The Passing Of A Legend

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I was saddened last week to learn of the death of Alan Abelson, long-time editor of Barron’s.  Although I fell from the ranks of subscribers years ago, I have for many years enjoyed picking up the magazine when I would happen upon it and quickly reading Alan’s Up and Down Wall Street column.  It would invariably prove entertaining – and usually education if he were writing about broad market themes rather than individual securities.

Alan had a droll wit and regularly directed heavy doses of sarcasm toward purveyors of Wall Street’s common wisdom.  He recognized and criticized the tendency of investors and advisors alike to fall in love with whatever had been moving aggressively upward.  And he wielded an especially derisive pen toward marketers of securities products with unsound valuations.  Those who read Alan’s columns over the years came away with a comprehensive understanding of sound investing principles.

Relatively early on in my investment career, I had the good fortune to get to know Alan.  Having founded Marathon Asset Management Co.–now a part of Mission Management & Trust Co.–in the mid-1980s, I was in my first years as a Registered Investment Advisor.  Alan came across one of my articles and published it in Barron’s.  Writing essentially for Marathon’s clients, I was surprised that my work had attracted the attention of one of the preeminent scribes in the world of financial journalism.  Only later did I learn from others far more familiar with the difficulty of getting published how fortunate I was to have been published nationally early in an investment career and without a publicist.

I met Alan only once in his New York office, but we interacted by phone from time to time.  He quoted me in his column occasionally, once sent a photographer and interviewer to my La Jolla office and even saw fit to put me on Barron’s cover page one week.  His belief in the president of a young company lent Marathon a credibility that helped us to grow.  It is with appreciation, respect and sadness that I note his passing.

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Valuation Update

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As several leading domestic stock indexes reach new highs, the vast majority of Wall Street analysts are increasing their bullish calls. Riding a wave of aggressive government stimulus and the promise of more, stock prices have risen aggressively since November. Investors apparently trust that the Fed will prevent any significant market declines. Clearly, momentum is powerful, and more people jumping on the bandwagon could keep the rally going. At the same time, it’s important to recognize that, notwithstanding analyst contentions to the contrary, stocks are extremely expensive relative to long-term historic guidelines.

At Thursday’s client conference, I presented the following valuation graphs produced by the excellent Ned David Research staff. The bottom half of each graph traces a valuation ratio over a period of many decades. In sequence, these ratios measure Price-to-Book Value, Price-to-Dividends, Price-to-Sales, Price-to-Cash Flow and Price-to-Earnings. On each, we have drawn a solid line across the full expanse of time from the valuation ratio’s level at the end of April. The first four graphs show the current valuation line intersecting the ratios in the period from the late 1990s into the first years of the present century and very little else as far back as the graph covers. In other words, by each of these measures, stocks are more overvalued today than at virtually any point but during the recent bubble period that resulted in the 50% decline from 2000 to 2003 and the even more severe 57% decline from 2007 to 2009. That includes the stock market peaks in 1929 and 1973, which preceded declines of 89% and 45%, respectively. The fifth graph shows Price-to-Earnings as less egregiously overvalued, although above average. Earnings, however, can be more easily manipulated and controlled than book value, dividends, sales and cash flow. In the aggregate, stocks are extremely overvalued.

 

 

 

 

 

The following graph shows valuation in a different manner. As with the preceding graphs, it depicts a ratio, the value of all common stocks compared to the size of the economy. Today’s reading is less extreme than that in 2000 and slightly less than that in 2007. It is far above, however, all other readings back to the mid-1920s, including the peaks in 1929 and 1973.

Comparing U.S. valuations, as measured by Dividend Yield and Price-to-Earnings, -Cash Flow and -Book Value, with other major world stock markets shows the U.S. more overvalued in the aggregate than Japan, France, the United Kingdom, Germany, Canada and Australia.

On the following graph, we have again drawn a solid line at the U.S. level for each measure across the full spectrum of the other countries.

 

For dividend yield, which we prefer to be high, the U.S. is the second lowest. We prefer Price-to-Earnings, -Cash Flow and -Book Value to be low. In descending order, the U.S. is the third, second and first highest for those valuations. In aggregate, the U.S. is more overvalued than any of the other six countries.

By itself, excess valuation does not preclude further price advances. It does, however, leave a stock market more vulnerable to other negative factors that influence prices. In the current environment, in which debt and solvency questions persist in many countries and banking systems, excess valuation raises the risk level for stock ownership.

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First Quarter 2013 Market Commentary

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Mission’s new formularized equity allocation processes, initially introduced in last year’s third quarter commentary, have produced increased profits for clients who have chosen to adopt them.  Although this won’t always be the case, each transaction produced a profit in the first quarter.  The full benefit accrued to those who adopted the processes in last year’s fourth quarter.  Those who began at various points in the first quarter received more benefit the longer they employed the processes.

Economic conditions throughout most of the world continue to deteriorate.  Europe’s recession is deepening. Emerging countries that have led the world recovery since 2008’s crisis are slowing perceptibly.  Japan’s economy remains in the doldrums.  The U.S. is experiencing its most sluggish recovery since World War II.  Sluggishness prevails despite world central bankers pumping far more new money into the banking system than ever before.  Despite years of aggressive stimulus, economies are not picking up steam.  In fact, recent economic deterioration has provoked central bankers to even more virulent stimulus.

Most of the world’s major stock markets have performed poorly this year.  The two striking exceptions have been the U.S. and Japan, whose central banks have each committed to unlimited quantitative easing.  Aggressive stimulus has not revived their economies but has powered their stock markets.  That divergence will not go on indefinitely.  The open question is whether the economies will pick up or whether the stock markets will falter.  The failure of stimulus elsewhere argues against the likelihood of economic revival, but it’s not impossible.  Multi-century history similarly suggests that it’s unlikely that major nations will be able to print their way out of debt crisis without considerable collateral damage.  Mission’s new equity allocation processes recognize the difficulty that faces the Fed, yet present opportunities to benefit should market strength continue, without assuming the risks that a permanent equity position presents.

The picture is similarly unattractive on the fixed income front.  The Fed has directed its stimulus effort toward driving interest rates as close to zero as possible.  That endeavor has provided artificially strong bond market returns for years.  Rates on most fixed income securities are now at or close to all-time lows.  While the Fed continues its commitment to hold rates near rock bottom for the foreseeable future, a growing chorus of critics is arguing that the unintended consequences of the policy will outweigh its benefits.  Some of those critics come from the ranks of Fed governors themselves.  Virtually all fixed income analysts agree that interest rates will rise from these levels sooner or later, doing damage to prices of all fixed income securities except those with the very shortest maturities.  To earn anything more than a minimal interest rate return, rates must decline even further.  While that remains possible, despite already historic low yields, the potential losses from rising rates far exceed the potential rewards from declining rates.  Slightly rising rates in the first quarter led to losses on longer maturity fixed income instruments.  Such losses could become far more severe should rates rise more aggressively.

As a hedge against the long-term inflationary effects of excessive money printing, we have held a small gold position for several quarters.  As we have said throughout that holding period, there is no way to compute an “appropriate” gold price based solely on fundamental factors.  Gold’s price is primarily determined by investor sentiment.  We acquired a 3% gold position in late-2011, indicating at that time that we would add to that position only if prices declined further.  Prices instead rose.  When it appeared that gold prices were unlikely to break to new highs, we scaled back by taking profits on part of that position near gold’s 2012 high prices.  Declining gold prices took a little out of first quarter performance.  We will build a larger position if the current decline continues, especially if prices move significantly lower.

The year ahead will likely present a great many twists and turns.  Most critical will be whether or not investors retain the belief that central bankers are capable of overcoming deteriorating economic fundamentals.  Governments have been winning that battle over the last few years, but risk levels remain extremely high.

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Central Bankers’ Giant Gamble

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Japan’s recent pledge to double its monetary base in an attempt to extricate itself from a two decade old deflationary cycle earns it a preeminent membership in the growing currency debasement club.  The world is experiencing the greatest explosion of new money ever.  Ostensibly, the exercise is designed to revive dormant, declining or barely growing economies.  Since the 2007-09 financial crisis, the flood of new money has been singularly unsuccessful in promoting strong growth.  At least in the United States, however, it has been eminently successful in pushing up stock prices.

Fed Chairman Ben Bernanke has made it clear that higher stock prices are a prime goal of current Fed policy.  Observing Bernanke’s success in rallying stocks, other central bankers and government officials have taken their cue from Ben. Mario Draghi’s “whatever it takes” pledge did marvels for stock prices throughout most of Europe until recent weeks.  China Securities Regulatory Commission Chairman Guo Shuqing indicated even more specifically that it’s necessary to intervene in China’s stock market at “key moments” to accomplish government goals.  The Bank of Japan has attacked the problem most directly by pledging to flood the markets with new money, not just by buying bonds but by purchasing REITs and equity ETFs as well.  I, among others, believe that our Fed has had a more direct influence on stock prices than it has acknowledged.  In any case, it has so far convinced investors that, like Draghi, it stands ready to do whatever it takes to keep prices rising.

While Bernanke still controls a majority, other Fed governors are becoming increasingly uncomfortable with unlimited quantitative easing.   Governor James Bullard yesterday called for an easing of the currently scheduled bond-buying program. Several other Fed voting members have voiced similar sentiments in recent weeks.  Some question the efficacy of the current program and readily admit to far less confidence than Chairman Bernanke that the Fed will be able to unwind this high-stakes experimental monetary policy.  Voices from outside the Fed are getting louder as well.  Among others, economists at the Bank for International Settlements, who claim their warnings of a credit bubble were ignored before the mid-decade financial crisis, are again pointing to unhealthy outcomes from seemingly uncontrolled monetary expansion.  Bernanke himself has admitted that his unconventional policies might not work “as well as we have hoped.”  At a recent press conference, he added, “We’ll be learning over time how efficacious they are.”

Central bankers have apparently painted themselves into a corner.  Debt levels have grown so immense that the Fed feels compelled to push interest rates close to zero so that debt service costs don’t overwhelm borrowers.  They have tried to accomplish that objective across the yield curve by buying unprecedented amounts of fixed income securities, thereby increasing total debt levels.  It is, of course, nonsensical to attempt to solve problems precipitated by excessive debt by adding more debt.

The lunacy of the current government approach is apparent as we observe monetary authorities now encouraging banks to ease their standards for real estate and automobile loans to include borrowers whose weak credit levels precipitated the prior crisis.  The Fed is pulling out all stops in an attempt to avert a recession that would lead to another round of bankruptcies and foreclosures.

Former Fed Chairman Paul Volcker warned Monday about potential dangers from what he calls “unorthodox” and aggressive moves by central banks around the world.  The King Report highlighted Volcker’s comments that central banks, including the Fed, could eventually inflict more harm by “what they’re doing with their portfolio to save the world economy….  Central banks are no longer central banks.”  The report added Black Rock’s Rick Reider’s contention that: “Fed policy has had a distorting effect on capital allocation decisions of all kinds at virtually every level of the economy.”  Finally, Dallas Fed President Richard Fisher added a final condemnation, arguing that the Fed’s programs are not working, are benefiting the wrong people, and may even be counterproductive.

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Cyprus – Canary In The Coal Mine?

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Another country bites the dust.

The dominant news item this week is that Cyprus has reached the point of no return without a financial rescue.  By itself, the failure of such a tiny economy would have virtually no effect on the broader world economy, notwithstanding the tremendous pain inflicted on direct creditors of the government or the country’s banks.  Cyprus’s economy is roughly the size of Vermont’s.  How this local crisis unfolds, however, could have far wider repercussions.

The banking system in Cyprus is far larger relative to the size of the economy (about eight times) than comparables in the rest of the world.  The United States banking system, for example, is about the same size as the country’s GDP.  Cyprus’s banks bet heavily on Greek debt, trusting that rescues ultimately would produce big profits.  On the contrary, losses were huge when Greek debt was restructured.

Eurozone monetary authorities have proposed a rescue plan, but have insisted that Cyprus’s banks bear a sizable part of the financial burden.  The initial plan, since rejected by the legislature, was to tax bank deposits up to 100,000 euros at 6.75% and above 100,000 euros at 9.9%.  Depositors both large and small screamed at such confiscation, especially because-at least at the lower level-deposits had been guaranteed, much as deposits in the United States are guaranteed by the FDIC.

Russia is expressing heavy displeasure, its citizens having deposited an estimated $12 billion in Cypriot banks.  Many in the Eurozone suspect that much of that money may be the product of “Russian Mafia” activities. Understandably, that suspicion lessens Eurozone members’ willingness to contribute to a bailout.

Unable to deal with the problem expeditiously, Cyprus has closed its banks until at least next Tuesday.  A primary concern is that open bank doors might lead to runs on the banks.  An even greater concern throughout the Eurozone is that depositors in financially challenged larger countries like Spain and Italy might begin to pull assets out of their domestic banks.  In an already precarious financial situation, the last thing heavily indebted countries want to see are pictures on the nightly news of lines of scared depositors streaming down the sidewalks outside major banks.  Such fears can become highly contagious.

Following the rejected tax on depositors, several proposed solutions have emerged, including tapping public pension funds. There is no clear Plan B.  Hope remains strong, however, that the other members of the Eurozone will ultimately pony up needed rescue money, rather than allow Cyprus to drop out of the 17 nation monetary union.

It is not at all clear which is the more powerful force: antipathy of Eurozone members toward providing more rescue money or fear of unknown consequences should Cyprus have to leave the union.  Should they leave, revalue their old currency and begin to recover, there could be a parade of others-led by Greece-that start down the same path.

While acknowledging that Cyprus’s default would barely register on the world financial scale, my first reaction was that this could be today’s version of the assassination of the Archduke Ferdinand, which line I used at a meeting yesterday.  I thought it was a clever analogy until I heard two others use it today on financial TV.  Let’s instead wonder whether Cyprus could be the canary in the coal mine.

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Eliminating Ego and Emotion – Rationale for Formularized Investing

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Ego and emotion have derailed more good investors over the years than any other factors except, perhaps, excessive leverage.  Acknowledging that historical fact when I established Mission’s equity selection process in the mid-1980s, I vowed not to fall prey to either of those stumbling blocks.  I didn’t want to depend on our investment team having to properly interpret hundreds of variables that can dictate investment success or failure.  And I certainly didn’t want equity selections that were heavily influenced by fear or greed– emotions that dominate Wall Street near price extremes.

After reviewing many decades of fundamental stock selection criteria, I put together a formula incorporating several measures that have over the long term identified stocks with strong potential of outperforming major stock market indexes.  These measures are all valuation-based and have served us well for most of the past 27 years.  Since the January 1, 1986 inception of the equity selection process through December 31, 2012, all the stocks we have owned produced an annualized return of 16.9%.  Over the same period of time, the S&P 500 returned an annualized 9.9%.  That big a difference in equity-only performance is almost unheard of.  In fact, one investment consultant told us that she would have ignored our numbers had Mission not been verified by one of the national firms that authenticated Mission’s compliance with Global Investment Performance Standards (GIPS®). 

Notwithstanding that stellar equity selection record, we have spent the past few years researching a new method to expand our equity allocation.  Several years ago, the Federal Reserve began to dominate the securities markets with unprecedented money creation and massive direct securities purchases. Their actions produced a situation in which very few companies exhibited the attractive fundamentals that had been prevalent in prior decades.  As a result, very few companies met our strict valuation-based selection criteria.  Because there is no way to know how long the Fed will be able to dominate the markets, we felt compelled to find an additional way of identifying opportunities for profiting from equities without forfeiting the defensive characteristics that have always typified Mission’s portfolio management style. 

Over the past year, we have found and back-tested a very broad collection of measures and studies that, in the aggregate, have outperformed the S&P 500 with fewer and smaller losses than that index has experienced over the past 32 years.  True to our belief that successful management requires the elimination of ego and emotion from the investment process, we have built these data into two formularized investment processes.  We have begun to offer them to those clients who want to increase the potential for profitable equity exposure while still retaining considerable protection against significant losses.

These newer approaches differ from our traditional valuation-based equity selection process primarily in the time frame in which data are measured.  Our traditional process assesses valuations over the full scope of market history.  And we are strong believers in reversion to historical means.  The two new processes measure data over short to intermediate time frames, using moving averages and volatility bands.

We evaluate a broad collection of data in such major categories as: money supply, interest rates and direction, availability of funds for investment, inflation, Federal Reserve stance, advancing and declining stocks, investor optimism, valuations, new highs/new lows, economic conditions and stock earnings yields.  Most importantly, we give heavy weight to stock price direction and stock price momentum.  Especially in an era of Fed dominance, heavy weighting of price activity prevents remaining too long in a position supported by fundamentals, yet contradicted by price action.  That weighting has been integral to preventing substantial losses over the 32 years of back-testing.

The objective of each process is to outperform the S&P 500.  The 2-mode process is designed to own stocks when equity markets are advancing and to keep assets safely in cash equivalents when markets are declining.  The 3-mode process attempts to provide a positive return in both rising and falling equity markets.  It attempts to own stocks in the most attractive market environments, to keep assets safely in cash equivalents in uncertain market environments and to short stocks in the weakest market environments.

The following table provides a picture of the two formularized processes’ performance history over the past 32 years from January 1981 through December 2012.

* Trading costs are not included.

There can, of course, be no certainty that what has worked very successfully for 32 years will continue to perform as well in the future.  We expect, however, that there is a strong probability of continued success for three primary reasons: 1) the success of the formula was quite consistent over nearly a third of a century and not simply due to a few periods of significant outperformance; 2) the data studied are numerous and diverse, reducing the potential that a few measures becoming less well correlated with future stock market progress will substantially reduce the effectiveness of the formulas; and 3) the heavy weighting of price direction and price momentum has quite effectively prevented staying too long in a position recommended by fundamentals, but which is performing badly.

By applying these data in historically tested formulas, we are removing the destructive forces of ego and emotion from the decision-making process.   In an era in which central bankers have done serious damage to time-tested valuation measures, we are confident that these new approaches will allow us to seek returns from equities without sacrificing important protection against significant losses.  And that protection could still be critically important with our Federal Reserve and other world central banks increasing debt levels as though there will be no negative consequences.

Please contact us if you would like additional information about the processes.

 

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Stock Forecasts Go To Extremes

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Hearing former Merrill Lynch technical analyst Charles Nenner forecast Dow 5,000 on Bloomberg TV today made me reflect on some of the more dramatic price calls in recent years.  Nenner has a wide institutional following, and this isn’t his first prediction of 5000.  In 2010 and 2011, his cycle work led him to expect the precipitous decline to 5000 by 2013.  He now expects that decline to begin in 2013 and continue to a bottom in 2017 or 2018.

Famed bond analyst Bill Gross made headlines years ago when he stepped into the equity arena and voiced his similar expectation of the Dow dropping to 5000.  Bob Prechter has gone him several better by pointing to an undated 1000 target.

Striking as those forecasts are in a negative direction, exuberant bulls are even more prevalent.  (Bullishness sells better.)  A few months ago, Thomas Lee, J.P. Morgan Chief U.S. Equity Strategist, opined that the Dow would hit 20,000 within four years–not an extreme outlook by historic standards.  Widely read commentator James Altucher recently predicted reaching a more aggressive 20,000 goal in a mere 12 to 18 months.  Of course, extreme predictions are nothing new.  In 1999, just before the dot.com bust, James Glassman and Kevin Hassett sold lots of books by forecasting Dow 36,000.  In 2010, Forbes upped the ante by profiling the work of an unnamed analyst who anticipated Dow 50,000.

Warren Buffett was interviewed for three hours this morning on CNBC.  In a wide-ranging discussion he voiced his regular theme that he is not a short-term market forecaster.  He has built Berkshire Hathaway over the years by persistently pursuing value and by buying companies that appear to have a durable competitive advantage.  While Berkshire has achieved an outstanding long-term record, Buffett reminded viewers that its stock price has been cut in half four times over the decades.  He retains his long-term bullish outlook for the American economy and stock market.

Any number of outcomes remain possible for U.S. and foreign economies and markets in the years ahead.  The upcoming decade or two could look like most of their recent predecessors.  On the other hand, they might not.  Domestic and world debt levels have risen to unprecedented heights and are still being boosted aggressively by a coordinated round of loose money and fiscal stimulus.  This Time Is Different, Reinhart and Rogoff’s comprehensive study of 800 years of financial crises, warns that such overwhelming rescue efforts typically end badly.  Nonetheless, Buffett and most others remain bullish.  We have long counseled that stock prices can continue to rise as long as confidence remains firm that central bankers will be able to counteract weak underlying fundamentals.  We have simultaneously warned, however, that such confidence can fade quickly and that years of gains can be erased quickly when confidence is lost.  Investors should weigh carefully current unique conditions when deciding on what percentage of assets to expose to equity risk.

In our last two quarterly commentaries and in other recent writings, I have discussed alternative investment processes that we have researched over the past two years.  These approaches are designed to evaluate short-to intermediate-term conditions in an environment in which the Fed has negated the effectiveness of many traditional analytic tools.  Since October, we have offered an alternative equity selection process which we have back-tested for 32 years.  It has historically outperformed the S&P 500 over that time while suffering fewer and smaller annual and quarterly declines.  For those desiring increased equity exposure, we are pleased to provide additional details.

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A Look At The Forest, Not Just The Trees

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Most investors–and investment analysts and managers as well–tend to get fully wrapped up in short-term news and market movements.  At times, it’s helpful to step back to observe markets and market-moving fundamentals from a distance.

In the early weeks of 2013, the S&P has climbed above the 1500 level, approaching highs that marked the market peaks in 2000 and 2007.  Since the turn of the century, investors have witnessed two destructive bear markets followed by two extended bull markets, each essentially recouping the capital lost through the preceding declines.  Examining a long-term price graph from DecisionPoint reveals an intriguing symmetry, but there are some interesting differences in the respective bull and bear legs.

Only a few panicky price dips in 2008-09 broke below the lower boundary of the 21st century range in the high 700s.  The mid-1500s have marked the upper boundary.

The initial decline lasted three full years from early-2000 to early-2003.  The 9/11 disaster in 2001 certainly cast a pall over the nation psychologically, but that cyclical bear market had already realized well more than half its ultimate losses by the time of the insidious attack.

The bear market from late-2007 to early-2009 was far more precipitous, covering a slightly larger price range in merely half the time. Debt problems that characterized both cyclical bear markets had become far more severe by mid-decade and led to frozen financial markets by early-2009.  Distrust of others’ balance sheets led major banks to refuse credit even to some of the world’s largest financial institutions.  Only unprecedented intervention and rescue money from government entities reliquified the financial system and prevented a monumental economic collapse.  The jury is still out on whether or not the ultimate costs of that intervention will prove more onerous than the pain avoided.

As confidence gradually grew that the system was not about to relapse, stock prices again began to rise.  But the cyclical bull market that began in March 2009 and endures today has some noteworthy differences from its two predecessors.  The move from below 800 up to the peak in early-2000 took a mere three years. It was interrupted by just one pullback of consequence, the precipitous price decline in 1998 corresponding with the Russian debt default and the collapse and rescue of Long Term Capital Management.

The next advance of about 800 S&P points took approximately four and a half years from early-2003 to late-2007.  It was noteworthy for its lack of even a single price decline of 10% or more until shortly before the ultimate price peak.  Investors became increasingly emboldened–despite burgeoning debt burdens around the world—by the belief that the “Greenspan put” guaranteed a Federal Reserve rescue effort should stock prices weaken.  As a result, a buy-the-dips mentality led to increasingly quick trigger fingers every time stocks paused for a breath. Dips became almost non-existent until prices rose above 1500.

The current cyclical bull market has a different look from its immediate predecessors.  Similar to 2003-07, this advance took just about four years to climb above 1500.  Dissimilarly, the path has not been a smooth one.  The economic recovery since 2009 has been the weakest in the post-World War II era.  Debt problems have continued to grow worldwide, leading to sovereign bankruptcies in several countries, with defaults avoided only by central bank rescues.  In the U.S., stock prices experienced major declines in 2010, 2011, and 2012 as Fed stimulus programs approached their scheduled terminations.  Unwilling to allow a recession while monumental debt burdens remained, the Fed in each instance figuratively revved up its printing presses and announced another round of stimulus with the acknowledged goal of lifting stock prices.  So far that move has worked to lift prices back to their former 2000 and 2007 levels.  So persistent and successful have been the Fed’s efforts in this cycle that the “Bernanke put” has acquired the status of its immediate predecessor, and many investor confidence surveys have risen back to their 2007 levels.

No one knows how long that confidence will last.  Clearly, the Fed will bend every effort to push stock prices through the highs reached in 2000 and 2007.  The promised unlimited stimulus, however, continues to expand already extremely dangerous levels of government debt.  Stock ownership today constitutes a bet that the Fed will win its dangerous gamble.  And a growing portion of the investment community is willing to make that bet.  Should confidence wane for any reason, it may be helpful to remember that prices were cut in half the last two times the S&P 500 rose to these levels.  And at both those prior peaks, debt levels were significantly lower than today’s.

Investors willing to speculate on continued Fed success should carefully calculate how they will protect assets should the Fed’s best efforts again fail to support stock prices, as has occurred numerous times over the past century.

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Reflections On The News

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Over the past few days, several interesting items appeared in the news and in investment-related reading that crossed my desk.

Thanks to Richard Russell, long-term publisher of Dow Theory Letters, for a quote from Ernest Hemingway: “The first panacea for a mismanaged nation is inflation of the currency.  The second is war.  Both bring a temporary prosperity.  Both bring a permanent ruin.  But both are the refuge of political and economic opportunists.”

Richard, now well into his 80’s, is an old friend from La Jolla, California.  Back in the early-1980’s he was one of the guest speakers at our annual client conference, followed over the years by such economic and market heavyweights as Marty Zweig, former Federal Reserve Governor Martha Seger and “Irrational Exuberance” author Robert Shiller.  Richard is still an eclectic reader and his experience makes his insights worthy of attention.  Very much in concert with my beliefs is the following excerpt from his February 7 commentary:

The Fed is printing like mad in an effort to keep the economy “above water.”  If so, you ask, “then why aren’t interest rates rising?”  I’ve stated that the Fed can continue to print until the bond market “says it can’t.”  Then, you ask, what’s holding the bond market up?

Here again it’s the Fed.  The Fed is buying $85 billion worth of bonds a month in its game of not allowing bonds to decline and not allowing interest rates to rise.  The whole manipulated situation has forced investors to move into the stock market.  The current low VIX demonstrates that option traders don’t perceive any danger while the Fed retains control and while the Fed continues its manipulations.

Corporate earnings remain good and dividends continue to be paid.  As I see it, there’s no timing the situation.  My belief is that we’re building a speculative and manipulated edifice like no other that I’ve ever seen.  At some point the edifice, with literally no warning, will topple over.  At that point, we may see one of the worst crashes in stock market history.  At that point, an angry crowd will turn against a chagrined Fed, and a new monetary system will have to be created.

The underlying question is whether central bankers can create wealth by essentially printing money.  Never in my 44 years of investment experience have so many central bankers pledged their troth to the common cause of cheapening their respective currencies.  Since there is no acknowledged standard of value, currencies measure their strength or weakness against one another.  It should be obvious that all currencies cannot be weakened simultaneously without substantial inflation.  Right now, the still powerful force of deleveraging at the consumer level is suppressing that tendency toward inflation.  That suppression fosters an unstable equilibrium.  When central bankers last behaved similarly – in the 1930s – currency wars and trade wars exacerbated the Great Depression.  Such experiences could be in our future.

I saw a CNBC interview yesterday with Fed Governor Charles Evans, a leading advocate of aggressive money printing.  Admitting that current Fed policy is experimental, he characterized it, not as a marathon, but rather as a half marathon.  Carrying his metaphor further, he indicated that the Fed has loaded the economy with carbohydrates and “energy bars.”

Having run a couple of dozen marathons–even one ultra-marathon–back when my knees and other body parts were far more tolerant of 50-to 100-mile training weeks, I can attest to the inadvisability of attempting even the half marathon distance without sufficient training.  Weaknesses in body parts you didn’t even know you had start screaming for attention when a runner ventures into distances not properly trained for.  Over the decades, the Fed has metaphorically run a few 5K and 10K races, and their healthy recovery record from those has been spotty at best.

The Fed’s acknowledgement that the current policy is experimental is a frank admission that they haven’t trained for this distance.  They don’t know what possible difficulties await them when they get past the 10-mile mark.  Their singular inability to promote even a historically normal economic recovery despite unprecedented stimulus is clear testimony to the difficulty of this race course.  Their biggest surprise could still lie ahead of them.

Fiendish race directors may not place a finish line at the 13.1-mile mark.  Instead, they may demand that the Fed keep running.  Having not even prepared properly for a half marathon, the Fed may be forced to proceed toward a more distant target.  The potential for serious damage to the system grows exponentially as the course lengthens.

I don’t know if Fed Governor Evans is a runner or not, but his analogy may be very apt, and even a half marathon may reveal weaknesses that the Fed doesn’t yet appreciate.

One last item from this week’s news.  CNBC this morning featured an interview with Rachel Fox, a 16-year-old actress with a part in Desperate Housewives.  She acknowledges her off-screen activities to include day-trading stocks.  While she is both intelligent and well-spoken, you can just imagine how much experience she brings to her financial endeavor.  This tale evokes recollections for anyone with a memory of the excesses at the two prior stock market peaks in this still young century.  I read (but don’t recall where) another comment about this story:  “Be afraid.  Be very afraid.”

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Soros Issues Both Praise And Warning

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This week many of the world’s wealthiest meet amidst the snow banks in Davos, Switzerland, accompanied by business people and politicians chasing that wealth and eager to influence it.  Inevitably, a sizeable press corps pursues interviews or at least sound bites.  And assorted glitterati prowl the premises doing whatever it is glitterati do.

A regular attendee at the World Economic Forum over the years, hedge fund pioneer George Soros is always in demand by financial reporters eager for a story.  Headlines this morning proclaimed Soros’ conclusion that central bank quantitative easing has prevented a worldwide depression.  The increasing success of multiple central bankers’ reflationary efforts has emboldened investors and underlies the continuing progress in most of the world’s equity markets.

Notwithstanding rising equity prices, Soros argues that Europe’s fundamental problems “have been papered over,” not solved.  He sees Germany’s insistence on further austerity–the price for ongoing rescue funds for endangered Eurozone countries–leading to further recession.  The division of countries into creditors and debtors with Germany in charge is “…in the long run, intolerable.”  He views the political instability as creating the “danger of destroying the European Union.”

Soros pointed also to problems brewing between Europe and other developed countries and warned of prospective currency wars.  No country wants the strongest currency, because it boosts the price of a country’s exports.  That dilemma looms as a possible problem in 2013 as countries throughout the world fight to retain their export competitiveness.  Historically, currency wars are unpredictable and highly destabilizing.  They will remain a hard-to-evaluate wild card for investors in the period ahead.

With its succession of quantitative easings, the United States is in the forefront of widespread efforts to weaken currencies.  This month marks a milestone in that unconscionable effort.  Merely four years ago, the balance sheet of the Federal Reserve showed a figure of approximately $800 billion after almost a century of existence.  After less than half a decade of unprecedented money printing, that figure has just reached the almost inconceivable level of $3 trillion.  It is scheduled to reach $4 trillion by year-end.  Members of the Fed’s apprehensive minority, like Dallas Fed President Richard Fisher, argue that the current level represents a massive gamble, since there is no precedent for withdrawing such a volume of stimulus.  In fact, as pointed out in great detail in Reinhart and Rogoff’s “This Time Is Different,” similar attempts to rescue countries from banking crises over past centuries have typically resulted in severe economic dislocations for a decade or more.  The Fed and other central bankers are playing with fire.

For now, however, such aggressive stimulus is pushing stock and bond prices up.  As we pointed out in last week’s year-end commentary, that rise can continue as long as investors retain confidence in central bankers’ ability to overcome weak economic fundamentals.  Investors are well advised, however, to continue monitoring that level of confidence, which can reverse quickly.

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