1/1/12 –

 

On 12/31/11 the S&P 500 closed at 1258, resulting in a total return of 2.1% for the year. All of this return came from dividends. The year starts with continuing sovereign debt problems in Europe. We will therefore first analyze possible significant events and then discuss our current asset allocation to stocks, given the situation. 

The Eurozone was founded by the Treaty of Maastricht in 1992. At that time, the founders hoped that their currency union would evolve into a political union. The currency union was a success, but the Council of Ministers failed to apply sanctions against France and Germany for continually violating their 3% government deficit/GDP guidelines and never fined Portugal (2002) and Greece (2005). In 2010, the Eurozone’s average deficit/GDP ratio was 6%.   

Both Eurozone finances and the U.S. system of derivative structured mortgage finance illustrate the idea that a theoretically flawed system can muddle through for years, provided it’s foundation isn’t too compromised. What cracked the U.S. financial system was (literally) a wholesale and reckless disregard for mortgage credit standards. What cracked the Eurozone was the admission of Greece, that had large deficit problems, and private credit and real estate bubbles in Ireland and Spain, the former requiring a large government bailout of its banks. These collapses called into question the markets’ conventional wisdom that the finances of all Eurozone countries were equally sound. In the U.S., Mr. Market’s conventional wisdom was that house prices would never decline.

In finance, the conventional wisdom is a straight line. People either believe that things will get better or worse forever ¹, transitioning abruptly between the two as circumstances affect the emotions of fear and greed. In the Eurozone crisis, the markets now believe the worst. To be logical, that is to keep your head while others are losing theirs, it’s useful to analyze what engineers call the system’s failure points to investigate in a more detailed fashion what might happen.

There are two major failure points in the Eurozone. The first is the banking system, and the second is an member state default or exit.

Failure of the Banking System

The balance sheets of European banks are highly leveraged. The leverage of an European bank may be 2-3 times higher than that of U.S. banks’. What justified this were two things: Advanced risk management practices (scratch that) and less risky investments in sovereign debt (that is what this is about). The European Banking Authority will require that their banks raise $150 billion in additional capital.

This is equal to the capitalization of one large U.S. bank, not at all meaningful for an economy that is just slightly smaller than the U.S.’s. We suspect more capital will actually be required to return the banks to health. On December 5, the European Central Bank significantly promised to supply its banks with three years of liquidity financing. The Fed will also make dollars available to the central banks to prevent a seize-up of the international financial system. The central banks have decided that there will be no “Lehman moment.” We’ll take them at their word. We think the banking system is well enough backstopped; although (to use a polite phrase) there will be some volatility if individual banks get into trouble.

Member State Default or Exit

If you see on television the demonstrations in the streets around the world, not just Athens, you are looking at the toll that financial excesses have caused. That might also be a moment to reflect on how effective institutions really do matter to keep a society functioning (also to give the U.S. stock market an average around which it can fluctuate).

Imbalances, that is a lack of equilibrium - static or dynamic, lie at the root of the Eurozone crisis. These imbalances need to be cured in both the short and long runs.

In the short run, many countries of the Eurozone now have credit problems. Italy, with the third largest economy in the Eurozone, is too big to fail. Countries that try to leave the Euro will assuredly destroy their banking systems. On rumor, their citizens will try to withdraw their bank deposits and convert them into foreign Euros.

A better solution is to have the ECB issue short-term guarantees of government debt. That would facilitate future financings, automatically improve bank balance sheets and let existing long-term debt accurately reflect the efficacy of the political and economic reforms that have to occur. The current problem is an ECB mindset that sees itself as responsible only for the Eurozone banks, not as a lender of last resort to governments. This excerpt from the 12/15/11 ECB website shows a certain head-in-the-sand attitude. In contrast, during the Financial Crisis of 2008, the U.S. Fed supplied $7.77 trillion in guarantees and loans, 55% of GDP, to the financial system. 

In the long run, as in the U.S., the public has to accept difficult entitlement and growth reforms. But the Eurozone countries are now being asked to give up their budget sovereignty; the proposed administrative measures of sanctions and fines are draconian if applied. They do not take into account the fact that Europe is comprised of countries. The attempt to impose a larger political order on Europe, that has scant public support, is a reach too far.

A long-term solution to this crisis could look like this: Manage by setting limits. Countries will maintain their sovereignty if they can access the credit markets at acceptable terms and comply with a budget deficit limit set higher than 3% ². If not, the IMF or EU will encourage them to properly maintain their properties in the Eurozone condominium. Right now, the Eurozone won’t put much money in a deal to rescue themselves. This is really a problem. 

What does this mean for investors? In spite of a few tentative “green shoots of recovery” beginning to appear in the United States, the short-term behavior of your investments will depend on the uncertain events developing across the Atlantic, which will be ongoing. Here is a really useful general rule for your investment money, also noted by John Bogle of Vanguard: The  bond ³ percentage of your portfolio should equal your age. The percentage of stocks will therefore equal (100-bond percentage). Most people should probably target a minimum of 20% stocks in their portfolio.

Given the above, we are comfortable with being invested in stocks at around 40% of target. This means that if the stock market drops by 30%, the portfolio will drop by a tolerable amount. Those who can’t stand any loss should stay in a laddered portfolio of bonds, but that is generally a bad idea – particularly since good stocks now yield more than 3%. Stocks are a source of income and an hedge against long-term inflation. 

The applicable motto is: Hope for the best, but prepare for the worst.⁴ In Europe, the best could occur after the worst truly threatens. 

 

 

¹ In The General Theory (1935), Keynes wrote about long-term expectation. “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel confident…For this reason the facts of the existing situation enter, in a sense disproportionately into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future *, modified only to the extent that we have more or less definite reasons for expecting a change.”

* Value investors do this as well, building in a margin of safety, but only for companies that have sustainable competitive advantages. All empirical quantitative analysis has, in some sense, to be historically based. Natural science analysis is based upon tables of correlated experimental numbers, from which laws. In the social sciences, additional considerations relevant to the ordering of society, the values of fairness and justice, also enter. These two values are usually implicit in political discussion.   

² In the difficult circumstances of 2010, the average Eurozone budget deficit was 6%, which could be about right for some sort of country upper limit. Out of the seventeen Eurozone nations, only Finland complied with the 3% limit.

³ add: A laddered bond portfolio differs from an intermediate term bond mutual fund. Laddered bond portfolios are comprised of individual bonds that are chosen to expire a set intervals, say in one year, two years…etc. As a result, the portfolio will continually be provided with liquidity for reinvestment at then current interest rates. Given currently low interest rates, we would definitely look into this type of bond portfolio to avoid large losses when rates rise in the future. This type of portfolio, containing only bonds of good credit quality, needs to be set up with the aid of financial specialists.  

⁴ This military motto is risk-adverse.

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From the feedback we’ve been getting, the article above has been received by some of our readers with a degree of concern. This is because people like certainty. Social institutions exist to make life more predictable. But the Financial Crisis of 2008 is now eroding the public system, including the system of sovereign debt. There are two possible solutions for restoring economic growth.¹ The simple solution is to seek the restoration of that growth by slogans that relate to second-order economic effects such as, “no new taxes,” or, “get government out of the way.” The last thing that people who really start new companies think about is the tax on expected profits. The U.S. now faces economic competition from highly government-directed societies. The effective solution is to directly confront the problem: reduce the growth in debt by making difficult fiscal reforms and restore economic growth by making social changes: changes in education, industrial structure, and government trade policies. The culture wars really get in the way of this.

The Financial Crisis of 2008 is compromising the institutions of society; and, as is happening in Europe, these social compacts have to be renegotiated. This, of course, creates investment uncertainty. There is no getting around this. The best we can do as equity value investors is to balance the add: system rewards and the risks. These risks will not go away for a long time; they are perhaps more characteristic of the developing markets. This is a complicated time when only a balanced rationality will get us out of present circumstances. The alternative is chaos or revolution, but the latter also has its costs.

Election year politics is not subtle; it is simple. However, if forced to make a choice between, “Government” or “No Government,” we would choose the former to make room for future solutions.

 

¹ Also low-risk assets yielding decent rates of return

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2/1/12 –

On 1/20/11 we began to increase our equity allocation from around 40% of target to 70% of target. The attitudes of the negotiators from both Greece and the EU are constructive, and we think it likely that they can reach an agreement that will enable disbursements of a €130 billion loan to proceed. Both Greece and Portugal together account to only 3.3% of the Eurozone’s GDP, but the stakes for the major Eurozone economies are huge. With a combination of both ECB and IMF funding (the Eurozone countries are expected to provide more than half of the latter) and some structural reform in Athens, the Eurozone is gradually getting control of their problems in their own way. add: The FT later suggests a better way.

This cultural distinction is crucial, and is an opportunity to briefly discuss how capitalism on the Continent differs from the Anglo-American market model, that (for better or worse) maximizes freedom. The American model is one of trial and error, based upon effective institutions. The net result is a dialectic, or dialogue, where changing circumstances modify institutions and vice-versa (provided ideology doesn’t get in the way).* This market system is highly creative, but also inefficient. Under this system individual economic actors are in an often wasteful competition, but the entire system effectively adapts to a changing environment.

►The American institutional solution for the Eurozone market crisis was simple and clear. Provide central bank guarantees to restore market confidence.

Germany is the premier economy on the Continent. Its evolution was, of course, shaped by its culture but also by the fact that it came late to the game of economic competition. The economic modernization of Germany provided a highly relevant model to the developing world that persists, via Japan, to this day in Asia. In a really notable article titled, “Ideas, Institutions and Organized Capitalism,” Christopher Allen writes:

One can tell a great deal about the organization of a nation’s economic policy by understanding the country’s timing of industrialization and democratization. Countries that industrialized early tended to have laissez-faire free market economies that gradually evolved into the world’s leading economies because their good fortune and path-breaking industrialization allowed them to have relatively easy access to resources, markets, and capital. The UK and the U.S. are the prime examples of this pattern. Countries that industrialized later, such as Japan, faced a different set of choices. Lacking ready and predictable access to resources, markets, and capital, they needed to construct a different set of institutions if they were to catch up to the earlier industrializers. In short, they needed to construct a model that maximized efficient access and use of resources, targeted foreign markets since their own domestic markets were so underdeveloped, and allocated capital so that each investment had a high probability of success. Unlike the “trial and error” economies of the earlier industrializers, the latecomers had much less margin for error...”Trial-and-error” capitalism was simply not sufficient or fast enough (our note)….because production for domestic consumption was a second order priority, providing some sort of social protection for the majority of citizens who were not favored in these top-down…systems was crucial. In essence, this was an ‘all eggs in one basket” economic policy-especially during the nondemocratic Bismarckian era - that required close coordination of all major producers and the emphatic provision of social order. **

This was a state-directed autocratic capitalism that involved the close cooperation between producer and financial groups where, “Bismarck used the state more as an architect, rather than in an interventionist, micro-managing way.” Combined with aggressive nationalism, this system contained the seeds of its own ruin in two World Wars. In the postwar period, Germany developed a state-directed democratic capitalism, for the same reasons as above, but including other social organizations such as the trade unions and their allies. In the 1990s, its social market economy began to erode in the face of globalization, the expansion of the EU, and most important, the stresses of unification.

The Financial Crisis of 2008 has now placed both the Anglo-American and the Continental Europe economic models at question. Mohamed El-Erian writes in the FT that critics conclude, “…the crisis in capitalism is caused by two distinct failures: the inability of the system to deliver sustained prosperity through economic growth and jobs; and the perception that it is grossly unfair and socially unjust…(raising) legitimate questions about the model itself.”

►What the United States sees as “dithering” is an attempt by the Europeans, and Germany in particular, to create a sound “architecture” of Eurozone institutions to meet new challenges. That is, to cut to the chase, mercantilist Germany gains such overwhelming benefits from the Euro - an undervalued currency and trade surplus - they will ultimately “pay anything” *** to keep the Eurozone intact until the economic reforms they advocate become a reality.  

Given the number of parties involved, this task will be slow and difficult. In contrast, the American challenge is somewhat easier, if ideology doesn’t get in the way, because its society is more simply organized around markets and founded upon institutions that require relatively moderate reform to become again effective. In specific, financial regulation needs to be improved; the social contract has to be slightly renegotiated; and the state has to become more involved in trade policy and investments for the future (as the Friedman book and Keynes suggested).

We think that a certain degree of optimism about the future is not misplaced. Relative to other societies, provided reform is not blocked, the United States has a more adaptable and coherent social system.

 

 * In 1943, Churchill said, “First we shape our buildings and then they shape us.” We think this idea is important.

** This article by Christopher Allen was published in the journal, “German Politics and Society,” Summer, 2010 issue. It is well worth your time if you are interested in how the economies of different societies are organized.

*** This is the view of Fred Bergsten, director of the Peterson Institute. He also discusses a question that interests us greatly. Why do experts disagree? A former U.S. government official said people disagree because of different philosophies and life experiences. Mr. Bergsten, more specifically, says that this is because of using different models. Pessimists about the Eurozone critique the system using an “optimal currency model,” no currency adjustment within the Eurozone therefore disaster. Mr. Bergsten, we think properly, uses a more general political economic model that starts with the culture and interests of those involved. Which model is right? The one that is closer to reality and therefore has the intended consequences.  

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These 12/2011 Fed statistics state the obvious. Total lending is growing but slowly, the amount of real estate credit (securities and lending) has decreased, but lending to the industrial sector is growing rapidly. This suggests to us that led by the industrial sector, the “green shoots of recovery” might finally persist after four difficult years because growth begets growth - absent major problems in Europe. However this recovery is anemic because usually housing leads and the total rebound is greater because both housing and business investment increase. *

 

                                                           

 

                                  U.S. Bank Lending (billions of dollars) ¹

 

	12/2010	12/2011	% Change
Total Bank Credit	9,205	9,416	+  2.3
All Real Estate Credit 2	4,874	4,863	-     .2
Commercial and Ind. Lending	1,215	1,338	+10.1
2 Sum of lines 4,7,11

 

  ¹ Federal Reserve 2/3/12 Call Report (p.2), seasonally adjusted

 

About value investing: Invest when prospects are bright and the sky is sunny? That is momentum investing, betting the market will increase from a P/E of 21. Invest when prospects are not so bright and the sky is cloudy? This is value investing when the market is around a P/E of 13. Value investors don’t mind investing into problems – at the right price. We did not invest when the market was at a P/E of 8 because the financial system was at question.

 

 

* By complaining about anemic economic growth, the Republicans really aren’t complaining about too much government. They are complaining that the U.S. isn’t building many more houses. It is contradictory to say that government should just let housing prices bottom and implicitly advocate building more houses to boost growth.

The above considers the U.S. stock market from a cyclical standpoint. The major issues facing the economy are long-term structural, requiring a role for government. The U.S. needs more than non-exportable houses to restore growth.

There is also a systems issue. Both evolving institutions and free markets error correct. When effective institutions error correct, as we demonstrated in How the U.S. Stock Market Works, the moderate change that conservative Edmund Burke valued results. But, as the Financial Crisis of 2008 demonstrated, when markets error correct they can – with globalization – destroy worthy companies and whole economies. Imagine what would happen if the market lost faith in the U.S. dollar due to large continued trade imbalances. This is why error correction by effective institutions is much better than error correction by panicked markets. Look at what is happening in the Eurozone.  

 

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The alphabet international organizations: The ECU, ECB, and IMF Troika, the Eurozone central banks and private lenders will likely reach agreement and lend an additional  €130 billion, provided Greece increases its austerity. That does not solve the basic problem of insufficient growth. The following IMF projections show that at least 2.5% real economic growth will be required for it to be able to reduce debt to 120% of GDP by 2020. But Greece has an import economy and may not be able to implement the necessary structural reforms.

 

                               Greece: Fifth Review 12/31/11 Revised Baseline Scenario (IMF report, page 71)                 

Year	2011	2012	2013	2014	2015	2016-2020
Assumed GDP Growth	-6.0%*	-3.0%	0.4%	1.9%	2.5%	2.5% +
Public Debt as %  GDP	161%	162%	155%	152%	147%	142%-120%**

* -6.8% (A) ** IMF research suggests, “105 to a maximum of 120 percent of GDP as a sustainable range for debt in market access countries.”

This means, as the situation now exists, the Greek financial crisis will likely be ongoing. If it proceeds on this course, the Eurozone needs to fence off the problem, to reduce contagion to other financial markets. It is estimated that seventy percent of the Eurozone’s new loan will be earmarked to paying off Greece’s existing debtors, less recent writeoffs. How long can this go on? The 2/10/12 FT points out a crucial fact. Greece’s primary budget balance is due to go positive this year meaning before debt service costs; they won’t need foreign capital.

 

                                    Greece: Fifth Review 12/31/11 Revised Baseline Scenario (IMF report, page 71)                  

Year		2011	2012	2013	2014	2015	2016-2020
Assumed GDP Growth		-6.0%*	-3.0%	0.4%	1.9%	2.5%	2.5% +
Primary Balance** as % GDP		-2.2%	+.2%	+2.6%	+4.5%	+4.5%	+4.5-4.3%
	* -6.8% (A) ** % Revenues – % non interest expenditures. The corporate equivalent of this is % net operating income.

 

It is useful to note the goal of the judicial Chapter 11 bankruptcy process in the United States and now similarly in England. The goal of bankruptcy is practical, to rehabilitate the debtor. This negotiated process results in a restructured corporate balance sheet. The company is then able to start anew.

Even though their government has a present problem with trust, the Greeks deserve more than a foreclosed future. The FT article simply suggests, “The Eurozone could press ahead with the steepest possible restructuring of privately held Greek debt – and drop its pretence that it be voluntary – then stand behind whatever remains by funding an escrow account for debt service. No more money need to be sent to Athens…Greeks could (then) choose for themselves how to continue their painful adjustment to economic reality.” * The net result is that the Eurozone will be guaranteeing itself for the remaining debt. With this, everyone – including the Eurozone itself - will be forced to own up to their mistakes. Before chargeoffs, Greek public debt is around 4.1% of the Eurozone total.

A problem with the idea of debt cancellation is that other countries, for instance Portugal or Ireland, could demand the same deal. The problems of fairness, however, pale beside the problem of trying to impose a draconian Treaty of Versailles on an increasingly unwilling Greek people. They should be able to decide whether to stay in the Eurozone or leave.    

 

* This is the best solution for Greece and the Eurozone as a whole, but there are conceptual impediments on the continent. This is no giveaway. Greece has not the capacity to reduce its debts and will not be able to access the debt markets for years. The alternative to substantial restructuring, now, is likely increased social violence and a failed state on Europe’s doorstep. If you think this idea is costly…

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3/1/12 -

On 2/21/12 the Eurozone ministers met in Brussels and approved a second €130 billion bailout for Greece. It is not likely that this will be effective because it does not meet the requirements that the noted classicist, Donald Kagan, set for a durable peace treaty: First, the peace treaty must reflect the true situation. Second, the principals must want to make it effective. This bailout meets neither requirement. The Eurozone has dodged the bullet of default; but all it has done is again kick the can down the road – while shoring up the firewalls to avoid contagion. It would have been much better if this bailout had been negotiated from the fundamentals. *

Since many of our readers are invested in stocks, this is a good opportunity to discuss two possible reactions to market declines. If you’re leveraged, you have to be a trader. Because, whether the price of a stock declines due to events or sunspots, the mere fact of decline can result in a margin call. Just ask MF Global. If you are not leveraged, you have time to ask whether that market slide is due to ordinary events that are inconsequential in the long-run (because you have conviction, having done your homework) or due to overvaluation or financial systems problems.

If ordinary events cause a stock market decline, and there will be many, the best advice is, “Roll with the punches.” We think the Eurocrisis is now in this category.

If the cause of a beginning market decline is overvaluation or severe financial systems problems, then it’s best to exit the stock market. Extreme overvaluation generally occurs when the economy has been doing very well and Fed is on alert to raise interest rates substantially to control inflation. Financial systems problems are rare; but if they do occur – as they did in 1930, the 1970s, and in 2008 – they can obliterate a substantial portion of the economic system and your portfolio. All these were caused by mistakes in economic regulation or policy, involving both the Federal Reserve Bank and the political party then in power.

Isaiah Berlin wrote that judgment is knowing when to act and when not to. Good judgment is what Aristotle called practical wisdom, almost always based upon the situation. In the last decade, many lost their lives and others lost their livelihoods due to the bad judgment caused by blind political ideology.

 

* Why is the Eurozone being, to use a polite word, so “obtuse”? To but chide Germany slightly. A member of the opposition Social Democratic party noted:

 

Angela Merkel risks a revolt within her own party should she agree to any measures that might impose costs on German taxpayers or diverge from German economic dogmatism, especially the mantra of central bank independence. From the beginning of this crisis, the involvement of the European Central Bank has been a sore point for Germany. It has become a question of principle rather than a question of economic reasoning (our note).   To outsiders this may astonishing…To cling to economic principles that predate monetary union and the evident market failures of the past years seems naïve at best, when considering the possible fallout….But to discuss alternatives to Germany’s central banking dogmatism is taboo for Germany’s right, regardless of advice from Nobel laureates and German economists.

 

What Greece really needs is a German Marshall Plan; but, unfortunately, memories are short. After W.W. II, the U.S. helped out Europe from an enlightened self-interest.

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Business can be very constructive. The head of the German manufacturers’ association calls for just this kind of Marshall Plan for Greece. This is different from playing the kind of games that caused the Financial Crisis of 2008. In this video, FT correspondent Martin Wolf discusses Greece’s horrific alternative.

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The European process of forming a workable constitution is different from the American experience in 1787. The delegates to the Constitutional Convention were negotiating out of a common culture and historical experience, having just won the Revolution. The Europeans do not have this positive commonality (neither, apparently, does the U.S. Congress as presently constituted). Bergsten and Kirkegaard of the Peterson Institute write that the four parties: the ECB, the creditor nations led by Germany, the IMF and the private lenders are negotiating a deal by playing a massive game of chicken with each other.* In this process they are trying to, “…fundamentally reform the Eurozone institutions and structurally overhaul many Eurozone economies.”

The result is not going to be to be a crackup. “Europe’s key political actors…will thus quite rationally exhaust all alternative options in searching for the best possible deal before at the last minute coming to an agreement….Europe’s overriding political imperative to preserve the integration project will surely drive its leaders to ultimately secure the euro and restore the economic health of the continent.” We discuss Europe in detail. Not only because it’s interesting, illustrating how different cultures effect social order **, but also to illustrate that equity investing is not riskless and that risk cannot be precisely controlled (unless the whole world is Gaussian). Risks can be categorized as either acute or Gaussian; the former to be avoided like the plague, the latter kinds are controllable. Equity investing also requires optimism.

 

* The problem with this game is that uncontrollable circumstances can intervene, plunging all into disaster. However, Bergsten writes, “The key to understanding the evolution of the euro is to observe and analyze what the Europeans do rather than what they say. They have solved all of the many crises that have threatened the European integration project throughout its history of more than half a century in ways that have strengthened the institutions and pushed European integration forward. At each key stage of the current crisis, they have in fact done whatever is necessary to avoid collapse….The ultimate political goals (of Germany and the ECB)…assure this result.”

** We obviously prefer U.S. freedoms. But, to also state the obvious, the reality of the world is that cultures differ and different peoples have different ways of settling conflicts and doing things. Judgment is knowing how and when to act in real situations.

 

4/1/12 -

The next problem is Iran. Its outcome has investment implications. We think that serious negotiations with Iran will likely be successful because there is a clear solution. Without boots on the ground, U.S. or Israeli military action to take out Iran’s uranium enrichment facilities will only swat the hornet’s nest, at most delaying its nuclear effort by a few years as the regime further disperses and hardens its nuclear facilities against more outside intervention. Military intervention, as a last resort, would drive the world economy into another recession, further disrupt the fraught Mideast and hurt Iran more than the rest of the world.

In a talk at Columbia University, inventor and entrepreneur Steven Perlman said that inventors formulate the right question to ask. From asking that question, the answer naturally follows. * In the Iranian situation, the crucial question is, “What policy will enhance the security of the United States, Israel, and generally the Mideast?” If that is the question, bombing is a very imperfect solution. It is more rational for all sides to seriously negotiate.

The U.S. could simply take Iranians at their own word. Iran’s former spokesman for the nuclear negotiating team, Sayed Hossein Mousavian (now at Princeton, he’s obviously gotten reasonable), suggests:

Going forward, any viable solution needs to meet the bottom lines of both sides. For Iran, that means the ability to produce reliable civilian nuclear energy as it is entitled to do under the non-proliferation treaty. For the U.S. and Europe, it means never having Iran develop nuclear weapons or a short-notice breakout capability.                                                                          Bloomberg, 2/16/12

     

  

 

 

 

This means that Tehran should manufacture and stockpile only 4-5% enriched uranium for energy production. Iran also claims it needs 20% enriched uranium for medical and research purposes, from which weapons grade 90% + enriched uranium can be manufactured with only slight additional effort; consider the second graph that justifies only 4-5% enrichment. The U.S. could demand unconditional inspections of any location* in Iran to be sure that no 20% enriched uranium is ever again produced or stockpiled. It can then supply the Iranians with a tagged and tracked quantity of 20% enriched uranium if necessary.

Are the mullahs of Tehran rational? Fareed Zakaria answers, definitely: 

Indeed, Iran has been very calculating in its behavior, far more than other so-called radical, revolutionary regimes….Their behavior for 30 years has been calculating. They respond to inducements and pressures in ways that are completely understandable. Their goals are not ours, of course, but that’s a very different issue.                                                                         CNN, 3/8/12

 There is a clear path out of this crisis, but there will be a lot of bazaar haggling. Zakaria makes a useful distinction:

 

A rational actor is not a reasonable actor. It is not somebody who has the same goals or values as we have. In international affairs or economics, the term rational actor is used to describe somebody who is concerned about their survival, prosperity or strength and is making calculations on the basis of these concerns. It describes someone who calculates costs and benefits.

    

     

 

 

 

 

Meir Dagan, the former Director of Israel’s Mossad, characterizes the Iranians he has met:

    

They are rational, not in the western sense (thinking generally ? 1), but in the sense they think through the implications of what they are doing (thinking about the situation they are in? 2)  Right now, they are being very careful. They are maybe three years away from the bomb.      60 Minutes, 3/11/12 1 Also abstractly. 2 A social scientist can think of conditions.

 

The International Atomic Energy Agency is charged with implementing U.N. Security Council resolutions. Their February 24, 2012 report indicates the current inspection protocols are very porous due to the lack of Iranian cooperation. We have reproduced the summary.

 

* The 3/19/12 NYT mentions two caveats: 1) “…asking the right question only works if you are prepared to hear answers you don’t like.”  2) “Sometimes (always, in the case of ideology) our leaders start with the answers and work backward, fixing the facts to the policy, as the head of Britain’s MI6 said of the Potemkin intelligence used to sell the invasion of Iraq….If Iraq taught us nothing else, it should have taught us this: Before you deploy the troops, deploy the fact-checkers.”

 

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On 3/13/12, the Fed published the results of its CCAR (Comprehensive Capital Analysis and Review) of the nineteen largest U.S. bank holding companies. This analysis contains a lot of good news and some bad news. Under a condition of major stress, to be later discussed, the Tier I common capital ratio of all bank holding companies (incl. Goldman Sachs) dropped from 10.1% in Q3 2011 to a minimum of 6.8% in Q4 2013, a ratio of 5% being the regulatory minimum. The U.S. financial system is sound. The further good news is that all large commercial banks (J.P. Morgan Chase, Bank of America, Citigroup, Wells Fargo, and BNY Mellon) survived a stringent stress test with estimated Tier I common capital ratios above the minimum, assuming no capital actions such as increased common dividends and share repurchases.

The bad news is that Citigroup’s Tier I common capital ratio was a decent 5.9% in Q4 2013 assuming no capital actions. But with likely aggressive capital actions (payouts) planned by management, that ratio dropped to 4.9%, the second worst in the group of fifteen commercial bank holding companies similarly analyzed. By planning premature capital payouts, Citigroup’s management probably made the same mistake that Bank of America made in 2011. We invest in Citigroup for a recovery in the U.S., its future growth potential in the developing world, and its ability to replace capital; but we do think more patience on the dividend side would have been appropriate.

The Fed first assumed the following five major stress conditions: 1) Nominal GDP growth on an annualized basis of -1.7% in Q4, 2011; decreasing to -5.39% in Q1, 2012  2) A Dow of 7089 in Q2, 2012  3) An unemployment rate of 13.05% in Q2, 2013  4) A further decrease in house prices of 20% between Q4, 2011 and Q1, 2014  5) A large decrease in Eurozone GDP from -1% in Q4, 2011 to -6.91% in Q3, 2012.

How to model the losses of large commercial and industrial loans? According to the Fed report, “Losses on large commercial and industrial…loans are modeled by estimating the impact of macroeconomic variables on the probability of default for these exposures. The first stage of the modeling process is estimation of a series of equations relating historical changes in the median probability of default for 12 different borrower industries, six credit quality categories, and countries of incorporation to macroeconomic variables, including changes in stock price volatility and the spread on BBB- rated corporate bonds. Default probability data are derived from expected default frequency estimates….” We do not have technical experience with econometric credit equations, but think the result of this analysis will be consistent and generally useful.

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Speaking of social science conditions: This article by Harvard Professor Larry Summers characterizes the current economic recovery. “Such recovery as we are enjoying is less a reflection of the natural resilience of the American economy, than of the extraordinary steps that both fiscal and monetary policy have taken to offset private-sector deleveraging – a process that is far from complete.” Since no one can gauge the future with precision, future macroeconomic policy has to be contingent. “The right approach is policies that commit to normalizing conditions, but only when certain thresholds are crossed. The Federal Reserve might commit to maintain the current Fed funds rate until some (publicized) threshold with respect to unemployment or expected inflation is crossed.…Tax reform could phase in new rates in pace with the rising economic performance.”

 

5/1/12 –

Preliminary discussions with Iran about their nuclear program have been “useful,” but not yet specific. Iran and six other nations have agreed to meet later May in Baghdad, where serious negotiations on proposals drafted by the EU and Iran will begin.

U.S. economic conditions are slowly improving. The IMF Global Stability Map on page 2 of the 4/12 report also describes presently improved European financial conditions. The Eurozone, the European Central Bank and the IMF now all have firewalls to deal with credit problems in Spain or Italy, that did not exist a year ago. However, some Eurozone countries have severe structural problems; and there is a beginning political backlash against economic austerity.

Policy matters. Consider governments’ policy responses to the Financial Crisis of 2008, having learned the lesson of the 1930s. In both the U.S. and Europe, the central banks dodged the bullet of financial contagion bearing down upon them and stabilized the system, by lending freely. But Europe is making a new mistake by implementing country programs that impose years of fiscal austerity. It makes no sense to free up resources (increase unemployment) if the economy doesn’t know what to do with them, due to path dependence like losing export manufacturing. * Severe austerity is appropriate only if there is no hope for future economic growth. More constructively, Greece requires a viable export industry; and the U.S. requires industry that can reduce imports.

Assuming future U.S. economic growth, government can cushion downturns with appropriate spending, plan for more growth and companies should be encouraged to invest in the U.S. and its future. Both the U.S. and Europe require a mix of policies to restore balanced economic growth. Taking a cue from how Asia developed, if we had to focus upon one thing, the U.S. should encourage industry that can gradually reduce imports. 

Experience from the Financial Crisis of 2008 might suggest that business confidence and therefore markets are by nature fragile. The financial abuses were, however, substantial. They are now being corrected, both by the markets and appropriately by government. Because the U.S. is slowly recovering and there are European firewalls, the yearly returns of the U.S. market are likely to exhibit a more Gaussian distribution than in previous years.** The stock market is also not expensive. Compare the S&P 500 P/E of around 1400 / (estimated operating earnings of 100 or 110) with1990-2012 historical data that included all sorts of economic environments.

 

add: * The standard IMF formula for countries in trouble is both austerity and devaluation, to free up resources and increase exporting potential. In the Eurozone, austerity without devaluation inflicts hardship on all except Germany. Previous economic recoveries after crises involved both economic restructuring and controlled foreign exchange devaluations, a useful example of this is the Asian Financial Crisis of 1997. In the absence of foreign exchange adjustments, Eurozone solutions have to be institutional.

As value investors, we are skeptical of Mr. Market. As a reality check, we spoke with a liberal economist with government experience who believes that markets can bring about necessary economic readjustments (at the macro level). Our latest article, “Economic Theory and Social Reality” suggests that the unrealistic classical market model needs to be corrected by institutions. In other words, both institutions and markets are necessary for economic growth; the question to ask is how the markets can best be corrected.

* * That is, the market will still vary, but in a more bounded way.

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Does the headline risk of a possible-likely Greek default warrant going to cash to prevent a permanent loss of capital? We don’t think so. A long-term loss of capital might result if the Eurozone were to totally unravel, due to financial contagion. If Greece, then Spain, then Italy…then…. An important issue is this; in the midst of turmoil, we don’t know what the European financial authorities will do. add: Suddenly issuing blanket Eurobond guarantees would (theoretically) solve the whole problem because the Eurozone as a whole has only a very slight trade imbalance. We are willing to withstand the volatility because the multinational companies we are invested in have high cash flows therefore high returns on capital, and we got them at a good price.

Possible market volatility would provide only the opportunity to buy more stock; we’re getting the benefit of dividends right now. This could be a useful moment of truth. You have to decide whether you are an investor or a trader; you really can’t be both. You’ve got to know yourself and decide; it’s really that simple. Also, being appropriately asset allocated doesn’t hurt. 

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Rioting in the streets does not add to confidence in the Euro. Of crucial importance is what Germany will do. If the Euro disappeared, the Deutschmark would be the only major store of value on the continent. It would then appreciate, pricing German exports out of the market. If the unthinkable happened and Greece left the Eurozone, the remaining countries would have to protect themselves from contagion by accelerating their institutional and economic integration – such as a banking union (add: at least), Eurobonds, and a unified fiscal policy. These are difficult but not impossible.

Our analysis of the situation looks something like this:  (+) Stocks are good value. It’s in Germany’s interest to keep the Euro. (-) Greece exits. The Eurozone implodes.  In this analysis, the seconds cancel out. Therefore, balance the value of stocks against a Greek exit. Which finally addresses the fundamental, balance the gains from long-term value investment against the losses averted from short-term trade.

Pimco expects the central banks to keep rates low, at least for a while. Therefore to earn anything on your capital, you will have to accept some volatility and maybe some risk. Take note of an asset allocation that is appropriate and that you are comfortable with; note that there are no longer any 5% low-risk bank savings accounts.

 

6/1/12 – U.S. housing starts, employment, and corporate/industrial lending are beginning to recover. However, these political events likely retard the market (add: and the economy) over the short-term:

1) Greece - At this writing, polling indicates that the centrist, pro-bailout ND and PASOK parties might have a majority of 11 to 16 seats in the 300 seat parliament. The perception may be growing that Greece must recognize its commitments in order to stay in the Euro. Greece could then continue to be engaged in negotiations with the rest of the Eurozone. Bloomberg reports that German Chancellor Angela Merkel said that she is willing to consider, “…a…European redemption fund that would help governments scale back outstanding debt to below 60 percent of economic output in return for constitutional commitments on economic reform.” The difference between government debt outstanding and that 60% would become the common liability of all Eurozone members. This idea will more easily preserve the banking system and retain country responsibilities. Note how this proposal handles two logical incompatibilities, country autonomy and European solidarity, at two different levels with reciprocal obligations. Greek elections are on June 17^th. 

2) Iran - As in the Israeli-Palestinian negotiations, the principals are now talking about trust-building measures. There is apparently a lack of trust between both sides. According to the NYT, “Both sides are expecting the other to take the first significant steps, without wanting to compromise on critical issues…” Negotiations will convene again in Moscow on June 18^th.

3) U.S. - Reuters reports that the Simpson-Bowles proposals are now back on the table. Messrs. Simpson and Bowles are working with a bipartisan group of “…47 Senators and as many House members to frame compromise on $7 trillion in looming financial decisions.” Efforts to forge this compromise will occur after the elections on November 6^th.

The discussion above illustrates that logical solutions to these problems exist, but these solutions have to be negotiated. There have been greater difficulties. In the 1950s, thermonuclear war threatened. If war had struck, the present value of all investments would have been negative. However, in that decade, the total return of U.S. large cap stocks was +19.4% per year. Since the U.S. was then the only major industrial economy in the world, we do not think that the market will provide these sorts of returns going forward. Nonetheless, this does illustrate that markets and investors can get used to considerable long-term political risk provided the heavens do not collapse, which they usually don’t.

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Polling in Greece, Germany, France, Italy and Spain indicates that 62% of all respondents want to keep the Euro their currency. Ireland is the only Eurozone country that votes directly to ratify a new European fiscal treaty; on 5/31/12 the voters approved its new budget control measures. The next day, the S&P 500 dropped 2.5% to 1278, slightly positive for the year. There are many cross-currents in the world’s very complex economic system.

We assume that our readers have already adjusted their portfolios to suit their circumstances and risk tolerances. The Eurozone can remedy its financial problems by placing some form of guarantee upon its sovereign and banking debts. If (or when) this occurs, the markets will rally. add: The Eurozone currently discusses a central authority to manage its finances, new powers for the governing European Commission, Parliament, and Courts, labor reform and so on. Too much, too soon. Much simpler to accept the existing nation-state structure with a common redemption fund for all Eurozone public debts in excess of 60%. (Germany’s Public Debt/GDP ratio is currently 82%.)

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Keynes was not only a famous economist, but also an accomplished investor. At the beginning of 1931, in a letter to the Board of the National Mutual, he succinctly described the state of the markets and his thoughts on their investment portfolio:

 

(1)   There is a great deal of fear psychology about just now. Prices bear very little relationship to ultimate values or even to reasonable forecasts of ultimate values. They are determined by indefinite anxieties, chance market conditions, and whether some urgent selling comes on a market bare of buyers. Just as many people were quite willing in the boom, not only to value shares on the basis of a single year’s earnings, but to assume that increases in earnings would continue geometrically, so now they are ready to estimate capital values on today’s earnings and to assume that decreases will continue geometrically. (2)   In the midst of one of the greatest slumps in history, it would be absurd to say that fears and anxieties are baseless. As I have constantly said, I consider the prospects of 1931 to be extremely bad. It is indeed only too easy to feel frightened, and to find plausible reasons for one’s fears. (3)   But I do not draw from this conclusion that a responsible investing body should every week cast panic glances over its list of securities to find one more victim to fling to the bears…. (4)   Moreover, the situation is quite capable of turning round at any time with extreme suddenness.  (Our note: This is a major event reason why we aren’t selling.)…The introduction of a tariff, a change of Government, and all sorts of things quite unpredictable in advance will suddenly cause people to turn right around, to appreciate how very cheap almost everything is, and to discover that the market is completely sold out. (5)   I believe, therefore, we should do well to make no more sales of securities except for very special reasons. I feel this with much more confidence because we have so thoroughly overhauled our list of late. Subsequent falls in price are an increased reason for not selling, and not the opposite. (Our note: This is the value investor philosophy.)   J.M. Keynes; Economic Articles and Correspondence: Investment and Editorial; Cambridge University Press (1983); p.p. 17-18.

   

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6/4/12 - German Chancellor Angela Merkel suggests placing the Eurozone’s twenty-seven largest banks under a single regulator. This will place “systematically important institutions” under uniform regulation that will, as in the U.S., likely preempt local regulation. The banks can also be more easily recapitalized. More important, this takes cognizance of the fact that the large European banks are multi-national, at the same time leaving room for local differences. (We’re only discussing Europe. Charles de Gaulle said, “How do you govern a country where there are 246 varieties of cheese?”)  

   

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Mr. Fuerst (economics, Oxford) said he was skeptical that Europeans would ever agree to delegate over their national budgets to a European authority as part of a fiscal union. European leaders would be better off concentrating on measures that are more realistic, he said, like a common system for overseeing banks, guaranteeing deposits and dealing with sick financial institutions. That could help avoid situations like those in Ireland, Cyprus or now Spain, where the cost of bank rescues raises doubts above the solvency of the national government.                                                                                                                                         NYT, 6/11/12

After the fall of the Berlin Wall in 1989, the socialist economies of the Soviet Bloc restructured. In Russia, the “Big Bang” method of sudden and wholesale market deregulation led not to a thriving market economy, but to wholesale corruption and economic deterioration as the Oligarchs grabbed the assets of former state-owned companies. The resulting economic chaos led the way, not to democracy, but to the autocracy of the present Russian government under Vladmir Putin.   

As tempting as it may be to try to entirely overhaul a malfunctioning economy, this is always not the best idea because, depending upon the political culture, the social costs of doing so can be very high. Both “formal rules” and “habits of thought,” work together to form institutions that guide human interaction. The two should be as complementary as possible to. This paper (Lenger, 2008) supports our contention that culture determines the nature of the political and economic reforms possible.* It would be much simpler and effective for Germany to focus more upon reforming the Eurozone’s problematic financial system.

 

 * We recoded (to use a fancy word) the author’s economic data on Table 3. This recoding found that all the countries of the former Soviet Union adopted, or eventually adopted, gradual or no economic reform. It also illustrates that with the exception of Slovenia, Hungary, and Croatia (3) a majority of the more westernized Central European and Baltic countries (6) adopted the Big Bang route to total economic modernization. The point we wish to make is that societies, often after considerable turmoil, develop the social structures most fitting to their own situations. This is not to say that social structure cannot evolve, but reforms that are contrary to a people’s historical experience won’t be successful. Transformational politics must search for reform where previous history is familiar and positive.

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The recent Greek elections have given the pro-bailout New Democracy and PASOK parties a majority in the legislature. Greece will likely stay in the Eurozone and be able to renegotiate its austerity program. However, the Eurozone suffers from a condition that has become acute.

The Eurozone was founded in 1992 as a currency union, with the hope that it would eventually evolve into a political union. But as Acemoglu and Robinson (2012) have written, the reverse is actually true. Politics precedes economics. The Eurozone is likely too national and complex to become a new polity in the foreseeable future.

Key manifestations of the above are the problems of a single monetary policy and fiscal control. Monetary policy can usually (but not always) accelerate or retard economic activity to achieve a dynamic economic balance. Furthermore in the United States fiscal spending is audited by the Office of Management and Budget. The Eurozone, on the other hand, subjects its constituent countries to a single European Central Bank interest rate regardless of national economic conditions and does not audit its own spending. Monetary and fiscal controls are not effective at the Eurozone level, thus there is now an acute financial crisis in a number of countries that need to become more competitive.

A minimum condition for financial stability is that the banking system be sound. There is therefore good reason for the major European banks to be subject to uniform ECB regulations, to cease bailing out their respective governments, and for those governments to offload their excess debts to a common pool. But granted stability, a problematic single monetary policy has to be somehow remedied. The issue of fiscal control depends upon the Eurozone’s political structure and the nature of its subsidies. 

We favor a low-risk portfolio income strategy because the macro situation in Europe, although improved, still has to be resolved. Our own opinion is that the Eurozone should try and centralize its banking system and otherwise decentralize as much as possible.

 

7/1/12 -

 The world has suddenly been afflicted with an outbreak of rationality, exemplifying Keynes’ fourth reason for usually staying invested (referenced above):

 

·         The Eurozone leaders, at the 19^th summit since the beginning of crisis, approved the direct recapitalization of their banks. This agreement breaks the link between banks and their sovereigns, in both their finances and eventual regulation. Both Spain and Italy went into the conference saying they would block all other agreements, including a $152 billion growth pact, until Germany did something to remedy their short-term market plight. The meeting began on Thursday. After an all-night session, Germany finally agreed to allow the Eurozone Bailout funds to directly recapitalize the Spanish banks, provided the European Central Bank set up a banking supervisory body.

 

This banking agreement finally establishes a required lender of last resort (Kindleberger, 2000 ed.). This BBC article summarizes the significant deal that has been reached.

 

·         The U.S. Supreme Court voted 5 to 4 to uphold the constitutionality of the administration’s signature Affordable Healthcare Act. By calling the healthcare mandate a tax, rather than a regulation under the Commerce Clause of the Constitution, the normally conservative chief justice, John Roberts, voted with the liberal minority to avoid rejecting an act of Congress. This important ruling reestablished the court’s non-partisanship in an election year. 

 

The U.S. government was the first in the world designed according to rational principles. But one essential feature seemed to be lacking. How, from the clash of partisan interests, is rationality for the system supposed to emerge? The founders of the Republic sought, above all, to avoid the concentration of power that could lead to tyranny. They therefore, using pluralist American society as a model, divided it up. In Federalist #51, Madison famously wrote, “Ambition must be made to counteract ambition….If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary.…This policy of supplying by opposite and rival interests, the defect of better motives, might be traced through the whole system of human affairs, private as well as public.”

But, with private faction restrained by the balance of powers, how does the public good happen? Madison identified the first cause, “…the great variety of interests, parties and sects which it embraces, a coalition of a majority of the whole society could seldom take place on any other principles than those of justice and the general good…” * But, we think there is a second cause due to the division of the United States government into the judicial, legislative, and executive branches. That cause is time. Important decisions require the eventual concurrence of all three branches of government; that tend in their respective concerns towards the past, present, and future. Particularly at the level of society, a good decision and a convincing narrative involve all three perspectives.

* By bargaining, unless obstructed.

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So what’s likely to happen in Europe? A recent newspaper article suggests the possibility of disaster: 1) The German policy of austerity is likely to produce a depression as everyone cuts back and 2) “…pride and prejudice make leaders unwilling to see what should be obvious…. Europe’s leaders are, by and large, neither evil nor stupid. But the same could be said…about Europe’s leaders in 1914. We can only hope this time is different.” Actually Germany’s Kaiser was stupid and, furthermore, Europe’s geopolitical situation nearly one hundred years ago was exactly the opposite of what it is now. It could be possible to get a general sense of what might happen from the study of history.

The distance between London and Istanbul is around 1500 miles, roughly the distance between New York City and Denver. In 1914, that distance spanned two democracies (England and France), one dissatisfied monarchy with a booming economy (Germany), and three empires that were not coping well with modernization (Austria-Hungary, Russia, and the Ottomans). Life in that system was complicated and insecure. After the Franco-Prussian War of 1871, Germany’s chancellor Otto von Bismarck, structured an international system of changing alliances that sought to avert a French alliance with Russia, with a vulnerable Germany caught in the middle. This system kept the peace until it was destabilized by the accession to power of Kaiser Wilhelm in 1888 whose blunders realized Germany’s worst fears. The historian, Donald Kagan (1995), quotes a biographer:

 

The last Kaiser’s most pronounced-and most fatal-characteristic was his habitual inclination to act almost entirely on the basis of his personal feelings. The most momentous decisions…his embracing the life and ethos of a Prussian lieutenant, his implementation in the mid-1890s of a reactionary domestic regime, and the campaign a few years later to construct a gigantic navy-can be traced to vanity or to pique This ineffable tendency to personalize everything stands revealed in the Kaiser’s correspondence…on countless documents, which display passion but rarely judgment.

 

The Kaiser then committed Germany to colonial policies and a naval race with Great Britain that turned Europe into a tinderbox. The war then began with the assassination of Austrian Archduke Franz Ferdinand in Sarajevo.

Compare the Europe of 1914 with the Eurozone now. Country boundaries have been settled, a nucleus of inter-state cooperation exists, and the Brussels Summit has resulted in a clear, but still general, commitment for bank recapitalization and regulation. Crucial to the evolution of the Eurozone will be the quality of its leadership. Germany is again front and center, but this time as the Eurozone’s lender of last resort. The current chancellor is the deliberate Angela Merkel, a PhD in physical chemistry from the former East Germany. The following BBC article describes the challenges she faces:

Chancellor Angela Merkel appears to be holding all the cards – she presides over Europe’s strongest economy and strongest government finances. Any rescue of the Eurozone therefore ultimately relies on German money. If Chancellor Merkel provides the money too readily, she fears weaker countries will keep coming back for more, while her own voters may lose patience. But if she does not provide the money, she risks letting the euro fall apart, in which case Germany will face a catastrophe -  massive losses on loans already provided by the country’s banks, government and central bank to Southern Europe, a collapse in demand from Germany’s biggest export markets, and an angry political backlash from the country’s closest allies. She is trying to use her power, and the reliance on her country’s money, to force through greater integration of the Eurozone, reasoning that this is the only way to keep the euro together in the long-term.

 

 

 

 

 

 

 

 

 

 

Ms. Merkel must undertake the difficult task of threading the needle between these two essential extremes. Likely the worst that can happen is that the Eurozone will muddle through for years, with its banking system stabilized. The best that can happen is that negotiation, adjusting interest to interest, enables the Eurozone to solve pressing problems, maybe on a more national basis, and restore growth. The dawn of reason may herald the day.

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This site is about the necessity of institutions and about the controlled creative destruction of markets.* Forget about rational expectations theory (early Enlightenment hyper-reason), that markets can foresee systematically significant events. Maybe this is true in simple, well-defined situations; but the real world is never at a static equilibrium. Consider the Eurozone crisis. In spite of its known flaws: no lender of last resort, no foreign exchange rate adjustment and no political union therefore no joint liability; the market considered the default risk of all Eurozone sovereign debt to be minimal in 2007, see this graph. Eurozone bond “analysis” neglected to thoroughly analyze the credit of each country. The Financial Crisis of 2008 resulted in the default of Ireland and the ongoing threat of a default by Greece. The market became (to use a psychological term) “primed” to consider the possibility of defaults in other Eurozone countries. The same graph shows that the later result was contagion, a massive increase in the default risk of distressed Eurozone countries. Here, market perceptions can affect reality, Soros (2008).

In a period of financial distress, investors require clear and significant actions by the lender of last resort. But:

1)      On June 28, the Eurozone countries finally agreed to the direct recapitalization of their banks by the €500 billion Eurozone Stability Mechanism, with ECB oversight to be soon established.

2)      On July 6, Reuters quoted a senior Eurozone official who, “…said that any direct aid would require the sovereign in question to give a ‘full guarantee.’”

3)       On July 9, the NYT wrote, “Reports last week that national governments would still have to assume ultimate liability for banks that are directly rescued with Eurozone bailout funds had taken some of the luster off the deal reached by European leaders at a summit meeting in late June…The interest rate… on Spanish 10-year sovereign bonds spiked above 7 percent again….The renewed uncertainty prompted the European Commission on Monday to ‘clarify’ that ‘there will be no need for a sovereign guarantee for banks being directly recapitalized by the soon-to-be-established permanent bailout fund, the European Stability Mechanism.”’

Had the Eurozone adopted bank recapitalization two years ago, there would be no widespread crisis today. To get ahead of the curve, the Eurozone also has to move to some form of limited or general debt guarantee acceptable to investors in their state of mind.

A 2010 IMF report was titled, “Default in Today’s Advanced Economies; Unnecessary, Undesirable, and Unlikely.” The conclusion of this report, that there is no borrower benefit from a default, remains valid. But it is very important that the markets not be allowed to force a default in a panic.

 

* In a 7/10/12 NYT article, Liu and Hanauer drew the appropriate analogy. The economy is not a machine; it’s a garden.

What we require now is a new framework for thinking and talking about the economy, grounded in modern understandings of how things actually work. Economies, as social scientists now understand, aren’t simple, linear and predictable, but complex, nonlinear and ecosystemic. An economy isn’t a machine; it‘s a garden. It can be fruitful if well tended, but will be overrun by noxious weeds if not…. Is it possible to garden clumsily and ineffectively? Of course. Wise regulation, however, is how human societies turn a useless jungle into a prosperous garden. This explains why wherever on earth one finds successful private companies, one also finds a well-regulated economy, and where regulation is absent we find widespread poverty.

There is an additional advantage to this analogy. There are English gardens, baroque French gardens and Asian gardens. Voltaire wrote, “It is necessary to cultivate our garden.” According to one interpretation of that enigmatic phrase, he was expressing, “…an optimistic faith in the man who is capable of improving his condition.”  The use of critical intelligence to improve one’s condition was the central practical goal of the Enlightenment.

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This article from Pimco is one of the best we’ve recently seen on investment policy. Neel Kashkari answers two main questions:

·         Given the volatility of the New Normal, why should I invest in equities at all? Why shouldn’t I just sit in cash and wait it out?

 

Unfortunately the final end-state for the global economy following this debt-induced crisis is unclear. If the global economy faces deflation, sitting in cash or fixed income instruments will probably be the best option. Purchasing power will increase as prices fall. While a deflationary scenario is not impossible, it is the least likely outcome given central banks’ actions to date. More likely is a moderate inflation scenario. Sitting in cash in such a scenario will see purchasing power degrade due to inflation. Equities should perform well in a moderate inflation scenario. This is our highest likelihood outcome….

 

Because of the uncertainty regarding the end-state of the global economy and the fact that the only scenario in our view where cash performs well is the least likely, deflationary scenario, sitting on the sidelines is unfortunately not a good option for those who have future liabilities (our note: requirements) they need to meet.

 

Given our outlook that moderate inflation is the outcome with the highest long-term probability, we believe equities should be a meaningful part of a diversified investment portfolio. Equity should continue to focus on higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends. (our note: like the multinationals.)

 

·         My clients just can’t take the equity market pullbacks. What should I do as a financial advisor?

 

Many clients are in this situation. From May 2002 to May 2007, during the old normal, the S&P 500 experienced a 5% correction from a recent high five times…and a 10% correction four times. In the three New Normal years from May 2009 to May 2012, the S&P 500 experienced seven 5% corrections, more than twice as often, and a 10% correction three times. This increased downside volatility not only has direct financial implications for clients, but also has indirect effects that are important too. The emotional swings are scaring clients into sitting on the sidelines. As discussed above, this could prove very costly if central banks are successful in engineering moderate inflation, let alone high inflation.

 

We believe clients and advisors should focus on strategies that can be used to manage downside volatility. There are a number of ways to pursue this: 1) Buying higher-quality companies and those with strong balance sheets, because they tend to more resilient against shocks…2) Buying companies at deep discounts to their intrinsic value. 3) Buying companies offering more immediate return on investment through dividends. 4) Actively hedging the portfolio, with tail risk hedging (which refers to taking a defensive position against extreme market shocks), or other means. 5) Investing in multi-asset solutions that provide diversification and include equities, fixed income securities, and commodities in one vehicle. (our note: value investing accomplishes the first three. Active portfolio hedging, buying options, is very expensive; unless you also sell options, which is complicated and risky. Market volatility is still less than it was in 2008, which may not be saying much.)

What’s going to happen in Europe?

The crisis in Europe will take years to resolve in part because policymakers there are trying to simultaneously achieve multiple, often-divergent objectives: 1) preserve basic Eurozone stability. 2) keep pressure on fiscal authorities to make hard choices and 3) keep inflation in check. These multiple objectives prevent them from taking final, decisive action to quell the crisis. Our base case outlook is continued spurts of crisis and volatility coming out of Europe. These policy and macro factors will likely continue to overwhelm company-specific factors in the short term. (our note: of course, not in the long term.)

8/1/12 –

Is this the start of severe financial system problems? We consider current problems in order of possible significance:

1)      Eurozone – Greece’s economy has declined to the point where its foreign trade accounts are in balance. Its large budget deficit is a problem, which includes interest charges. The remaining debt is 132% of GDP, with 60% ideal. Greece’s private creditors have taken large chargeoffs, but its government creditors have not and are unwilling to substantially renegotiate. On July 24, the Troika of the EC, ECB, and IMF will visit Greece to discuss whether to distribute the next tranche of €8 billion, enabling Greece to meet its expenses and debt service until December. This debt collection process has gone too far; we’re not sure what it accomplishes because Greece’s public creditors are essentially paying themselves.

 

The Eurozone has made Spain responsible for the new debt of its banks, in advance of setting up uniform bank regulation. Again, we’re not sure what placing bank debt upon the sovereign accomplishes, beyond delaying the inevitable – partial or total joint assumption of debts. The Eurozone problem is a long-term condition, whose solution awaits the formation of a political consensus.

 

2)      Iran – Negotiations over Iran’s nuclear program seem to be deadlocked over the phasing of various “confidence building” measures. The press reports that the U.S. learned that Iran did not intend to give up its ability to build nuclear weapons with highly enriched uranium. Iran has now stated its intention to build a nuclear submarine, which must be beyond its technical capabilities. The Iranian problem will be resolved in the short-term.

 

3)      United States – faces the Fiscal Cliff. But there are now discussions in Washington about how to climb down. One suggestion is to let the Bush tax cuts expire in January. Taxes will increase, and then the Republicans will vote on middle-class tax reductions, not violating their “No New Taxes” pledge to Grover Norquist. The Fiscal Cliff problem is short-term, that will likely be resolved.

 

Each of these events, taken singly, will likely not cause severe problems for the U.S. markets. What is likely to cause severe problems would be the combination of (1) with any of the others. We have stated the risks the best we can. In any case, we don’t think that a systems collapse is likely; which of course would be our main concern. We are furthermore long-term value investors. The best we can do is state the short-term investment risks, and let our readers make their own decisions whether to bear them.

This is not meant to plunge anyone into severe doubt. Value investors are simply company investors, and generally do not take into account – 2008 being an exception, and the present being a topic for interesting investigation – the complicated macro environment and the business cycle. They assume the institutional environment will support the company balance sheets, cash flows and values that they calculate for the long-run. Commenting about the United States in 1930s, Keynes noted, “I feel that general disaster for a great country like United States is a far more unlikely event than disaster for particular firms or industries, and that nine times out of ten it is a safe bet that the extremes of misfortune will not occur.” However, some reforms are now necessary.

 

9/1/12 –

Issues of personal trust aside, Mitt Romney’s selection of Paul Ryan as his running mate ties him even closer to the Republican party’s ideological base. This election therefore offers the American people a choice of which political philosophy, leading to more or less government, will best solve the nation’s stubborn economic problem of low growth. The key question is whether or not government can improve the investment results of the U.S. economy.

At the root of America’s present economic problems is the lack of profitable past investments to create present jobs. For example, under the previous administration the U.S. incurred more than 4,400 military casualties and a liability of more than $3 trillion dollars (20% of 2011 GDP) in a generally unsuccessful effort to bring liberal democracy to sectarian and tribal Iraq. More directly, driven by the forces of unmediated globalization, U.S.companies located a large fraction of their industrial bases abroad, resulting in a massive tradable goods deficit of $738 billion in 2011 (representing lost U.S. jobs) and resulting in a large domestic misinvestment of resources in ultimately unproductive real estate  and exotic financial instruments that concentrated rather than dispersed risk. The resulting mania, panic and crash resulted in the writeoff of a large fraction of the U.S. financial system’s net worth and nearly destroyed the world’s financial system.

The analogy we make with portfolio management is apt. Misinvestment will reduce the long-term return of your portfolio, creating consequences for years afterwards. The United States and southern Europe both misinvested. From 2007 to 2011, the U.S. economy grew by only .52% per year in real terms, with 3%+ typical.  

Will more or less government improve the growth of the U.S. economy?  In 1776, Adam Smith published the Wealth of Nations, arguing that the unrestricted free market economy best increases the benefits to society. In 1783, the Whig* leader Charles Fox gave a business reaction to Smith, “In that book it was stated that the only way to become rich was to manage matters so as to make one’s income exceed one’s expenses. This maxim applied equally to an individual and to a nation. The proper line of conduct therefore was by a well-directed economy to retrench every current expense, and to make as large a saving during the peace as possible.” Fox summarized the business common sense of Smith’s book. This would probably be Mitt Romney’s reaction as well, after a career in leveraged buyouts.    

But, of course, that is not all. Fox did not mention Sir Issac Newton (1642-1727) at Cambridge. The role of business is to make things happen in the short-term, but societies also require investments for the long-term. This is why education, government-sponsored research and infrastructure matter very much. Education is the path to the future, for it allows the next generation to think well and differently to adapt the country to new circumstances. Government-sponsored research at the National Institutes of Health and Darpa provide the fundamental scientific understandings necessary for new products. (Bell Labs, formerly owned by the communications monopoly AT&T, invented the transistor, the laser, made major advances in communications theory under government contract, and developed the widely used C computer language.  In 2006, Alcatel-Lucent acquired Bell Labs. In 2008, the scientific journal Nature reported that only four scientists remained in basic physics research.) Infrastructure is the public road on which private benefits travel.

To grow the United States economy, long-term investments are necessary. Short-term markets and businesses competing in those markets simply do not provide them. Markets and businesses worry about earnings next quarter. Keynes noted this fact in 1933, and it is true today. The rest of the world is getting more capable; the U.S. must up its game.

 

* The Whigs were a 17^th century English political party that represented the growing commercial interests, in opposition to the Tories that represented the landed interests. After the revolution, there was also a Whig party in the United States.

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Boiling down the Republican convention to its few specifics, Mitt Romney’s convention speech suggested he would do two things besides abolish present healthcare reforms: “…reducing taxes on business (our note: also on all)…simplifying and modernizing the regulations that hurt small businesses the most.” In essence, he proposes reducing the size of government to Paul Ryan’s goal of 20% of GDP. At a time of considerable resource underutilization, that will likely increase unemployment and further retard economic growth.

Do federal government expenditures as a percent of GDP determine the degree of economic recovery and growth? We think not, at least not within a wide range. The German government sent Ruprecht Polenz, chairman of the foreign policy committee of the German parliament as a convention observer. Here are his observations:

Americans have a fundamentally different view of social policies; also in their relation to…what the state should do….And the Republicans emphasize this very specifically. For us, it was always hard to fathom – and many may have not even been aware of it – that before Obama’s healthcare reform, a large number of Americans had no health insurance whatsoever. For Germany, that is really incomprehensible. We simply have to chalk this up to an essentially different mentality. But I also have to say that the U.S. vice-president (our note: candidate) has announced as a goal a 20 percent public expenditure quota [ratio of government consumption to GDP – the ed.]. Ours, in Germany, is more than twice that. I think therein lies the difference, in a nutshell, between our understandings of state and private…

      

Are the Germans groaning under “big government?” Apparently not. According to World Bank statistics, from 2007 to 2011, the German economy grew at an annual real rate of 1.13% per year, as opposed to .53% per year for the United States (The World Bank uses a slightly different base than the U.S. to calculate real economic growth.) The structure of Germany’s export economy differs from the United States’ consumption economy. During a time of slow economic growth around the world, their growth rates are not high; but still higher than ours. The Republican ideology of minimal government is certainly no law for economic growth.

The Wikipedia table, International Government Spending…,  shows if you consider all (federal, state, and local) government expenditures as a percent of GDP, the U.S (38.9%) is in the middle range of all countries. Use the table symbol ♦ to sort the data. The real question is how well government funds are spent.

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A real plan should reasonably relate to real social conditions.

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Why did Siemens AG (Germany's General Electric) locate a new large turbine manufacturing plant in North Carolina, generating 825 new jobs?

A 9/4/12 Washington Post article indicates that it was mainly due to public sector factors:                                           

Ask Siemens executives why they placed their bet on Charlotte and they talk about public investments such as the state-funded rail spur that runs through their facility (our note: to transport the large turbines) and the city’s international airport (our note: to transport management from Charlotte to Munich), which recently added a fourth runway using $132 million in federal funds. They talk about the Export-Import Bank, an independent federal agency that in January approved a $638 million loan to finance the sale of turbines to Saudi Arabia, helping Siemens beat bids from companies in Germany, South Korea and Japan. And they talk about the quality of the workforce in Charlotte, where local leaders are retooling the public education system to churn out the engineers and skilled technicians needed to operate one of the most efficient gas-turbine plants in the world. “A lot of things that were offshored in the past were offshored because of lower-cost labor, but that’s no longer the most important factor,” said Eric Spiegel, president and chief executive of Siemens’s U.S. subsidiary.” The reasons you bring a plant like this to the United States are higher-skilled labor, access to the world’s best research and development, and good, sound infrastructure. All those things together make the U.S. a good place to invest.”… “What we’re seeing globally is we have a real opportunity to bring a wide range of jobs back to this country-including manufacturing jobs-because you see an acceleration in labor costs in other markets,” said Dean Garfield, president and chief executive of the Information Technology Industry Council, which represents 50 of the worlds largest tech firms. “To the extent we get the right policy mix, we can do a lot to encourage locating as many jobs as possible here in the United States.” (and)…”You don’t hire people just because there’s a tax credit here…You hire people if there is demand…to produce more.”

     

From this article, we can see that a number of factors result in wealth-generating regional industrial growth. Tax policy is barely mentioned. Market forces and government investments in education, research and development and infrastructure are gradually restoring lost manufacturing jobs to the United States. These are highly skilled and well-paid jobs, likely available mainly to those who have just graduated. The U.S. has exported its mass production abroad, and it will not return. What about those who are presently unemployed? A combination of relevant retraining in different fields and individual incentives will likely be the most effective. A set of pragmatic, unimpeded, policies should make possible general economic growth.

Concentrating on the essential: this election is choice between growing the economy from the middle out, where everyone gains; or from the top-down, where only a few will.

 

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We trimmed back slightly on stocks sold a stock on 9/18/12 for valuation reasons. We shall comment on add: broad investment issues next month.

 

10/1/12 –

As a value investor, our major concern is whether the intersection of untoward events in the Eurozone, the Mideast, and Washington could lead to a 2008 systems breakdown. We think that is unlikely.

 

Eurozone

On 9/15/12 FT reported:

      

Global stock markets were buoyed yesterday as confidence grew that central banks had acted decisively to buttress the European and US economies, while averting a possible euro-zone break-up. European shares hit highs not seen for more than a year. On Wall Street, the S&P 500 extended an advance that has pushed the index to its highest level since late 2007.

Recent developments * have largely taken the major market risk of an Eurozone systems breakdown off the table. This is a major effect.

 

Iran

Nuclear talks with Iran have apparently stalemated, with the U.S. drawing a line at the act (rather than their capability) of building a nuclear bomb, that may be manifest a year or more hence. The Iranian leadership, as has been reported, is rational. The Iranians should therefore be incented to seriously negotiate if the pain of widespread international sanctions and the likelihood of further action exceeds the possible gain in national power and security from having a nuclear bomb.

Iran has devoted extensive national resources to their program; they are unlikely to give it up. But they could agree to limit it, and then abide by the agreement. **

 

Washington

Will Washington compromise on the budget after the elections, thus avoiding the “fiscal cliff”? According to present discussions, perhaps. ***

 

More generally, in almost any society and most of the time, decisionmakers are expected to keep the system running and make life better. Disruptive innovation is good in business, but it is not good in politics because it carries very high costs. In market societies, it is the role of the political system to facilitate, regulate and ameliorate the creative destruction of the economic system.

 

 

Some Facts We Note:

* The Eurozone crisis illustrates that additional research can dispel some uncertainty. The Eurozone’s most recent “moment of truth” came on 9/12/12 when the German Constitutional Court approved Germany’s €190 billion contribution to the European Stability Mechanism, dismissing a blocking motion brought by 37,000 plaintiffs. This decision also made further contributions subject to parliamentary review, freeing Chancellor Angela Merkel to use German funds to support reforms in the rest of the Eurozone.

Before the fact, how would the German Constitutional Court have likely decided? A review of membership indicated that it is comprised of twelve judges (eight were involved in this ruling), many from the German academic community with two of the judges educated at the law schools of Harvard and Michigan. We had a sense that the court might rule in favor of the Eurozone.    

** Iranian society is much more divided than is North Korea. The negotiating strategy likely takes this into account.

*** The elections on November 6^th will give the winner a mandate to deal with the deficit. This 9/20/11 Washington Post article suggests a compromise will be in the offing, with the ideologues in the House a problem.

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A 9/30/12 NYT article by Thomas Friedman sums up the situation well:

 

Add it all up and it’s a world in which America will have greater responsibility (because our European and Japanese allies are now economically enfeebled) and fewer resources (because we have to cut the defense budget) to manage a more complex set of actors… This complexity doesn’t argue for isolationism. It argues for using our powers judiciously and in a nuanced fashion.

     

  

11/1/12 –

We recently attended a Stanford Business School reunion. We noted the teaching of Silicon Valley’s ‘disruptive innovation”, or Schumpeter’s “creative destruction”, and discussions about the Eurozone.

Innovation

How would you design a new product for farmers in the developing world? They are discerning customers who, by definition, have low incomes. You would go through the following analysis to produce a profitable product:

1)      Understand the problem by talking to people.

2)      Observe the problem’s context. (The analysis here will take into account a number of factors.)

3)      Most important, establish a point of view.

4)      Develop a prototype.

5)      Test it. (Iterate the design.)

Education is the economy’s path to the future. In a 10/16/12 NYT article, Thomas Friedman notes, “…we needed to move to some form of universal postsecondary education to keep pace with globalization and I.T., we didn’t. Instead…‘our high school graduation rates stopped improving and our growth in college graduates slowed substantially – far below what we needed for rapid growth and shared prosperity.’” Mohammed El-Erian writes that school curricula need to be, “…more global, interactive and engaging...”

Eurozone

The economic problem du jour is Europe. Central bank intervention has taken the risk of wholesale default off the table, but the Eurozone has fundamental organizational issues. If liberalism is a reasoned form of government, and the Europeans live in liberal democracies, then they should be willing to reason themselves to effective political and financial compromises. Some very knowledgeable professors and European alumni suggested, not. An attendee noted that the United States is more than 200 years old (and its history has not been without problems). In contrast, the Eurozone is only twenty years old; and its member states are loath to compromise because their publics do not have a political allegiance to it and therefore do not perceive a shared future. This unfortunate situation suggests the following train of events.

Since The Eurozone countries are unwilling to compromise and write off each others’ debts (our modest suggestion), the most likely set of events will be a grinding process somewhat akin to a loan workout, where the financial system slowly earns its way out of debt, aided by the financial repression of 0% interest rates. But since Germany will demand economic reforms akin to those that it has implemented domestically, the Eurozone will lurch in a series of crises to force compromise among different cultures. The mistake the founders of the Eurozone made was to place economics before politics, to think that economic integration would result in political integration. Our article, “Economic Theory and Social Reality,” describes exactly the opposite process. The Eurozone’s 14.2% share of the world’s 2011 GDP is the second largest in the world. Europe is a continuing concern, but should not bring down the world’s economic system.

Markets and Politics

At present, the bond markets do not accurately reflect the fundamentals in the world’s economy, due to expansive central bank monetary policies that buy time. Bond prices are too high. The U.S. stock market more accurately reflects the prospective long-term level of economic growth. We shall discuss the investment implications of this and the consequential outcome of the November 7^th elections. Politics is not the same as economics. There is a need for a gradual political treatment to restore economic confidence and to allow the patient’s recovery to continue, not an ultimately “severe” conservative ideological agenda.

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Since the Crisis of 2008, we have been investigating in detail the interaction between politics and economics. This concern can be summarized by an equation of change and growth:

     Disruptive Economic Innovation + Political Innovation = k, a constant

In this formula, the more of one, the less of the other. It says that businesses will invest in the future and grow if they can be assured a stable political environment. If the political environment is very innovative, that is the description of revolution. How do revolutionary conditions affect economic growth? The answer is, not well.

Describing French economic conditions after the Revolution, historian Simon Schama (1989) wrote, “In 1795, the total value of France’s trade was less than half what it had been in 1789; by 1815 it was still at about 60%. The momentum of economic and social change in France only picked up as the Revolution and the military state it created in its wake disappeared.” (This is the description of the equation above.) After the Russian revolution of 1993, that country’s GDP then dropped by 20% between 1992 to the trough in 1996. Now, consider the economic effects of the “Arab Spring”. According to the European Union *, the real GDP of Egypt decreased from 5.1% in 2010 to .6% in 2011; the real GDP of Tunisia (where it all began) decreased from 3.7% in 2010 to -.7% in 2011.This is simply to say that revolutions, regardless of their reasons, have high economic costs, and should not be undertaken lightly.

The best solution for societies, if possible, is the slow evolutionary political change advocated by Edmund Burke. That requires the interests of all be respected. This is why Americans have traditionally seen themselves as shareholders in their society.

 

* Article in the 10/9/11 FT.  

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On November 6, President Obama won both the electoral and popular votes, thus obtaining from the American people the approval to continue economic reform. This election averted the libertarian ideology of minimal government. The practical American electorate realized the Republicans had no effective steering link between their minimalist values and the track of a real policy appropriate for the interrelated 21^st century.

The goal of monetary policy throughout the world is to buy time, and its success will depend on how that time is used. Since the country has once again reiterated that it is practical, will the Republicans abandon their “no new taxes pledge” to Grover Norquist, thus lending their useful perspectives to policy that the government always needs to be more efficient and that direct hiring occurs at the local level? Or will they continue to obstruct necessary long-term government investment? There seem to be few new investment opportunities in the U.S. because we have not made the necessary long-term commitments to education * and research. Here, the social issues of inequality and immigration become relevant. The U.S. should reach out, both developing and importing more talent to grow its economy. It can’t do this while preserving existing economic interest behind the fortress of political oligarchy, all in the name of freedom.

The political history of single-minded ideologues, whether in Washington or elsewhere in the world, is not encouraging. When faced with defeat, they simply try harder. We truly hope that the loyal opposition will start trying to solve problems in the real world, a task for which they were also elected.

* This is not an abstract issue. Quoting the 10/24/12 Business Week:

A Council on Foreign Relations Independent Task Force report…concluded that American Schools “are not equipping the majority of students to effectively participate in an increasingly fast-paced and interdependent global society.” The report found that only 4.5 percent of U.S. college students graduate with engineering degrees; in China, 33 percent do.* Beyond hurting American economic competitiveness, the knowledge gap is affecting the ability of the U.S. to defend itself. Among eligible high school students, 30 percent score too low on the Armed Services Vocational Aptitude Battery to qualify for military service. * We had to verify this astounding comparison. We traced the data to a National Science Foundation report. The gist, if not the percentages, is correct. In 2008, the U.S. granted 69,908 bachelor’s degrees in engineering out of 1,580,413 undergraduate degrees (4.4%). China granted 704,604 degrees in engineering out of 2,256,783 degrees (31.2%). Look also who is staffing the STEM (science, technology, engineering, and math) graduate departments in the United States.

 

In the 19^th century, the United States built its economy on 1) the opening of new markets and natural resources as the nation expanded westward 2) waves of immigrants (to operate a very disciplined mass-production industrial system) and 3) technological change. Now, in the 21^st century, it must rely mainly upon technological change add: and a technologically adept work force for growth in an increasingly developed world.

Manufacturing requires a high degree of appropriate social organization. An 11/23/12 NYT article discusses BMW:

In 1987, a recent engineering graduate named Norbert Reithofer (currently the CEO) wrote a treatise that in retrospect reads like a manifesto for the German economy. The only way manufacturers in a high-cost country with few natural resources could survive, he argued, was by becoming the most flexible and efficient in the world….Next year, BMW plans to introduce a battery-powered car with a body made primarily of carbon fiber and aluminum. These materials are lighter than steel but much more costly to deploy in a mass-produced car. The effort…is especially risky given that sales of electric cars like the Nissan Leaf have been disappointing so far. But Mr. Reithofer said he saw …(the) car that will be built in Leipzig, Germany, as a way of preparing the company for long-term changes in the industry….”If you can’t build in a place, then you can’t innovate there either…”

 

BMW could invest in the future because it is profitable in the present. The electric car might be presently more appropriate in Europe, where gas costs the equivalent of $8 per gallon. By analogy, according to data in a MIT article, recent oil shale discoveries in the United States could substantially reduce oil imports by 4.2 million barrels per day by 2020. This would reduce the trade deficit by $130 billion/year out of a total of $560 billion in 2011. But the experience of the United States with the Dust Bowl of the 1930s shows that it is not wise to fool with Mother Nature. The federal government had to literally rebuild the prairie states after agricultural excesses. As Hurricane Sandy illustrates, the long-term consequences of global warming are becoming manifest. Growth and sustainability, economic social and ecological, could be balanced policy goals.

From a balanced position, the U.S. will better have the ability to shape change and thus its future.

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 (We deleted a 11/7/12 excerpt on current tax policy for the above discussion.)

 

12/1/12 –

Rules of thumb are practical. Yet they involve implicit assumptions. Take, for example, the asset allocation rule that the percentage of bonds in your portfolio should equal your age. This rule is simple, and meets the common sense test that the amount of risk you take should decrease with your age.

The Gordon Model analyzes the long-term components of stock market returns. It is derived from the rigorous present value model for valuing financial assets. The simple Gordon model is best used when evaluating high-dividend paying companies, with stable growth rates and leverages, over a very long time period. The model states that:

A Stock’s Investment Return =  Present Dividend/Price + The Nominal Growth in Dividends                                                                                                                                                                               (Earnings) after Inflation

     

This model enables us to separate the components of the S&P 500’s past investment returns, and thus to arrive at an estimate of its future returns. To assess the accuracy of this model in the real world, we utilize stock market data for the 55 years between 1947 and 2002, when returns were distorted neither by major war nor financial crisis.

Real GDP Growth ($1.8 trillion in 1947, $11.6 trillion in 2002, BEA statistics)        Annual Inflation (1947-2002, Ibbotson)                                                                            S&P 500 Dividend (1947, quarter 1, S&P Statistical Service 1992)                                                      Calculated Annual Return of the S&P 500 during Period                              (Actual Annual Return of Large Cap Stocks 1947-2002, Ibbotson)

3.4%   3.9%*   4.7% 12.0% 12.9%

A 90 basis point understatement of return in any particular year may seem insignificant. Yet over a 55 year period, that slight return differential will compound to a 1.55X understatement of future stock value ($1.00 will compound 790.98 times vs. 509.32 times). We are going to use the Gordon model because the following comparison is striking:

Projecting forward into the future:

Real GDP Annual Growth (avg CBO estimates)       Annual Inflation (Cleveland Fed estimate)              S&P 500 Dividend (current)             Estimated Annual Long-Term Return of the S&P 500

2.3%**      1.5%        2.1%     5.9%

Due to lower economic growth, inflation and higher stock prices the estimated long-term return of the S&P 500 is around one-half the return in the past. This is also true of the bond market. Between 1947-2000 the return of long-term corporate bonds was 6.1%. The current yield of best-grade corporate bonds is 3.6%.

So what does this do to the asset allocation rule? These statistics seem to suggest that investors should dump all low-returning and likely more risky bonds in favor of stocks, as low as their likely returns will be. We think this is not a good idea. It violates the first rule of prudent financial management, that investors should keep their assets somewhat diversified (What if the whole world tips into recession again?). The second reason for maintaining the general asset allocation rule is that it can be tweaked, to somewhat ameliorate the low long-term returns of stocks and bonds. Here is what we are doing:

1)      Stocks – Value companies have sustainable competitive advantages, moats around their markets, and sell at bargain prices. The philosophy of value investing uses more reliable near-term balance sheet and historical cash flow information to determine value, rather than optimistic projections. For large cap stocks, we use a discount from calculated value of 33%. ***

 

2)      Bonds - The Fed’s interest rate repression has reduced short-term returns to 0% and long-term returns to a very low level. (If you have a laddered portfolio of medium-short-term bonds, the problem will cure itself over time as you replace maturing short-term bonds with longer term ones.) This had led to an increased investor interest in “alternative assets”, that is assets that they don’t generally understand. We suggest another alternative for current yield.

 

Publically traded master limited partnerships generally engage in activities involving natural resources, such as pipelines. Pipeline MLPs provide high 6-9% distribution yields and are described on pages 613-624 of the current Value Line_®. We would invest in these equity partnerships (here considered debt) only in conjunction with a bond portfolio, because excessive industry concentration is not a good idea in an income portfolio. These investments should not be held in IRAs or 401(k)s and should be bought for keeps. A large proportion of the ancillary tax benefits available under current law will be recaptured by the IRS as ordinary income if these investments are sold. They should always be bought on their fundamentals. Make sure that the leverage is not excessive and that management makes related acquisitions for sound operational reasons. add: By investing in pipeline MLPs, we’re also moving along the risk curve. If the market drops, so will the MLPs (but likely somewhat less). Their distribution yields are very high. We realistically assume that the U.S. economy won’t entirely fall apart.

 

We have suggested that the asset allocation rule should be modified by taking on (some) increased risk, as is the Fed’s intention. add: It is simplest to consider this minor modification to the asset allocation rule an exception, for exceptional circumstances. Also, know what you are invested in. Our next posting in January will discuss the future of the U.S. economy.

To note again the purpose of this website. The purpose of this website is to publish research about the markets and the interaction of such with the political order. To comply with the Uniform Securities Act and state regulations, we have to write for general purposes only. For advice that is related to your specific situation, we encourage you to speak with a qualified investment advisor. After reading these articles and postings, you will be an informed and challenging client; but do be aware of all sorts of costs as well. Generally, the simpler the better. We recently attended a national brokerage firm’s presentation of complicated structured financial products that bundle life insurance, “Run, don’t walk…”

 

* If you use annual data between 1968 and 1999 to analyze the willingness of people to invest in stocks, the inflation coefficient is negative. That is, an increase in inflation is even worse for stocks over the short-term, when the bond markets are crashing. If you analyze the returns of the stock market, over decades, then stocks are a hedge against inflation. There is a difference between short-term and long-term analysis.  

** The Bureau of Economic Analysis estimates that real economic growth in the U.S. will be below historic levels. The major issues are entitlements, high debt levels and the need for structural economic change to emphasize growth rather than consumption.

*** In Value Investing (2001) page 144, Bruce Greenwald presents a modified present value model that determines a company’s value from its operations (return on capital), required return (cost of capital), and conservatively estimated growth. The result will be the company’s intrinsic value, the value of a franchise that management is tasked to maintain and grow.    

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Growth is a function of labor, capital and how these inputs are used to produce GDP. According to a 12/5/12 NYT article, insufficient demand chips away at labor, capital and productivity thus reducing investment and therefore future growth.

Keynesian economics is mainly demand-side management. We think there is a further structural supply-side problem; current demand also leaks abroad, resulting in increased imports (GDP = …+Exports-Imports). The problem facing the U.S. here is the same as that facing many other countries. The U.S. has to increase public and private investments and the inventiveness * of its industrial economy.

* Why are people inventive? In the November, 2012 Foreign Affairs Magazine, Neil Gershenfeld writes about the Digital Fabrication Revolution, “To be able to invent, people need to question assumptions.” That sentence is the (unfortunately then unstated) reason why we had to take Freshman English and Western Civ as core requirements many years ago. The purpose of those courses was Socratic, but it wasn’t just to examine life. It was to establish a habit of questioning that is the cornerstone of innovation.

Mass production is now in Asia. U.S. innovation is likely to be in the highly capital intensive process industries such as energy and biotech and in decentralized manufacturing that is flexible, innovative and of course networked. 

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The U.S. system of shared political power is supposed to produce real policy appropriate for the times, not ideology. It solves engineering problems in the real world ^*, not physics problems in theory. The role of the state is to enable a diverse people to live together, not to pursue – as in traditional non-democratic societies – “virtue,” that is of course my values. In The Sense of Reality (1997), Isaiah Berlin humorously wrote:

To be rational in any sphere, to display good judgement in it, is to apply those methods which have turned out to work best in it. What is rational in a scientist is therefore often Utopian in a historian or a politician…Botany helps gardeners, laws of dietetics may help cooks, but excessive reliance on these sciences will lead them – and their clients – to their doom (Berlin essentially argues against an impersonal logic or technique applied to human affairs).

Markets (whether political, economic or financial) require a balanced diversity of participants who will freely do business with each other according to common rules or procedures. If all the world were either value or momentum investors, the markets would not error-correct and thus self-destruct. The present fundamentals of the U.S. economy are improving. As long-term investors, we are not overly concerned with short-term issues; but Washington does have hurdles to clear to achieve a consensus on the budget and thus a way forward.

 

^* What makes an engineering design work in the real world is the appropriate laws invoked.

 

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