Quarterly Commentary – Third Quarter 2012

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The Federal Reserve Board and other central bankers around the world have taken control of most major stock and bond markets. The quandary facing all who make investment decisions is whether or not they can count on a continuation of that pattern. It is essentially a two-part question: 1) Will central bankers choose to continue their interventional practices? and 2) If so, will their efforts continue to be successful?

The issue has come into sharp focus over the past several months as economic fundamentals have deteriorated markedly in virtually all corners of the world. At the same time, to prevent “bad” from turning into “dangerously bad,” central bankers have flooded their countries’ financial institutions with unprecedented amounts of new money. So far, those efforts have warded off disaster but have had little noticeable positive effect on economic conditions, which continue to decline–even in formerly strong emerging countries. The main beneficiaries have been world stock markets, with only a few exceptions (China most notable among them). Because much of the new money has also been directed to bond purchases, central bankers have depressed interest rates and boosted bond prices.

To appreciate how successful this coordinated central bank policy has become, one need only observe stock market behavior on days of negative fundamental news announcements. When stocks go up immediately after negative news, it is apparent that buyers are concentrating on the increased probability of additional central bank rescue stimulus rather than on the weak underlying fundamental condition. That optimism is precisely the effect central bankers hope to produce – investors’ positive response in anticipation of a future central bank action, reducing the need for the action itself. So far, faith in central bankers is trumping deteriorating fundamentals, as most world stock markets have been rising since 2009.

Overwhelming Debt Burdens

To understand the prospect for ultimate economic and investment outcomes, it is essential to understand the underlying reality. The United States and numerous countries throughout the world will never be able to pay for existing debt plus existing promises of future benefits. Mature economies simply cannot grow fast enough to satisfy those liabilities. There remain only two alternatives – defaults on some of those obligations, or enough inflation to diminish the debt burden (another form of default).

Almost certainly, the major central banks of the world fully appreciate the severity of the situation. Very few investors, however, much less the general public, have any real appreciation of the hopelessness of the debt dilemma. Politicians (at least not since Ross Perot) have no incentive to shed light on the problem. They have to condemn the policies of the other guy and offer hope that their administrations will provide economic growth and good times. Reality would not win votes. Voters want candy, not castor oil.

With debt burdens at unsolvable levels, recession has become an unacceptable condition. Throughout history, recessions have been the necessary cathartic to rid economies of the excesses of prior expansions. So severe are the debt excesses in the present instance, however, that recession has already led to the need for rescues of some of Europe’s weaker countries. The current broad European recession is tightening the noose on three of the four largest Eurozone economies: Spain, Italy and France in ascending order of size.

The European Central Bank is faced with an extremely difficult situation, compounded by the complexity of needing to satisfy 17 autonomous governments, many of which have warred with one another repeatedly over the centuries. The prospect of a lasting monetary union is remote at best. The ECB is doing what it can, however, to contain the damage from a condition it can’t cure. Central banks can usually deal with liquidity issues but can’t overcome solvency problems, which the ECB is wrestling with today. The financially stronger northern European countries are faced with the dismal choice between providing an ongoing stream of bailouts for their weaker southern neighbors or allowing defaults, which would decimate their banks holding the bonds of the countries in danger of default. Consensus on how to proceed has been hard to come by. European leaders lurch from meeting to meeting followed by optimistic progress reports, yet no real progress. By preventing collapses so far, they have effectively “kicked the can down the road” and provided hope to investors in both stock and bond markets.

The Fed’s Rescue Attempts

Our Federal Reserve doesn’t have to worry about 17 separate economies – just one. But like much of Europe, the United States is burdened by monumental debt problems. The Fed has made the determination that we cannot withstand a recession, so it has resorted to a series of rescue efforts unprecedented in the history of our nation. Its zero interest rate policy has been in place since 2008, and the Fed has vowed its continuation until at least 2015. The Fed’s rescue efforts are being borne on the backs of savers, disproportionately the elderly retired. Having run out of short term interest rates to reduce, the Fed then turned to active money printing, more than tripling its balance sheet in just a few years. Most recently Fed Chairman Bernanke and his board majority have prescribed Quantitative Easing “Open Ended,” pledging unlimited new money as the Fed determines its need. With nearly $2 trillion in cash still sitting in the banking system, even Chairman Bernanke admits that new money will be unlikely to have any appreciable effect on the underlying economic problem of severe unemployment. He believes, however, that such money will have a positive “wealth effect,” boosting housing and stock prices and impelling Americans to spend more, thereby lifting the economy.

Not everyone agrees that the benefits will exceed the costs. St Louis Fed President James Bullard warns that any benefits today will be paid for with future inflation that could persist for years. Philadelphia Fed President Charles Plosser warns of a risk to the Fed’s credibility. Dallas Fed President Richard Fisher, a frequent outspoken critic of Fed policy, recently said, “The truth…is that nobody on the committee, nor on our staffs at the Board of Governors and the 12 Banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course. And nobody – in fact, no central bank anywhere on the planet – has the experience of successfully navigating a return home from the place in which we now find ourselves. No central bank – not, at least, the Federal Reserve – has ever been on this cruise before.” While not speaking directly about current Fed policy, former St. Louis Fed President William Poole succinctly summarized the magnitude of the underlying problem by saying: “We’re only a few years behind Greece when you look at the numbers.” Clearly, we are not in a “business as usual” environment.

The Investor’s Conundrum

The ambiguity of today’s situation puts a huge burden on anyone making investment decisions, including our investment management team. Can central bank money printing overcome deteriorating economic fundamentals? So far, at least in terms of stock prices, central banks are winning. Will investors retain confidence in central bank efficacy if economic fundamentals continue to deteriorate? If confidence remains, stocks could continue to rise. If confidence disappears, world economies could fall into serious recessions, and stocks could plummet. We are faced with atypical risk/reward considerations, because nobody knows how or when these questions will ultimately be resolved.

Central Banks Don’t Always Win

Because most firms in our industry focus on quarter to quarter returns, they’re essentially forced to stay relatively fully invested whether they perceive a highly uncertain environment or not. That approach would have been well rewarded over the past three years, but would expose clients to huge risk of loss if deteriorating fundamentals ultimately overwhelm the best efforts of central banks. And while central banks are succeeding in the current cycle, they don’t always win. Most notably, despite aggressive central bank action, stocks dropped by 89% from 1929-32, 50% from 2000-02 and 57% from 2007-09. In Japan, stock prices are down by 77% since 1989 despite constant central bank efforts to revive the economy.

Relying On Value

Mission’s equity selection process is based on a deep appreciation for and understanding of historically sound value. We buy value when we find it and don’t force equities into client portfolios when stocks don’t meet all our selection criteria. The annualized performance of the equities we have owned since inception at the beginning of 1986 is 17.28% compared to 9.97% for the unmanaged S&P 500. In recent years, as sound values have become scarce, we have found a diminishing number of stocks meeting our strict criteria. That scarcity has kept us from participating heavily in stocks over the past three years, although it has produced safe, far better than average total portfolio returns for the century-to-date. By holding to such a conservative course (relying on a reversion to normal valuation levels), we will avoid serious negative consequences should weak fundamentals drag stock prices down again. On the other hand, conservative portfolios will lag more aggressive portfolios as long as central banks are able to keep stock and bond markets elevated.

An Alternative Approach

Not knowing how long central banks will be able to dominate world equity markets in this cycle has forced us to search for an approach to employing more stocks while still limiting exposure to risk. We have always been strong advocates of formularized evaluation processes. Formulas take ego and emotion, the two biggest roadblocks to investment success, out of investment decision making. For years we have reviewed literally hundreds of studies in an attempt to identify a composite of economic and market criteria with a strong, long-term track record of highlighting periods in which stocks perform positively. A good many criteria and combinations of criteria have met that standard. We have also demanded that any acceptable formula be able to recognize quite consistently periods in which stocks perform poorly. Several sets of criteria also met that standard, but virtually all have experienced rare, but substantial losses. To us that was unacceptable, especially in an environment as dangerous as is the present. To avoid unacceptable losses, it is essential that any formula have the proven ability to correct and reverse position when markets go contrary to an earlier forecast.

We have finally identified a set of criteria that have satisfied these requirements for more than the past three decades. A two-mode process identifies periods in which to hold stocks and periods in which to remain safely in cash equivalents. A separate three-mode process identifies periods to own stocks, a smaller number of periods in which to sell stocks short, and lengthy periods of time in which price direction is less predictable and cash equivalents are the asset of choice. Over the multi-decade history of the study, the two-mode process has earned more than 4% per year on average above the unmanaged S&P 500 index. The three-mode process earned more than 6% per year more than S&P 500. Over the 31 completed years of our study, the S&P 500 has declined in six of those years. Each of these formularized processes had negative results in just three of the 31 years. The S&P’s worst one-year decline was -37.0%. The worst year for the two-mode process was -3.4%; for the three-mode, -6.7%.

While there can be no guaranty that what has worked successfully in the past will necessarily work well in the future, we believe there to be a strong probability of success for a few reasons: 1) Results have been quite consistently successful for a multi-decade period of time. Good long-term results have not been built on just a few periods of strong outperformance; 2) The criteria measured in the formulas are numerous and diverse, reducing the potential that a few becoming less well correlated with market performance will negate the formulas’ efficacy; and 3) The heavy weighting of stocks’ price movements protects significantly against getting locked into an equity position which fundamental considerations support powerfully, but which is experiencing an opposite price reaction.

Detailed descriptive materials about the new processes will be available soon. Please let us know if you would like to receive them. The addition of these new processes will in no way alter our primary value-based investment strategy that has proved its long-term worth over a quarter of a century. These will be optional alternatives for those willing to assume a little more risk in a quest for greater equity returns.

Fixed Income

Our outlook on fixed income is unchanged. Fixed income yields are near historic lows, although they have bounced off July’s all-time lows for most U.S. Treasury securities. Most central banks around the world are committed to keeping them as low as possible. Markets, however, don’t always follow the dictates of central bankers. Should rates rise for any reason (inflation or China lessening its U.S. bond holdings, for example), minimal positive returns could quickly turn negative. The potential loss from being wrong in a bond portfolio is greater than the potential reward for being right. We’re facing a poor risk/reward equation at current yields.


Because both the Federal Reserve and the ECB have clearly indicated their intentions to make new money readily available in unlimited amounts, we began to build a position in gold in late-2011. Our average purchase price is about $1600 per ounce on spot gold. We have no strong conviction about the probable near-term price movement. Gold has rallied nicely from our purchase levels and could continue higher from here. If so, we will have a nice profit on a still modest position.

But gold’s price could also fall–even precipitously–should the best efforts of central bankers fail and the world fall into a widespread recession. Under such circumstances, stocks could fall aggressively, generating margin calls. As happened in 2008, quite a bit of gold might be sold to meet stock margin calls. Should prices decline, we would be pleased to add to our gold positions. Over the long run, a larger position acquired at lower prices could offer substantial profit potential.

Serious Concerns

We face the uncertainty of the period ahead with a number of serious concerns:

1) Debt levels are so extreme that they may be beyond the reach of central bank efforts. It is highly unlikely that central banks can in the long run stabilize economies and put them on the path to sustainable growth.

2) Negative outcomes could unfold quickly although central banks will bend every effort to defer them.

• One or more countries could be kicked out or choose to leave the Eurozone.
• Iran and Israel could get into an armed conflict.
• Problems in Syria could spread violence.
• Any of these events could happen overnight.

3) Positive investment returns are dependent upon investors retaining confidence in central bankers. That won’t go on forever.

4) Consequences of central bank failure could lead to extreme market volatility and losses.

In such an environment, investors should maintain flexibility in all investment portfolios. This is not a time to buy and hold.