they wanted for three years at a mere 1% interest.  Where did that money come from?  In an era of make believe, there’s no good reason not to create it out of thin air.

In the United States, we have more debts and promises of future payments than we will ever be able to pay.  We are adding to that debt load by more than $1 trillion a year.  So far, stock and bond investors are making believe that an unpayable debt load doesn’t really matter.  Somehow, it will all work out in the end.

Right now, equity investors–at least in this country–are focusing on improving business conditions resulting from the most monumental rescue and stimulus effort in history.  If they view these debts as a problem, it’s clearly not today’s problem.  Analogously, this seems to be a case of concentrating on a relatively healthy grove of blossoming trees while overlooking a pernicious blaze growing in an adjacent section of the same forest.  The safety of the blossoming trees is heavily dependent on remaining isolated from the blaze.  Winds, however, are variable and unpredictable, like investor attitudes.  Should events like rapidly rising interest rates in Portugal, Italy or Spain or a political impasse over the U.S. budget deficit lead investors to focus on the long term debt realities, winds could shift direction and intensify.  The debt blaze has the potential to overwhelm even the healthiest grove of trees.

As we have stated repeatedly, markets can continue to perform well so long as governments and central banks can keep looming debt disasters out of investors’ consciousness.  And they are obviously bending every effort to do exactly that.  So far, they have kept the blaze from consuming the forest.

Firefighters frequently set small backfires to prevent potentially lethal forest fires from spreading.  World central bankers (as firefighters) have set any number of such backfires in the form of increased liquidity.  Unfortunately, by using massive blast furnaces instead of modest blowtorches, our firefighters have increased the risk that when the wind shifts, the ultimate conflagration will be far worse than the original blaze.

I have no time to write a full blog entry today, but I came across two interesting and thought-provoking written pieces that I want to pass along.

In his annual letter to shareholders, General Electric CEO Jeff Immelt wrote:

• “We live in what most business commentators call a volatile world. I would argue that when the environment is continuously unstable, it is no longer volatile. Rather, we have entered a new economic era. It could remain this way for a long time.”

The instability of which Immelt speaks is a result of the monumental debt edifice that has been constructed over the past three decades throughout most of the world. That debt began to take its toll in Japan at the end of the 1980s. Notwithstanding dramatic rallies from time to time, the Japanese stock market today remains 75% below its high at the end of 1989. At the end of the 1990s, we began to identify debt along with excessive stock valuations as the precursors of the next long weak cycle in the United States. That cycle began in 2000 and continues through today. The Eurozone debt crisis has more recently grabbed the headlines from the U.S. Fully recognizing the scope of the problem, central bankers throughout the world have sprung into action. The Financial Times profiles their responses as follows:

• “Indeed, central bankers have ramped up their efforts, seemingly planning for the worst. The Fed introduced a currency swap line to alleviate U.S. dollar funding concerns in Europe. The ECB conducted its three-year long-term refinancing operations. The Bank of England provided another dose of quantitative easing. The Bank of Japan pursues its newly anointed inflation target. These are all variations of printing money.
  
  With all major countries printing money, the problems in the Eurozone may ease for now. Add to that the large degree of short positions previously built up in the euro that still need to be wound down, and the single currency should do just fine for the time being.
  
  There’s a price to be paid, though: we don’t see how the ECB, in three years’ time, will be able to mop up the trillion-euro liquidity it has provided. The ECB has now introduced a structural rigidity into its monetary policy akin to what the Fed is faced with. In many respects, central banks have disrupted the natural transition of market-ascribed economic health by imposing their colossal might (balance sheets) on to the markets. This should be alarming. Central bankers are increasingly manipulating rates all along the yield curve.
  

  Such policies take away crucial economic gauges (market-based interest rates across the yield curve) from investors and policymakers. As a result, policymakers can no longer rely on these metrics in setting appropriate monetary policy.”

As Jeff Immelt stated, instability could remain with us for a long time. The most recent central bank actions have succeeded in boosting investor confidence and stock prices, as they did in their last easing cycle until both confidence and prices collapsed from 2007 to 2009.

Current conditions leave investors in both stocks and bonds with the quandary of whether or not to follow the world’s central banks in the hope that newly printed money will, at least for the foreseeable future, overpower underlying financial and economic instability.

Spending a couple of days at home recovering from a minor operation, I had an opportunity to watch Margin Call on DVD. Starring Kevin Spacey, Jeremy Irons and Demi Moore, the movie was a fascinating recap of one of Wall Street’s least auspicious moments. It’s a worthwhile two hours for anyone involved with investments. A warning, however, to those squeamish about crude language – such language is a Wall Street staple. You should, though, be ready to give these characters a pass, because they are, after all, masters of the universe – intelligent, aggressive, competitive, rich and filled with an exaggerated sense of entitlement. Why should they bend their language to society’s civility conventions?

The movie focused on the unraveling of the subprime mortgage market. Knowledge of that arcane segment of the fixed income market, however, is not necessary to appreciate the key messages of the movie. Most memorable are how rapidly the price of a basically flawed asset type can plummet and how vulnerable a major firm can be when overleveraged. Once the profiled firm’s senior executives recognized the severity of their overexposure to subprime assets, they quickly determined that they needed to sell their entire position in a single day before the rest of the street fully understood the implications of the fire sale. Bids in the low-90s on the opening bell had eroded to the low-60s by that day’s close. In the current crisis, only Greek debt has so far demonstrated such vulnerability, but there are definitely more candidates.

In the prior crisis, precipitated by subprime mortgages, Bear Stearns and Lehman Brothers were the most public failures, yet uncounted others were at the edge of the cliff but for history’s greatest-ever government bailout. AIG, with a longstanding reputation for sound business practices, bet the ranch on not having to pay off on widespread business failures. As in Margin Call, the egregious misjudgments of one of that company’s divisions sunk an otherwise successful firm. And if the government hadn’t bailed out AIG and its clients, would Goldman Sachs and others be alive today? Obviously, a great many people still question the propriety of using taxpayer money to rescue firms which made tremendously flawed business judgments. We could soon again face the uncertainty of whether or not some firms have badly miscalculated, this time regarding the prospect of Greek rescue efforts triggering an unknown, but still potentially dangerous amount of credit default swaps.

Judging from the frantic recent expansion of its balance sheet, the European Central Bank believes there is serious danger of both bank and sovereign failures throughout the Eurozone. So far that rescue effort has buoyed the spirits of equity investors who have faith that central bank efforts will succeed, at least for a while.

Realistically, there are only three alternatives for dealing with excessive sovereign debt: 1) repudiate it (with central banks so far trying to avoid that option at all cost); 2) grow fast enough to pay it down (not realistic for most developed countries); or 3) inflate it away. Thus far the major central banks have set themselves on the path of the third alternative, although they’re adamant about their commitment ultimately to withdraw all the newly created liquidity and about their ability to do it successfully. History casts serious doubt on central banks’ ability to accomplish that task, however, now that debt levels have reached current heights. In This Time is Different, authors Reinhart and Rogoff spell out in copious detail how inflating away the debt has been the method of choice for centuries.

Notwithstanding the already massive levels of debt, central banks around the world appear willing to lend even more if economic growth remains sluggish. How long will investors let governments and central banks play the game of inflating away excessive debt by printing new money? If currency is methodically being devalued by the printing press, investors will logically begin to demand higher interest rates to compensate for the anticipated diminished value of the currency at maturity. So far that has not happened except in countries in which creditworthiness is suspect. The situation could change quickly, however. Once again, Margin Call can provide insight. When the firm’s most senior executive foresaw the potential calamity in the subprime mortgage arena, he counseled others that while it might become a huge problem for the industry, it would not be as bad for the first one out the door. So far there has been no apparent move toward the door with respect to most central bank supported debt. Given the underlying insolvency of some of the guaranteed banks and countries, however, it is not farfetched to expect worried investors to consider being the first out the door. Investors have to evaluate whether or not Margin Call may be prophetic on a broader level.