1/1/13 –

On 12/31/12 the S&P 500 closed at 1426, resulting in a total return of 16.0% for the year. Congress will likely pass a bill to raise revenues and move the fiscal cliff to February.

We have already suggested that returns from the financial economy are not likely to be high. However, relevant to the future is how well the real economy will do in the coming decades. If the real economy does well, financial returns might improve.

Crucial to the diagnosis of the current economy is asking what actually happened in 2008. In a 12/6/12 speech to the German union, IG Metall, the economist James K. Galbraith of the University of Texas contends that the economic crisis was not a series of separate events, but one crisis in a deeply interconnected world system, created by markets and globalization.

The crisis of 2008 is the culmination of three forces operative in the world economy since the 1970s.

1) Starting with the OPEC crisis in the 1970s, the cost of energy has increased. Future problems were suppressed by new discoveries and the geopolitical situation. In the last decade, the cost of energy has doubled and climate change is upon us. (If social development is largely due to increased energy capture (Morris 2011), general economic growth will decrease over the long-term.)

2) Technical change has resulted in the digital revolution and globalization. We live in an era where technology is labor-saving. Computerization and its associated technologies are now doing to the office worker what the internal combustion engine did to the horse.

3) The ideology of neo-liberalism assumes, “…markets can function on their own without breaking down or blowing up. It is this notion as applied especially to finance. This is the great illusion of the last generation, and it fostered a form of economic growth that was intrinsically unstable and unsustainable. Why? Because it was based on declining standards for loans and on lax accounting of the proceeds of those loans,” in other words bad investments, notably in the U.S.

In the United States and Northern Europe, the effects of financial panic and collapse were mitigated by strong national institutions, built on the tradition of social solidarity and social insurance. “(Institutions are)...the critical tradition of any successful society in the modern world – of the ability to react to stress (our emphasis).” Unfortunately, the institutions on the Continent were built according to a neo-liberal model, built on free-market ideas exported from the United States. These included arbitrary debt and deficit ceilings, a monetarist central bank charter that mandated only control of inflation and the reliance on capital buffers (as opposed to asset regulation). The weakness of a social arrangement, that minimized institutions, was exposed during the last financial crisis.

Beyond flooding their systems with liquidity, we note that the Eurozone, the Brics and the United States must react in their own ways to these general forces, all requiring the actions of government to remedy the consequences resulting from the breakdown or absence of markets as coordinating mechanisms.

The Eurozone

After countless iterations, Greece’s public debt is now concentrated at the level of the central banks, where it can be charged off or not. As the Eurozone’s strongest economy, Germany has the main say on the disposition of that debt. In advance of pending elections, it has not been politically feasible for Chancellor Merkel to propose charging off this debt, as that is not acceptable to the German public. ¹

Galbraith notes that every surplus has a deficit; it is just a matter of economic bookkeeping. The prosperity of the Germans was built upon the deficits of the Greeks. Rather pointedly, he notes that by refusing to write off Greek debts, the Germans are confusing religion with economics. He ended with a quote from Keynes’ prescient The Economic Consequences of the Peace (1919), chapter 1:

If the European Civil War is to end with France and Italy abusing their momentary victorious power to destroy Germany and Austria-Hungary now prostrate, they invite their own destruction also, being so deeply and inextricably intertwined with their victims by hidden psychic and economic bonds.

German politics will determine whether the Greeks can start anew with a future. But Greece joined the Eurozone before it was ready; it has to reform itself. A goal of economic policy should be balance.

The Brics

The growth of Brazil, Russia, India, and China was fueled by exports to the developed world that has reached the limit of its indebtedness. Between 2000 and 2008, as the 12/26/12 WSJ reports, the Brics averaged a GDP expansion of 8% per year, almost six percentage points above the G-7 average. In 2013, that growth is expected to be 5.5%. Export growth to 2008 averaged 20%-30% per year, now it is expected to rise by only 5% -10% next year.

Faulty domestic investing is starting to cause problems in those countries. The following table suggests, unlike the developed countries, the Brics have less margin for error in economic policy. Investments should be profitable.

The U.S.

The United States has natural resources, entrepreneurship and a basically sound government. A Stanford economist gave a talk about the future of the U.S. economy. He was optimistic. Among other things, American companies are the best managed in the world, and America is still rich after 150 years of economic growth.

The magnitude of wealth disparities between the developed and developing worlds is very large.

World Bank Per Capita National Wealth in 2005 *

(U.S. $, simple average of per capita country wealth, next data 2012)

Eurozone	454,737
Brics	45,520
United States	734,195
World	115,484

* The current World Bank definition of national wealth includes past capital investments, the value of natural resources, net foreign assets, and –most important - intangible human capital that comprises 64% of total wealth. Intangible human capital is defined as a function of years of schooling and measures of health. It is closely correlated with per capita Gross National Income. add: The 112 country sample mean for years of schooling is 6.52 years.

After several steps, this link leads to 2005 data; click on “wealth per capita 2005.” It is possible to deduct intangible capital from the above figures to calculate the total of tangible capital such as capital produced, minerals, cropland, etc.

The U.S. educational advantage relative to other countries means that it can improve its own condition. But it can spend time on political squabbles, changing deck chairs on the Titanic as the ship sinks ever so slowly beneath the waves; or it can reform its politics, government, secondary educational system and markets to provide the right environment for new opportunities to grow. To overstate just slightly, the No Government Party needs to become a better government party.

This financial crisis has shown that people in groups can act badly. Writing more acutely at the end of W.W. II, the theologian Reinhold Niebuhr wrote essentially that the war was a “…historical refutation of the eighteenth-and nineteenth-century conception of a harmless and essentially individual human life. Human desires are expressed more collectively, are less under the discipline of prudent calculation, and are more the masters of, and less limited by, natural forces than the democratic creed has understood.” ² To prevent manias, panics and crashes, government institutions are necessary to set the rules of the road. With appropriate rules, free markets can function for the benefit of society rather than to its detriment. They enable people to combine resources in novel ways to produce new businesses. ³

Economies need to be balanced, profitable and capable of reform.

¹ National debt is ultimately a claim on future national production. The implications of this are obvious.

² Niebuhr, Reinhold; The Essential Reinhold Niebuhr; New Haven: Yale University Press 1986 (ed.); p. 172.

³ Specifically important are innovation clusters, ideas and capital.

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In a 1/3/11 Washington Post article, Fareed Zakaria notes a possible future for the U.S. The useful analogy is not Greece, but Japan:

Recently, scholar Ezra Vogel, who predicted that Japan would become the world’s No. 1 economy, explained that although Japan’s economic miracle was real, he never foresaw how its political system would seize up and become unable to solve the challenges it faced in the 1990s (economics depends on politics). Today, Japan remains a rich country but one with a diminishing future. Its per capita gross domestic product is 24^th in the world and falling; its gross government debt-to-GDP ratio stands at 230 percent.

What we don’t want is to contribute toward a scenario in which, 20 years from now, we look back and say that the U.S. economy was basically vibrant but its political system seized up, damning the country to a Japanese fate.

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A former OMB official during the Bush administration discussed the cause of Mitt Romney’s defeat in the 2012 elections in a 1/14/13 Barron’s article. His conclusion: Romney lost because, “He needed to bring every issue back to …the economy and the budget…Free markets and smaller government are good for the U.S., its economy, and its voters. Delivered well, that message should be the Republicans’ best way of addressing everyone’s concerns…”

We think this is an unfortunate misdiagnosis. The solution to current economic circumstances is not, “smaller government,” gotten out of the way. Qualitatively, due to the growth of entitlements – social security and medicare (most of all) – the burden on the government to meet its future promises will have to increase, not decrease. The really relevant question is, how much?

Many Americans are individually – for the most part - honestly conflicted on the scope of government. Tradition competes with the requirements of the present and future. That conflict is translated by the entrepreneurship of the competitive political process – now offering minimal government as an alternative - into polarization and gridlock. But a notable NYT 2/11/12 article is titled, “Even Critics of Safety Net Increasingly Depend on It.” To quote that article:

One of the oldest criticisms of democracy is that the people will inevitably drain the treasury by demanding more spending than taxes. The theory that citizens who get more than they pay for will vote for politicians who promise to increase spending.

But Dean P. Lacy, a professor of political science at Dartmouth College, has identified a twist on that theme in American politics over the last generation. Support for Republican candidates, who generally promise to cut government spending, has increased since 1980 in states where the federal government spends more than it collects. The greater the dependence, the greater the support for Republican candidates (our note).

Conversely, states who pay more in taxes than they receive in benefits tend to support Democratic candidates. And Professor Lacy found that the pattern could not be explained by demographics or social issues.

The article also discusses the individual dimensions of this dilemma. Values conflict:

Many people say they are angry because the government is wasting money and giving money to people who do not deserve it. But more than that, they say they want to reduce the role of government in their own lives. They are frustrated because they need help, feel guilty for taking it and resent the government for providing it.

The psychological theory of cognitive dissonance describes what is happening. According to the Wikipedia, “The theory of cognitive dissonance…proposes that people have a motivational drive to reduce dissonance by altering existing cognitions (which is what should happen), adding new ones to create a consistent belief system, or alternatively by reducing the importance of any one of the dissonant elements (by putting on ideological blinders)…The key assumption is that people want their expectations to meet reality, creating a sense of equilibrium.”

What creates a sense of equilibrium (the ancient Greeks called that ataraxia) is dealing rationally and effectively with reality, not with an ideological dream world (very true also for investing). The following table compares healthcare costs for several developed OECD countries:

OECD 2009 Healthcare Costs

Rank	Country	Per Capita Health Expenditures	%GDP
1	United States	7,960	17.4
2	Norway	5,352	9.6
6	Canada	4,363	11.4
9	Germany	4,218	11.6
16	United Kingdom	3,487	9.8

The U.S. has the most expensive healthcare system in the world, by far, that obviously needs to become more efficient. We purposely included three English-speaking countries, that have rather similar cultures. * The impediments to U.S. healthcare reform are:

1) The ideology of minimal government

2) Imperfect information that results in inefficient markets, combined with the inertia of existing organized interests on both sides of the healthcare market, supply and demand.

3) The U.S. is less likely to look abroad to adopt best practices because it is the dominant international power and a large country with large domestic markets.

System reforms will be necessary for U.S. healthcare to adapt to new demographic and economic circumstances. **

* Political scientists like to say that the United Kingdom and its progeny are all exactly the same, liberal democracies. Actually, they aren’t; and the issue of health care emphasizes this. The colonies, in what is now the British Commonwealth, evolved away from the mother country; there is consequently a much greater role for the state in providing medical care. The United States was the world’s first revolutionary state. Is the revolutionary attitude appropriate for healthcare?

** This Washington Post article discusses the situation of U.S. healthcare system. add: The U.S. healthcare system is furthermore geared to disease intervention, rather than disease prevention. It costs $2.7 trillion/year. As a result of this inefficient system, U.S. life expectancy is 50^th in the world.

2/1/13 –

Capitalism and democracy are generally consistent with each other. The community dimension of capitalism is the market and its rules. The community dimension of democracy is social practice and law.

The foundation of American democracy is Greco-Roman, that is a combination of the negative liberties codified in Roman law, stating what the state may not do to preserve libertas, and positive social practice, embodied in both American attitudes and ancient Athenian institutions to preserve eleutheria, freedom, in the highly war prone city-state system. ¹ The major positive elements of social practice, enabling cooperation, are and were:

The ability of a democratic people both to lead and to follow.

In the United States, this ability enables the formation of the crucial voluntary organizations of civil society, forming a sphere of collective action that is not taken over by the state. In ancient Athens, the direct democracy of the state was organized around this ability. Executive authority was invested in the Council of Five Hundred, that carried out the day-to-day administration of the state. Members of this council were selected by lot to serve for a term of one year; this schedule resulted in an automatic rotation of elites. Thus, “…command and obedience, rather than being opposed to each other as two absolutes, became the two inseparable aspects of one reversible relationship (over time).” (Vernant, 1982, p. 101) Democracies result in social change.

Citizens of a democracy need self-control, both to keep from committing violence and to allow power to pass peacefully from one group to another.

In typical fashion, the Greeks contrasted eleutheria, or freedom, with a respect for nomos, the law, “the wise restraints that make men free.” The resolution of this conflict was the social order of the polis.

Athenians became increasingly aware of the sharp contrast between their own political system and that of Sparta. They realized that democracy guaranteed them the greatest possible freedom in their private, social, and communal lives; it imposed the fewest restrictions and afforded them the most freedom of action and the best opportunity for self-fulfillment. (our note) It soon became a fixed (commonplace) that democracy allowed the citizen, “to live as he likes.” More was behind this principle than unrestricted freedom, although opponents misinterpreted and attacked it as license and lawlessness, while supporters defend it as compatible, even necessary linked, with respect for the nomoi (laws). What mattered rather was that democracy wholly accepted the free citizen in his capacity as a free person and thereby enabled him fully to realize his personal potential in both private and public life. Here presumably lay one of the basic preconditions for the Athenian citizens’ ability to develop a specifically political identity and to commit themselves to public service in extraordinary intensity – without being forced to do so by rigid social pressure. (Raaflaub, 2004, p. 263)

The Middle Class.

Due to the economic forces of technological change, energy costs and declining investments in the future – education, infrastructure and research - , the real incomes of middle-class households decreased by 7% between 2000 - 2010. For U.S. democracy to thrive, this decline has to be reversed.

A major Greek ideal was balance, and this ideal would be reflected in a society that was structured in the distribution of power, honors and wealth es meson, at the center.

The new social space was organized around a center. Kratos (rule)…(was) no longer to be found at the top of the social scale; they were located es meson, at the center, in the middle of the human group. It was this center that now as valued; the welfare of the polis rested on those who were known as hoi mesoi, because, being equidistant from the extremes, they constituted a fixed point on which the city was balanced. Individuals and groups all occupied symmetrical positions in relation to this center. The agora, which represented this spatial arrangement on the ground, formed the center of a common public space. All those who entered it were by that fact defined as equals, isoi. By their presence in that political space they entered into relations of…reciprocity with one another. (Vernant, 1982, p. 125)

Greek, that is Athenian, democracy was not immune from making very large mistakes; but it survived for almost 500 years in a practical world. Classical scholar Josiah Ober writes in Athenian Legacies:

…tensions (within the Athenian political community) were in a strong sense productive rather than destructive: the solution to the mystery of going on together is not to be sought…in construing Athenian democracy as a neutral space in which tensions arising from diversity and inequality are finally resolved. Rather the solution lies in recognizing in democracy a sophisticated means for transforming into productivity potential divisiveness arising from diversity. That transformation is effected through an ongoing discursive acknowledgment of differences, and through a willingness to make and carry out public decisions in the face of unresolved tensions….the democratic process holds out the promise that the ledger will be balanced over time…

At the heart of the tensions that defined Athenian political life…was the contrast between an outwards-looking “centrifugal” push toward social diversity and an inwards-looking “centripetal” pull towards political coherence. Rather than expending vain effort in an attempt to finally resolve that dichotomy through strong homogeneity or “once-and-for-all” constitutional enactment, Athenian politics existed, and flourished, through a refusal to give up robust commitments to both diversity and coherence. (Ober, 2005, p.p. 5-6,7-8)

There are two conclusions to be drawn from this analysis. First, in the Middle East, a lack of these positive practices – requiring social trust – is the source of many political problems. Second, in the United States, functioning democracy requires a larger positive cooperation; not just negative liberties steering society by the invisible hand of the decentralized market. The key to economic growth is not one or the other, but getting both to work together in America’s distinctive public-private partnership. ²

Current attitudes and procedures in the Senate and House prevent reciprocity and compromise – that is doing business. Regarding, at least, a change in procedures until the next election: The Senate has watered down a proposed reform, requiring a senator seeking to block legislation by filibuster to actually talk. In the House, the Hastert Rule requires a majority of a majority to agree to hear any legislation. This allows the committed minority of the Tea Party to bring government to a halt. One can explain the current polarized state of affairs in any number of ways. But increasing the traditional ability of legislators to form coalitions across party lines will enable Washington to better deal with America’s social and fiscal problems.

¹ The Greek concept of freedom evolved over time. Eleutheria first meant freedom rather than despotism (after the Persian wars); it was then expanded to include the “free, internal order of a community;” and then expanded further to include its well-being. According to Raaflaub (2004), “The concept of freedom claimed by the Greek polis came to cover the entire sphere influenced by the polis,” signifying the ideals of equality and solidarity, individual self-sufficiency, freedom of action, generosity, also the will to power (in foreign affairs).

Contemporary American freedoms are likewise manifold and not single-issue.

² (add)In the Jan/Feb 2013 Foreign Affairs, Fareed Zakaria writes, “The modern history of the United States suggests a correlation between (public) investment and growth. In the 1950s and 1960s, the federal government spent over five percent of GDP annually on investment, and the economy boomed. Over the last 30 years, the government has been cutting back; federal spending on investment is now around three percent of GDP annually and growth has been tepid….Rebalancing the budget to gain space for investment in the country’s future is America’s greatest challenge….Technology and globalization have made it possible to do simple manufacturing, and Americans will not be able to compete (on wages) against workers in China and India…That means that the United States has no choice but to move up the value chain, relying on a highly skilled work force, superb infrastructure, massive job-retraining programs, and cutting-edge science and technology – all of which will not materialize without substantial investment.”

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(This entire section rewritten for greater clarity.)

The following discusses a judgment that markets enable. The market faces both the Fiscal Cliff and the Interest Rate Hike that will accompany sustained economic growth.

The effect of the Fiscal Cliff will be more immediate. A prolonged Congressional lack of consensus on the budget will reduce short-term government spending on defense and other programs, reducing GDP by a CBO estimated .5% this year. The Fiscal Crisis of 2008 required the major involvement of government. Whether in the U.S. or in Europe, a major determinant of what now happens will be political. We simply cannot predict how the ideologies, dynamics and entrainment of events will affect what Congress does or not.

Beyond the above is the prolonged Interest Rate Hike. The thirty year treasury bond is currently at 3.12%. When the prospect of sustained real economic growth (that we truly welcome) becomes apparent, institutional investors – trying for now to earn some income – will sell the long bond to protect principle.

But calculate a modified Fed ratio, LT Corporate Bond Yields/Stock Earnings Yields, measuring the willingness of investors to buy stocks. At current market rates, that ratio is .0366/(100÷1500) = .55. The usual level of that ratio is around 1.50. Since the economy’s intrinsic growth rate is lower, that ratio should be around 1.0 (applying a present value calculation). Due to deep investor pessimism, the market might be less susceptible to interest rate increases.

If this holds true, interest rates will increase; the stock market will also increase until it doesn’t. Is this helpful, maybe. Our portfolio strategy is add: might be called adaptive control, selling stocks when they reach full value but not replacing them. This strategy is not market timing, and might result in some short-term loss. The index fund equivalent of this is to sell some of the index when the stock market reaches new highs.

↓ WE ALSO SUGGEST THE FOLLOWING: ↓

3/1/13 –

(For some reason) the article above states the general principles of democracy, and the following describes the specific U.S. instance. In a globalizing world, the arrows of causation now likely run both ways.

Congress was unable to reach a budget agreement to avoid sequestration that will begin on March 1^st, potentially reducing total federal expenditures by $1.0 trillion over the next decade on top of the $1.5 trillion already set to take effect. The effect of the sequester will be to reduce real GDP by around .5% per year. These cuts fall almost totally upon the discretionary part of the government’s budget (-5.3%), reducing investments in education and infrastructure; rather than upon entitlements, the third rail of American politics.

What are the causes of this impasse? The first cause is the U.S. culture of freedom, catalyzed by the Great Recession of 2008. The second is the institutions of Congress.

“Albion’s Seed” ¹ describes the four (or more) varieties of American freedom that grew in the colonies from their regional British origins:

· The New England idea of ordered liberty and communal restraint that a community imposed itself in a town meeting. This concept also stressed the importance of domestic and international institutions.

· Virginian liberty conceived, “…as a hegemonic condition of dominion over others and - equally important - dominion over oneself…a truly free man (and gentleman) must be the master of his acts and thoughts.”

· The Quaker idea of “a universal ‘inner light,’” bringing salvation to all who realized its existence, “…encourag(ing) a spirit of fraternity with other people.…and welcomed others of many different backgrounds to live beside them.”

· The Border idea of natural liberty, “…was… at once more radically libertarian, more strenuously hostile to ordering institutions…The remoteness of the population from the centers of government and the absence of any material necessity for large-scale organization created an environment in which natural liberty flourished…Patrick Henry consistently defended the principles of minimal government, light taxes, and the right of armed resistance to authority in all cases which infringed liberty…” This sounds familiar.

These regional cultures were extremely vexing to the British colonial authorities who tried to impose rule upon the naturally contrarian and feisty colonials. The result was the Boston Tea Party and the American Revolution of 1776.

Why didn’t the United States dissolve into sectarian strife, as the British expected? There were likely three main reasons:

1) David Fischer, the author, writes, “(The British challenge)…threatened all four American cultures at the same time. In response to a common danger, (the practical colonists)… forgot their differences and joined together in the movement that led to the American Revolution.” After all, they spoke the same language and had originally left England for their own reasons.

2) The founders of the Republic could compromise. Religious freedom for all was enshrined in the First Amendment to the Constitution in order to preserve the religious freedoms of Virginia and Pennsylvania, while protecting New England’s religious establishment. From the ability to compromise flowed the reason-inspired Federalist Papers of 1787, written by Madison, Hamilton, and Jay to urge a remarkably well-educated American public to ratify the Constitution.

3) The diverse American concepts of freedom are not a sign of weakness, but of strength. These differences provided the United States with the resources to be formidable at war (when the nation sets its mind to it) and at the arts of peace, as occurred at the end of W.W. II. Having defeated the Axis, the United States founded the international organizations that kept the peace.

The ability to turn diversity into strength results from the negotiation of differences within American society, within the American psyche and among the elected political parties to turn the vast resource of national diversity into effective plans for the future. The present situation in Congress is obviously dysfunctional because one party, under the thrall of the Tea Party (2010), has simply refused to negotiate realistically. The decision structures within Congress allow a disgruntled minority to block the progress of all legislation.

¹ Fischer, David; “Albion’s Seed;” Oxford University Press, New York; 1989; p.p. 411, 416, 429, 777, 778 and 826.

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Markets react; they don’t look too far ahead. The sequestration, if continued, will begin to drag upon the recovering health of the U.S. economy.

4/1/13 –

On 3/29/13 the S&P 500 closed at a record 1569. Since the stock and bond rallies have relied upon ample liquidity provided by the Fed, a reversal of that liquidity would cause problems in both markets. The following analysis, however, suggests that real economic growth is likely to be slowed by a current lack of consensus in Congress. The disconnect between the financial markets and the real economy will continue, for at least a while.

The following illustrates how specific circumstances can be classified as general economic conditions.

1) U.S. economic growth < (less than) 2%

Flooding the economy with liquidity in order to enable legislative profligacy has traditionally been a formula for disaster, overdriving the economy. In the present situation, the Fed has continually flooded the economy with money because the legislature has not spent sufficiently and effectively to restore growth; and the private sector has not taken up the economic slack. There is, of course, an appropriate balance between the public and private sectors, between long-term and short-term investment.

We have a general sense that the economic distortions this imbalance creates will cause future problems. Earnings will cease to grow and so, eventually, will the stock market. To those who complain about government misspending, expected returns (interest rates) are how capitalist economies crucially allocate capital. Interest rates at the zero bound for many years will cause massive misallocations, likely again towards real estate. “…the U.S. central bank is absorbing an estimated 90% (sic) of total net debt issuance in the country, including corporate and municipal bonds.” (WSJ, 3/31/13)

The CBO estimates that sequestration will decrease economic growth by .6%/yr. Further add to that the Eurozone’s botched Cyprus bailout.

In Cyprus, the Eurozone sought to speed overall banking system reform by initially demanding a tax on all deposits including those of less than €100,000, as a condition for bailout. This has once again called into doubt the Eurozone’s ability and willingness to backstop its own financial system. By itself, Cyprus (less than 1/2% of GDP) is unlikely to take down the banking system. But this reduces confidence in the Eurozone deposits and, of course, further diminishes growth.

2) U.S. economic growth approximately 2%

This is the present situation, where the U.S. economy is balanced between recovering domestic growth and decline in Europe. This economic growth, threading the eye of the needle, is actually best for stock and bond investors because it will keep the Fed from raising interest rates to normal levels.

3) U.S. economic growth > 2%

Earnings will grow, but interest rates will rapidly increase to more normal levels. This would be great for the economy, for savings accounts; but likely less so for stock and bond investors. The previous overreliance upon monetary policy has unfortunately created an overreliance upon low interest rates. If growth accelerates markedly, earnings will increase but so will interest rates presently at the zero bound – likely in a violent manner.

We rate the likely growth of the U.S. economy < 2%, in the first condition. Obviously, a higher growth would be much better.

Most value investors consider the macro picture either irrelevant (because they are patient) or unknown. But both the U.S. and Europe, the latter to a much greater degree, need to improve their political coordination.

Ultimately, growth and job creation are the best guarantors of creditworthiness.

Larry Summers, Harvard University

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4/3/13 We reduced our weighting in Citigroup (C) to a more normal level. The company has rebuilt its capital as expected, but now must rebuild its profitability. – management is setting about to do this (add: there are many ways). Its return on equity is presently only around 5%, after now taking into account normal loan loss reserves. Because of this, the book value of the company still substantially exceeds its present market price. Commercial banks were traditionally measured at book value, likely an appropriate way to value money center banks if they don’t try again to emulate the vanished investment banks.

This is a long-term holding, but we thought it prudent to reduce the stock’s portfolio weighting because the market is close to an all-time high.

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4/5/13 What’s happening? In March, the U.S. economy created only 88,000 jobs; with around 210,000 required for decent economic growth. The reason for this slow growth, according to Pimco’s Mohamed El-Erian, is that the United States economy faces structural problems because it has not invested sufficiently in the tradable goods sector (exports), favoring the non-tradable goods sectors (like real estate). Having lived abroad when we were in the Peace Corps, we are conscious of how scarce foreign exchange can be and the deleterious effects of imported consumption goods upon the rest of the economy.

The Fed has been increasing the money supply in order to buy time for Congress to act. The crucial question is how long it can continue to fund the economy without causing really bad problems. Economic policy is much more like an engineering problem than a physics problem. It is necessary to consider the situation first and then the appropriate analysis and remedy, rather than the reverse.

Combined with increased automation, the result has been an unbalanced U.S. economy that has not created jobs for Americans. This interview is one of the best we’ve heard, and furthermore suggests that investment strategy should emphasize the preservation of capital.

5/1/13 -

A former British prime minister famously said that there is no such thing as society (only individuals, families and by further implication markets). Can markets exist without society? A market is a place where people come to buy and sell based upon price. The following describes real situations where exchange markets require social institutions.

The Eurozone

In an April address at Goethe University George Soros noted, “The (larger) European Union was meant to be a voluntary association of equal states but the crisis has turned it into a creditor/debtor relationship from which there is no easy escape. The creditors stand to lose large sums of money should a member state exit the union, yet debtors are subjected to (austere ¹) policies that deepen their depression, aggravate their debt burden and perpetuate their subordinate status.”

The Eurozone currency was founded with many defects that went unrecognized. “Developed countries outside a currency union have no reason to default; they can always print money. Their currency may depreciate in value, but the risk of default doesn’t arise. By contrast, third world countries that have to borrow in a foreign currency like the dollar run the risk of default…In short, the euro relegated what is now called the periphery to the status of third world countries.”

IMF data indicates that between 2008-2012, the real GDP of the European Union declined at an average annual rate of .5%. Soros says that Germany can either leave the Eurozone, thus allowing the foreign exchange rates of the remaining members to adjust so they can export, or it can stay and exercise a leadership role that it has avoided. Germany’s unwillingness to accept leadership is deeply ingrained in its society, due to historical experience. We note that it would likely be catastrophic for Germany to leave the Eurozone and experience the rapid appreciation of the Deutschmark, thus pricing its industry out of the world markets.

Soros suggests the obvious solution of Eurobonds. “If countries that abide by the Fiscal Compact are allowed but not required to convert their entire existing (our emphasis) stock of government debt into Eurobonds, the positive impact would be little of short of miraculous. The danger of default would disappear and so would the risk premiums (in markets)….Individual countries would still need structural reforms, but the main structural defect of the euro would be cured.” The German public does not like this idea but, “People don’t realize that agreeing to Eurobonds would be much less costly than doing only the minimum to preserve the euro….Individual countries would still need to undertake structural reforms (to lower the cost of additional debt issues).”

The Eurozone requires collective action; but everyone cultivates his own garden in the face of common ecological problems:

The U.S. Congress

The United States Congress exists for collective action, but the reason for present gridlock lies within the institution. One of the unfortunate byproducts of the Iraq war was the discrediting of George W. Bush’s “compassionate (i.e. mainstream) conservatism” within the Republican Party. In 2010 a highly dissatisfied Tea Party minority emerged, ideologically fixated upon restoring the assumed freedoms of the price-auction model as the key to economic growth, but not considering the long-term issue of investment and the broader responsibilities of citizens for the future of their societies. The result has been a departure of moderates from a radicalized Republican Party and legislative gridlock.

The election of the Tea Party has unfortunately depleted Congress of social capital, even within the Republican Party that has become ungovernable. Social capital refers to the norms of reciprocity or networks of engagement that can improve the efficiency of society by facilitating cooperation. The 2010 elections greatly disrupted the networks of cooperation in Congress. The solutions to present legislative gridlock are either that members of the Republican Congress become more willing to compromise or that they be replaced in 2014. Michael Lynch (2012) notes that in a democracy, “You don’t help your message by displaying a haughty (or oblivious) indifference to others’ challenges.”

We have illustrated how institutions provide social contexts for real markets. Specifically, Europe requires guarantees; and the U.S. requires compromise.

¹ Soros comments upon the policies of economic austerity upon developed economies, “The financial problem is that Germany is imposing the wrong policies on the Eurozone. Austerity doesn’t work. You can’t shrink the debt burden by shrinking the budget deficit. The debt burden is the ratio between the accumulated debt and the GDP, both expressed in nominal terms. And in conditions of inadequate demand, budget cuts cause a more than proportionate reduction in the GDP – in technical terms the so-called fiscal multiplier is greater than one.”

Less technically, the purpose of austerity is to free up resources for the export industries. But if the (path dependent) structure of the economy is insufficiently industrial, then all that austerity does is depress the whole economy without the benefit of new business growth.

Therefore government investment in the economic fundamentals: workforce skills, industrial structures of cooperation and R&D is crucial for the future.

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A prolonged period of low growth will have adverse social consequences to the United States and leave the economy vulnerable to shocks.

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To cohere, societies require a moral sense of fairness, that is giving each person his due. From the time of Plato and Aristotle, the Greeks explored the question of a just society using reason.

Both conservative neo-liberalism and liberalism have their roots in the Enlightenment, which started (in the case of democracy) with reasoning individuals and then asked how they could live freely in a just society. Although both political causes have the same roots, their scopes are very different. To the conservative, social organization tends to be limited to family and private voluntary organizations, with the role of government minimized. This is the ideal Jeffersonian world of small farms and self-sufficient communities, whose motto, at the extreme, is “Don’t Tread on Me.”

To the liberal, social organization has a wider scope. This is the complex Hamiltonian world of commerce, large organizations, long-term investments in education and R&D, safety nets, market regulation, globalization and international supply chains. Dealing with this complicated environment obviously requires rules at the appropriate level and continual reform.

The main difference between the two is whether to deal with wider systems questions. The conservative would claim that government cannot deal well with these questions, if they at all exist. But U.S. history, from the regulation of monopolies in the 1890s to the establishment of a new international order in the 1940s, illustrates that government can be effective; and, in certain cases, is indispensible to preserve freedom. With globalization, the international environment has become even more complex. It is a bad idea for the U.S. to bury its head in the sand.

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What’s a real market like? On a trip to Turkey, we visited the Istanbul Spice Bazaar, a place where sailing vessels of yore brought spices and rare silks from the East. In the best Adam Smith fashion, we set about to Max Utility by Min Price, buying saffron, an ingredient of paella. (merchant thought: Here come those tourists.) After some dickering, we got the price down by 20%; and that seemed to be that. I turned to my wife to discuss this gift purchase. (merchant: They might walk.) He dropped the price further, and the deal was done.

This apparently simple transaction wasn’t that simple. What affected the final price was not only some calculation like Min Price, but also social factors like mood and pacing. The general pattern of Adam Smith’s capitalist market exists in a social matrix that equilibrium economics simply ignores.

There was also some political turmoil that undoubtedly reduced the bazaar's business that day.

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6/1/13 –

On 5/22/13 the S&P 500 closed at 1655, nearly a record high. Yet, there is disquiet among some money managers. By conventional measure, the S&P 500’s P/E valuation of 17 times trailing operating earnings is not excessive, but consider the following event quotes:

Financial Times, Gillian Tett, 5/16/13:

Are markets going mad?...stocks in the UK, eurozone and US have soared – even as bond spreads (pricing credit risk) decline.…what is most striking about the current market trends…is not simply those dazzling equity and bond prices; instead the really notable issue is how many long-standing data patterns have broken down.

Take a look at the link between unemployment and equity markets. Between 1997 and 2011 the level of unemployment in the eurozone was always inversely correlated to the Stoxx index. However, since 2011 the Eurozone jobless rate has jumped from 10 to 12 per cent – even as the Stoxx has risen 10 percent.

Corporate earnings are another case in point. In recent decades, US earnings revisions have tracked swings in the stock market. But since the start of 2012 there have been net downward earnings revisions – while US stocks have soared. So too with credit spreads and leverage rates. In the past two decades, spreads on investment grade companies have always widened when corporate debt levels rose. But since 2011 the leverage ratio of eurozone companies has risen from 1.4 times to 1.7 times, while spreads have declined from around 210 basis points towards 120 bp. A similar pattern is at work in the U.S….

However, the crucial question is just how much longer these bizarre conditions can continue. Right now the betting among most analysts I have recently spoken with in London and New York is that these distorted conditions will remain in place far longer than most people expect (months or years, noting Keynes’ comment, “The markets can remain irrational longer than you can remain solvent.”)….

…while the flood of central bank liquidity is enabling the system to absorb small shocks, it is also masking a host of internal contradictions and fragilities that could surface if a shock hits (say from Europe).

Pimco, Bill Gross, May 2013 posting. In this article, he suggests four different ways financial assets can be given haircuts by the central banks:

(1) Negative Real Interest Rates – “Trimming the Bangs” During and after World War II most countries with high debt overloads resorted to artificially capping interest rates below the rate of inflation. They forced savers to accept negative real interest rates which lowered the cost of government debt but prevented savers from keeping up with the cost of living. Long Treasuries, for instance, were capped at 2 ½% while inflation was soaring towards double-digits. The resulting negative real rates together with an accelerating economy allowed the U.S. economy to lower its Depression-era debt/GDP from 250% to a number almost half as much years later, but at a cost of capital market distortions. Today, central banks are doing the same thing with near zero-bound yields and effective caps on higher rates via quantitative easing….Are treasuries money good? Yes. But are they good money? Most assuredly not, when current and future haircuts are considered.

The article then goes on to discussing additional haircuts such as currency devaluation, capital controls and actual default. The last two are likely not relevant to the U.S, we hope.

In other words, due to central bank interventions, the financial markets no longer accurately reflect fundamental economic conditions. To bring the issue home, just ask where are those 5% risk-free savings accounts? Since 2008, the Fed’s holding of securities has increased from $496 billion to $3.1 trillion (about 20% of GDP), as it has continued to buy U.S. treasuries and mortgage backed securities, the latter to keep the financial markets functioning. The markets, to use Robert Zoellick’s term, are on a “candy high.”

We now ask, “How will it all end?”

The Fed is planning a strategy that will enable it to smoothly exit without, it hopes, creating extreme market turmoil. In a 5/16/13 speech, Fed governor Raskin said, “Given its statutory mandate, the FOMC’s policy actions and communications have naturally sought to lower interest rates as a means of strengthening aggregate activity…We will continue to calibrate monetary policy – including both the ongoing pace of asset purchases and communications about the likely path of the federal funds rate – in light of our interpretations of the latest data, and the implications for the outlook for economic activity, labor market conditions, and inflation.”

“Calibration” can occur only if the economy increases its growth, recovery taking hold without the aid of fiscal policy. Although the bond market might then crash, the stock market might not due to increasing earnings. We think this case is less likely. What is more likely, growth increases somewhat; the Fed then tries to reverse Quantitative Easing. In the absence of fiscal policy, the economy and markets start to decline. Then the Fed has to continue more QE by purchasing more securities until something breaks, either here or abroad (in months or years). The economy has unfortunately become addicted to low interest rates from the Fed, and adjusted its structure accordingly. The Fed must continue to fund consumption in the form of new real estate and consumer purchases. ¹

Bill Gross discusses a portfolio policy, that as a value investor we are pursuing:

Let’s acknowledge (the) possibility, along with the observation that all of these haircuts imply lower-than-average future returns for bonds, stocks, and other financial assets…The easiest answer to the question of what to buy is to simply take your ball and go home. If the rules aren’t fair, don’t play. That endgame however, results in a treasury bill rate of 10 basis points or a negative yield in Germany, France and Northern EU markets. So a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing. PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond….The same conclusion applies to credit risk alternatives such as corporate bonds and stocks. Granted, this sound a little like Chuck Prince and his dance floor metaphor does it not? His example proved that dancing and full heads of hair are not forever. So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of... (massive loss). There will be haircuts. Make sure your head doesn’t go with it.

We sell stocks that have reached full value without replacement in order to maintain portfolio quality. The contrary view is, “There are no alternatives but equities.” The Fed is asking investors to move along the risk curve a lot ² in order to capture 2-3% dividends. Stock market volatility is therefore low, leading to current complacency. This view is valid, provided the risk doesn’t actually materialize. We think that the risk is material.

¹ Consider three issues du jour in Washington: Benghazi, IRS targeting, and AP subpoenas. These issues have nothing to do with economic growth. We think economic growth warrants more national urgency than the above; but Congress, unfortunately in its trance, doesn’t think so.

In the real, as opposed to financial, economy; a forward-looking fiscal policy has to become possible in Congress. This would enable productive infrastructure investments (anyone been to JFK recently?), industrial education and R&D. These will rebalance the economy, opening it up to more possibilities, enabling it to grow. Congress really should come to an agreement on, at least, this.

In the May/June 2013 issue of Foreign Affairs, Brown University political economist Mark Blyth published an article called, “The Austerity Delusion”. He summarizes the economic policy mistakes of the 1920s in Washington, London, Berlin, and Tokyo with the heading, “Austerity Now, Insanity Later.” He then discusses the current failure of austerity policies in the non-export led economies Europe. Concerning the United States, he writes:

The United States…should take advantage of the fact that it is not saddled by the kind of institutional flaws that exist in the Eurozone and that it can borrow for virtually nothing. Now is a good time for Washington to make useful investments. Take just one example, around a third of the bridges in the United States are badly in need of repair. Fixing them would enhance U.S. productivity and have no downside. In this sense, austerity is not just wrong because of the problems of distribution, composition, and logic described above; it also carries a dangerous opportunity cost. If the United States were to proceed down the path of austerity, roads would go unrepaired, students would miss out of gaining knowledge, and the skills of the unemployed would atrophy. The country’s position relative to any country that did not do this would worsen. The United States would end up poorer and more debt-ridden than before, and what is most problematic, it would lack the capacities needed to generate future growth (our emphasis).

There is a developing consensus that the United States needs more investments for the future. Ideological legislators, detached from economic reality, are doing real harm by neglecting the economic basis of the U.S. international dominance they so cherish. Slogans aren’t thoughtful policy.

² 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.

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7/1/13 –

On 6/24/13, the U.S. stock market dropped to 1573. Monetary hawk Richard Fisher, president of the Dallas Fed, recently described some investors as “feral hogs,” formerly domesticated pigs run wild, testing the market when a change occurs. (This is a day-to-day trading view of what happens in the markets.) He then told the Financial Times that the Fed would not be deterred, “…markets should not think the Fed would end up propping up the economy indefinitely, or that it could be pushed to keep buying Treasuries at the same pace, thereby inflating asset price bubbles.”

Ben Bernanke’s statement that the U.S. will begin to reduce its purchases of treasury and mortgage securities has helped cause world markets to drop. We think the key question is whether or not the present U.S. economy has been suffering from a cyclical downturn or a structural one. If the former, economic activity will recover and interest rates will increase rapidly. If the latter (our belief), then economic activity will have recovered only in the interest sensitive housing and auto sectors.

U.S. industry now counts for a decreased share of GDP (12%) and employment (9%), both down from 24% in 1970. Before globalization, first the interest sensitive housing and autos grew, then manufacturing and finally the resource industries. With the economy’s share of manufacturing now greatly reduced, that sequential growth can no longer occur; and U.S. exports are growing slowly. There is also a more general concern. Modern economies increase their wealth by industrial, that is technological, advances.

There are implications of this for portfolio policy. If the economy is cyclical, interest rates will eventually soar. The obvious thing to do is to step out of the way and leave your portfolio in cash and live with low returns for at least a while, because interest rates have been at historic lows. If the economy isn’t cyclical, then it makes sense to phase into income producing investments, expecting that a rise in interest rates over a period of years - say to a 5% U.S. long treasury -, will be balanced by the years of higher income received. We are of the latter view, thus are slowly increasing our holding of income-producing assets, at first higher yielding pipeline MLPs that are also capable of growing their earnings over time then later intermediate term corporates.

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The 6/26/13 CNN reports, “Gross domestic product…rose at a mere 1.8% annual pace between January and March, marking a sharp downward revision from the 2.4% pace reported by the Commerce Department last month.”

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Egypt and Turkey are different countries. Both, however, have been ruled by an executive from the Muslim Brotherhood, a former Egyptian terrorist organization that in the 1970s renounced violence. But holding a majoritarian view of democracy *, both recently began to install a theocracy (The hapless Morsi – among other things – by revamping the Egyptian constitution; and Erdogan by muzzling the press, jailing his opponents and proposing to build a mosque on Republic Square). Both have been rightly accused of neglecting the other 49% of society that didn’t vote for them.

The question to ask now is what institution leads towards the stability of the country and the eventual growth of a system of liberty with some order. In Turkey, the likely source of stability is the AK party itself; it could begin to address the interests of the rest of society by establishing a credible rule of law and a growing set of real rights that establish an expanding zone of freedom for citizens rather than subjects.

In Egypt, the obvious source of stability is the army that is generally seen as a source of national order. Canadian Foreign Minister, John Baird, was recently interviewed by the 7/4/13 WSJ:

WSJ: …is this the appropriate action (in Egypt), and does Canada support it?

Mr. Baird: The military has taken the action. I think if you look at the democratic space in Cairo, there has been a substantial amount of support for that. Obviously we prefer democratic transitions. Egypt is nothing proximate to a full western-style liberal democracy. It needs strengthened institutions, and it needs a real political process.

Some have called its governance of the past year a failed state sic. Obviously we want to see it continue along the transition to the respect for pluralism, freedom, and the importance of civil society.

WSJ: It doesn’t sound like Mr. Morsi is getting a lot of love from Canada.

Mr. Baird: Listen, the president is accountable for his own actions. Obviously, this is not an on or off switch, where it can be a democracy or non-democracy with the flip of our switch. Obviously, our preference is to see Egypt develop its freedom and democracy as it goes forward.

To note how history can be very contingent, the prospect for liberal democracy in Egypt now depends on what the Muslim Brotherhood does (maybe 25% of the electorate), how the army reacts and how the opposition organizes. The beginning is not too auspicious. On 7/4/13 the army arrested and charged the leadership of the Muslim Brotherhood. Contrast this with South Africa’s Nelson Mandela who opted for, “Truth and Reconciliation.” Democracy is a reasoned form of government; it therefore requires the first. Democracy is also a way for citizens to live together; it therefore requires the second.

* In contrast, the U.S. system of liberal democratic government was explicitly designed to prevent “tyranny of the majority.” In Federalist #51, James Madison (1788) wrote:

If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primarily control on government; but experience has taught mankind the necessity of auxiliary precautions (our note).

The 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.

The separation of powers; dividing the government into judicial, legislative and executive branches; also addressed and reconciled the society’s past, present and future. This is an example of what Reuters calls “institutional depth,” that sustains the system of democracy when the tide of public opinion turns..

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The near-term course of the Egyptian Revolution will most likely be determined by Mr. Morsi’s willingness now to compromise.

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On 7/8/13 the army opened fire on Morsi supporters, killing 51 and wounding hundreds. Later on the same day, the interim government published a plan for constitutional reform and new elections. The 7/9/13 NYT reports that it does not have the support of either liberals or conservatives.

The Egyptian and Turkish examples illustrate how old political habits vie discordantly with the requirements of modernity. Harvard Law professor, Noah Feldman, writes, “Rashid Ghannouchi, the spiritual leader of the Tunisian Islamists, has emerged as the closest thing to an Islamic Nelson Mandela. During his decades in exile, Ghannouchi wrote extensively about the compatibility of Islam and democracy, and developed a relatively liberal vision of how Islam and the state should interact.” The Tunisians are on the verge of enacting their new constitution that is likely to be successful because it is written by elected delegates.

His May 31, 2013 address to the Brookings Institute is a very practical guide on how to build a state comprised of Berber tribes, Sunni, Shia, Islamists and Secularists. It addresses the core issues:

1) The country is for all, not just the majority. It is necessary to build a coalition government where moderate secularists and Islamists can co-exist.

2) The conflict between Islamists and secularists in the Arab world has wasted enormous energy, enabling dictators to control their countries. An alliance between these two is therefore important for the establishment of democracy and society.

3) Ideological polarization, “…is a recipe for chaos and failure.” (The Tea Party should note.)

4) The role of the state is not to impose a certain way of life. Sharia is not included in the constitution because a constitution should be what people agree about.

5) The role of the state is to provide security and services to people so they can choose their way of life. The constitution includes civil society.

6) Tunisians should be able to see themselves in a constitution that represents all.

7) The constitution is built upon the idea of human rights.

8) Tunisia may be the first democracy in the Arab world.

A constitution is an observed practical arrangement that enables people to live together. Egypt, Thomas Friedman notes, is pluralistic without pluralism.

8/1/13 –

On 7/19/13 the S&P 500 closed at an all-time high of 1692 after recovering from a low of 1573 on 6/24/13, a gain of 7.6%. The reason for this increase was not an improvement in economic fundamentals. The reason for this increase was an event, a hint that the Fed would not take away the spiked punch bowl, and the party could continue for a while longer (the market reacted badly to an earlier Fed statement). A few days ago Ben Bernanke reported to Congress:

We are relying on near-zero short-term interest rates, together with our forward guidance that rates will continue to be exceptionally low…to help maintain a high degree of monetary accommodation for an extended period after asset purchases end, even as the economic recovery strengthens and unemployment declines toward more-normal levels. In appropriate combination (Fed funds rates near zero and asset purchases) can provide the high level of policy accommodation needed to promote a stronger economic recovery with price stability.

…if needed, the Committee would be prepared to employ all of its tools, including an increase the pace of (asset) purchases for a time, to promote a return to maximum employment in a context of price stability.

All things being equal, an expansive monetary policy encourages growth of the private sector; an expansive fiscal policy encourages growth of the government. An expansive monetary policy should have increased economic growth; but did not due to impaired business confidence and a lack of innovation caused by making R&D and scientific education low priorities. Furthermore, current economic fundamentals do not justify this stock market increase. The June increase in employment of 195,000 jobs included a large number of part-time positions, S&P 500 operating earnings in the nine months ending 3/31/13 dropped by .65% compared with the previous nine months and long-term interest rates have increased. It is now obvious in extremis the economy needs both policies.

In The General Theory (1935), Keynes essentially wrote that markets are short-term and do not make the necessary investments for the future. To do this, he looked to government. Nobel Prize winner, Michael Spence (2011) writes, “The main job of government is to facilitate structural change by investing in human capital, protecting people in the transitions through income support and access to basic services, and then to let the market forces and investment incentives work…. (Specifically) growth comes from a complex interaction of the public and private sectors, with effective governments investing, building institutions, and actively filling in gaps.” Good government has a major role in promoting economic growth.

Transaction markets (e.g. financial markets) alone won’t produce long-term economic growth. Economic growth and a rising standard of living requires long-term technological progress.* The Tea Party might note** that Bell Labs, inventor of the transistor and discoverer of communication theory that makes possible the Internet, has been dismantled by the parent’s profit pressures. The government has launched specific initiatives to improve the inventiveness of the U.S. economy and its skills. We think these kinds of programs matter for the future, not an economic ideology that assumes the answer had been found, the market fundamentalism that one size fits all.

Absent a break in congressional gridlock, what can be said about the short-term stock market? The stock market is very high relative to its fundamentals; a drop might occur as investors begin to perceive that the growth they expect in six months (a usual time frame for expected improvement) is not realistic. The stock market rally has caused almost all our portfolio stocks to reach their sell valuation targets, with the exception of Citigroup. Value investors are long-term investors. Citigroup’s profits are improving significantly; we will hold the company until its approaches book value.

* Economic growth also requires manufacturing. On the 7/21/13 Meet the Press, former Michigan governor Jennifer Granholm said, above all, the U.S. needs a strategy to create middle class jobs through manufacturing. In a global economy, other countries including Germany and those in Asia have been able to do this. The U.S. should learn from the best practices abroad. Now it has a gridlocked, “hands off” congress.

** add: We originally used the words, “should note”. Maybe we should have kept those words. A 7/23/13 NYT article indicates that the House Republicans are going to threaten a Government shutdown after September 30 and (again) threaten a financial default (the U.S. will run out of money early November). Wisconsin Representative Paul D, Ryan said, “It’s about time we cut some spending around here.” These are some of the items the proposed House budget will cut:

1) The Environmental Protection Agency’s budget by 34%

2) Fish and Wildlife Service, 27%

3) Education grants to poor students, 16%

4) Advanced Research Program for Energy, 81%

5) Corporation for Public Broadcasting, 100%

6) The SEC, 18%.

A rational (as opposed to an irrational) policy considers the merit of actions by their consequences. The proposed House budget cuts Federal government spending in order to lower taxes. Lower taxes do not enhance the creation of new businesses. Entrepreneurs start new businesses because they want to solve problems and do things better. If an entrepreneur tells a venture capitalist that he wants to start a business, “To make money,” he will be declined.

The Tea Party’s House agenda will degrade the U.S.: leaving it less educated, more polluted and economically challenged. Society has to achieve a viable balance among many considerations, particularly in a more complex globalized economy.

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As we post, this 7/21/13 WSJ article appears, “U.S. Growth Outlook Stuck in Neutral.”

9/1/13 -

On 8/14/13 The S&P 500 closed at 1685. Although events could drive the stock market somewhat higher, the stock market, in response to expansive central bank monetary policies, is very overvalued. The most obvious fact, to us, is that almost all the individual stocks we bought now exceed their sales targets. Another fact is what some in the financial markets are saying:

Our valuation methodology begins with a company’s adjusted cash flow, that is EBIT, earnings before interest depreciation and taxes. This metric is also used in the deal business, that is in real estate (cash on cash) or in leveraged buyouts (cash flow). Apollo Global Management is a contrarian and value-oriented investor in private equity. The 8/2/13 Bloomberg quotes its CEO, Leon Black, “It’s almost biblical: there is a time to reap and there’s a time to sow. We think it’s a fabulous environment to be selling. We’re selling everything that’s not nailed down in our portfolio.”

What does the cloudy crystal ball of the intermediate future look like? Our sense is that the future won’t be bright unless the U.S. does what is necessary to restore real economic growth.

In a May, 2013 article, PIMCO’s Mohamed El-Erian discussed several topics. We summarize his comments in italic:

1) The current course of apparent economic stabilization may become untenable in the future as countries have to either reform themselves structurally to restore economic growth or slide into extremely low growth that will fuel greater social tensions, political dysfunction and debt crises.

We averted the worst financial crisis since the 1930s. It is unrealistic to expect that business will return to normal without appropriate economic policies.

2) The central banks have done their utmost to buy time. But their involvement can adversely push countries back toward old and exhausted growth models, (such as consumption-led growth in the West) and export-led growth in the East.

We think this is a major issue. For all its virtues, an expansionary monetary policy tends to perpetuate the status quo, enabling people to continue to do what they have been doing without changing the behaviors that new economic fundamentals demand. Markets, provided they do not also destroy society, do force people to change.

3) The central banks will maintain their pragmatic experimentation mode, targeting growth and jobs more explicitly, supply small and medium-sized businesses with credit and broadening the set of assets they will purchase, essentially becoming fiscal agents on behalf of the government.

Although (financial repression aside) things may appear normal in the financial markets, they aren’t. An 8/10/13 NYT article notes that the U.S. government backs or finances nine out of 10 residential mortgages today. In 2006, when the private sector was happily issuing securitized junk mortgages, Fannie and Freddie had only a 37% share of the total market. Since this is a capitalist system, the private sector ought to be much more involved in making sound loans.

There is, furthermore, another more general issue. A premature increase in interest rates will certainly do short-term harm. But, like an emergency drug given too long, low interest rates to restart growth are badly distorting the economy in ways that will affect its future performance. Classical economist David Simpson (2013) cites three major effects of prolonged monetary easing, that we think are valid:

a) It results in asset price bubbles, as the rationing effect of price is neutralized.

b) It is associated with an increased level of fraud (that the government is still mopping up).

c) Because money is fungible, money created in 1998 to ease the financial system through the Long Term Capital Management crisis helped to inflate the dot.com bubble in 2001, culminating in the housing crash of 2007-2008.

It is easy to spike the punch bowl, but difficult to take it away. There are now calls for reflation of the economy, which would further lower already negative real interest rates (affecting savers); this is another view from Paul Volker. An accommodative monetary policy prevented a catastrophic meltdown of the economic system, but has proved to be less effective in stimulating real and balanced economic growth.* The most important economic goal is the creation of skilled, well-paying jobs in the real economy. Present conditions of private sector reticence requires fiscal policy, structural investments from Congress in areas important to future growth like education, infrastructure, science and technology.

4) Investors should resist the short-term focus of those who have abandoned fundamentals in favor of just obsessing with what is cheaper only in relative terms. Investors should not give up liquidity. “Optionality is valuable in a changing world subject to unpredictable forces.”

This course of action can be followed by value investors, by going into cash when stocks have reached their intrinsic values, so they can later buy bargains with a sufficient margin of safety.

A recurrent message, both here and in Europe, is that higher growth is the only way out of the numerous financial, political, and social dilemmas caused by low growth. Higher economic growth, however, does not just happen. In the 21^st century, the United States really needs to dial down its culture wars and to dial up real economic and educational concerns. Our next essay will discuss the roles of science and technology, and the ways they contribute to U.S. growth beyond shorter-term market transactions.

* Cúrdia and Ferrero (2013) of the Federal Reserve Banks estimate that the $600 billion program to purchase long-term treasury securities, known as QE2, added about .13 percentage points (sic) to real annualized GDP growth in late 2010. Although it increases asset prices, monetary policy has clearly reached the limits of its effectiveness in the real economy.

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More about our Citigroup holding. In investing, what matters most is to act consistently and according to the opportunities that the markets present. We have extensively discussed the macro environment because it matters for the long-term future. However, value investors are primarily company investors; and that is our investment philosophy because the value strategy fits our training and temperament.

For momentum investors, price matters the most; therefore a sell signal flashes when short-term price momentum is expected to cease. In the ecology of the financial markets, this eventually provides an opportunity for value investors who mainly concentrate upon companies and their valuations. Those who study markets like diversity. We really like to do business with momentum investors; without them, there would be no markets.

Citigroup is the only stock we now hold; it is not a large portion of our portfolio. If it drops significantly, that would present an opportunity to buy more (as long as the improving fundamentals of the company continue). If you bought this stock, this is indeed an opportunity to find out whether you are a value investor or a momentum investor. If you sell Citigroup, you are a momentum investor. If you continue to hold it, you are a value investor because the stock is trading below its book value. If you aren’t sure what to do, this is a good time to decide and then act accordingly in the future.

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A doctor once succinctly said that medicine is an exact science with an inexact application. We contend that investing is an inexact science with an inexact application. The market has its own behavior, and each individual investor has his own unique facts and circumstances. Regarding the first, we are restricted by SEC regulation to giving only impersonal investment advice.

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8/28/13 - We have set our holding in Citigroup to a normal portfolio level.

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It is now timely to discuss losses. Economic research has shown that people, on average, are loss-adverse. They value losses averted twice as much as they value profits gained. But if investors want the long-term rewards of stocks, they have to be willing to suffer some short-term loss.

With the fundamental value investing philosophy, it might be possible (with judgment) to avoid a large downside risk. But it will be impossible – especially under turbulent market conditions - to pick a market bottom and then immediately invest 100%. It will also likely be unrealistic to wait for turbulent markets to stabilize, because markets spike at the extremes. In engineering terms, just think of turbulent flow.

What we are saying, even with the most astute trading, it will be impossible to avert short-term losses if you want long-term investment gains. This statement is also implicit in modern portfolio theory. Where (to an improper exactitude) investors are supposed to trade (in a timeless model) a portfolio’s risk (standard deviation) against its return. What is here at question is only the magnitude of the losses, which we try to minimize with the concept of an investment margin of safety.

We will discuss profits later.

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An appropriate response to the complex and appalling Syrian situation is necessary. Sometimes useful is the apt analogy:

Syria is a quagmire. A quagmire just sits there until someone steps into it. Syria is not a quagmire.

Syria is a hornet’s nest. A hornet’s nest just buzzes around, but swarms when swatted. Syria is not a hornet’s nest.

Syria is a forest fire. A forest fire, if it does not first burn itself out, must be contained. The Sunni-Shia religious divide * now threatens to turn Syria and the Mideast into a conflagration.

People like to use analogies because they are vivid. But if they are not misleading, they must essentially correspond to the actual situation. Add: Doing nothing will likely end in a Sunni-Shiite war throughout the Mideast. ** Foreign fighters are flooding into Syria from around the Muslim world. Doing the wrong thing is likely to have the same result, only sooner. The choices in this complex situation cannot be binary. The only alternative is to contain that forest fire appropriately.

* The doctrinal differences between the two sects of Islam are like some of the differences within Christianity. Politically, the hierarchical Sunnis in Turkey, Saudi Arabia, the Gulf States and formerly Iraq dominate the Shia. After the Iraq war, the Shia began to form a crescent from Iran, Syria and now Iraq. In an 8/29/13 NYT article, David Brooks wrote, “…The Syrian civil conflict is both a proxy war and a combustion point for spreading waves of violence. This didn’t start out as a religious war. But both Sunni and Shiite power players are seizing on religious symbols and sowing sectarian passions that are rippling across the region. The Saudis and Iranian powers hover in the background fueling each side.”

Former U.S. ambassador to Syria, Ryan Crocker, writes, “This will be a long war. There is little the United States can do to positively influence events in Syria. Our focus must be on preventing further spillover beyond its borders (our note).”

The Sunni and Shia of Syria are locked into an existential conflict. During the 17^th century, Europe had its own religious wars that dragged on for thirty years, devastating Central Europe.

** With obvious consequences to U.S. energy prices.

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9/9/13 - Better yet if the U.S. can accomplish its goals without actually resorting to force. Russia, and its ally Syria, have now (in principle) agreed that Syria should place its chemical weapons under international control These diplomatic results were likely not possible without the credible threat of military action and without prior conversations between the United States and Russia. The latter likely fears a spillover of Syrian instability and WMD to the Caucasus.

9/14/13 – The announced agreement between the U.S. and Russia, reached in record time, provides for the total disposal of Syrian chemical weapons by mid 2014, as a goal. The agreement does not contemplate any UN military action unless Russia agrees in the Security Council, which it will not. Assad’s use of chemical weapons was egregious. Russia – in its own self interest – is committing to eliminate the threat of chemical weapons to the southern Muslim republics. *

From the Russian standpoint, the mere threat of U.S. force became a catalyst for serious negotiations. From the U.S. standpoint, the outcome could not be better. This incident illustrates that when it comes to social policy, it is a bad idea to keep repeating unthinking formulas. It is also necessary to consider the overall situation and the interests of the people involved.

* A 9/23/13 Reuters article discusses why Putin wishes to contain, if not settle, the Syrian civil war. “…Putin issued a fresh warning of spillover from the Syrian civil war. In the Russian Black Sea resort city of Sochi, he told former Soviet allies that Islamist militancy fueling the war in Syria could reach their countries, some of which have Muslim majorities…' The problem of terrorism spilling from one country to another is absolutely real and could directly affect the interests of any one of our countries.'” The main issue is that the Syrian chaos affects Russian interests.

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Under ordinary conditions, low interest rates accelerate economic growth by making more projects feasible, or at least financeable. What current economic conditions encourage are real estate projects, funded by low interest rate mortgage debt. Due to the aftermath of the Financial Crisis and globalization, what “projects” does not mean is the industrial projects that grow the economy. These projects are required for balanced economic growth and generally require projected rates of return of around 15%, returns that are not widely available given sequester and a lack of government investment. * For these projects, a one or two percent increased cost of capital is irrelevant.

After a 9/18/13 Open Market Committee meeting, Ben Bernanke indicated that the Fed would continue buying debt at a rate of around $85 billion per month to keep interest rates down. Interest rates could remain low for years; savers should note.

The Financial Crisis of 2008 was caused by investors taking on excess risk to earn some additional promised income (remember those mortgage backed securities, they’re back). Almost all the stocks we held have exceeded their valuation targets. Given the economic fundamentals, we wouldn’t rely upon continued equity appreciation. We are concentrating on portfolio income by slowly purchasing more pipeline MLPs. After accumulating a sufficient amount of MLPs (60% of our fixed income allocation), we will then begin purchasing shorter-term treasuries (40% of our fixed income allocation – if the House doesn’t blow up the financial system). Such a treasury allocation will provide diversification.

Stocks? We aren’t momentum investors, low interest rates cause collateral damage to the economy and the Tea Party is brewing trouble.

* In capitalist economies, the government does not create private sector jobs directly. But, like the Fed, it can influence the economy by giving it a push in the direction the markets were taking anyway. An example might be a beginning trend of manufacturing return to the U.S. Manufacturing is driven by costs. ¹ The U.S. is becoming cost competitive with foreign suppliers when the products are built to customer design or complex. The production of these products requires a highly trained work force and long-term investments in R&D.

¹ Labor costs carry around a 75% weight in foreign plant relocation decisions, according to a MBA classmate of ours.

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9/24/13 Confronted with the serious problem of helping to restructure the economy so it can benefit all Americans, the House has embarked upon a symbolic crusade to defund the discretionary portion of the Healthcare Act, threatening a shutdown of the U.S. government.

To prevent a “tyranny of the majority,” the Constitutional Convention of 1787 set up a democratic system, where the independent branches of government could check and balance the actions of the others. Thus getting something substantial done required the assent of all branches, as did occur after the passage of the Healthcare Act of 2010, that became the law of the land. The Republicans of the House are said to carry around pocket copies of the Constitution to remind themselves of the founders’ “original intent”. In accord with the process of ordered liberty, the House could theoretically reverse the Healthcare Act by passing a nullification bill, sending that to the Senate and then to the President. There is, of course, no possibility that such a House bill could survive due constitutional process.

Violating “original intent,” the House now threatens to impose upon the nation a “tyranny of the minority,” by tying symbolic healthcare defunding to a crucial bill funding the entire government, threatening to shut it down and then blowing up the world’s financial system. Reminiscent of the worst preschool behavior, the narrow-minded ideological radicals * of the Republican party are throwing a tantrum, threatening to pull everything down if they and their constituencies don’t get their way.

In democracies, legislation almost always gets passed by coalitions of groups that ultimately compromise, the bargaining process constructively taking into account different perspectives. The impractical Republican party should be recognized for what it is; it should not be able to impose its dysfunctions upon everyone else.

* A 9/24/13 CNN Money article reports that the Business Roundtable, a lobbying group representing leading CEOs, pleaded with Congress to fund the government and raise the debt limit. “…It’s an open question whether (the appeal) will make any difference. The faction of Republicans who appear to be driving their party’s strategy going into the showdown have so far proven resistant, if not outright contemptuous, of appeals from the sorts of establishment authorities that traditionally have been able to break through Congressional gridlock….The top-down dynamic that once prevailed in the institution (party discipline), allowing Congressional leaders to hatch deals to move the business of governing forward, has eroded. It’s been replace by…power centers accountable to no one but an increasing feverish base (our note)….The BRT’s message join a growing pile of warnings from a corporate sector vexed by Republicans it supported with 72% of its contributions in the last election.”

We’ll let the facts themselves speak.

10/1/13 –

The financial credibility of the United States (and its present ability to finance large trade deficits) was built upon the military victories in W.W. II and years of international leadership, that is now placed in jeopardy. As of this writing, the House has decided to fight the culture wars by any means possible, trying to reverse the Healthcare Act by holding up funding for the government and later the debt.

In the U.S., as in the Mideast, disagreement on the nature of the state is problematic. This disagreement is ultimately caused by the dislocations that large economic and social change bring, some people responding positively to that change and others taking refuge in an imagined past or worse.

Years ago, Americans chose the Hamiltonian road of national economic development and change, with an activist government, rather than a bucolic Jeffersonian path of small family farms, with minimal government. Essentially writing about industrialization, Adam Smith wrote that the wealth of a nation was, among other things, found in “the skill, dexterity and judgment” of its people. The way out of the downside of competitive globalized markets is long-term investments in education, scientific research and infrastructure - to restore the U.S. economy’s potential for growth. In an increasingly interrelated world, government, business and civil society need to cooperate with each other to make this possible.

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The present series of Congressional confrontations will ultimately concern raising the U.S. debt limit. Before October 17, The Democratic Senate will likely pass a clean bill authorizing the issuance of additional U.S. debt. That bill will go the House where Speaker Boehner will have to decide whether to invoke the Hastert Rule, requiring the approval of a Republican majority of a majority before allowing legislation to be voted. If he decides to invoke the rule, the Senate bill will be defeated; and the U.S. will default on its debt. If he decides not to invoke this rule, this U.S. debt limit bill will be passed by a coalition of Democrats and Republicans. The radical wing of his party will then likely go after him.

Speaker Boehner will have to choose between our country and his unruly caucus. The press has likened the present Republican party to a “circular firing squad.” In 2014, the voters could choose more practical legislators.

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House Speaker Boehner can end this legislative crisis by simply not invoking the Hastert Rule. If he were not to do so, the House would be able to pass clean debt and government funding bill(s) with a coalition of Democrats and moderate Republicans. What ails the House is what James Madison called “the violence of faction”. In Federalist #10 he writes:

By a faction, I understand a number of citizens, whether amounting to a majority or a minority of the whole, who are united and actuated by some common impulse of passion, or of interest, adversed to the rights of other citizens, or to the permanent and aggregate interests of the community….

The latent causes of faction are…sown in the nature of man; and we see them everywhere brought into different degrees of activity…A zeal for different opinions concerning religion, concerning government, and many other points, as well of speculation as of practice; an attachment to different leaders ambitiously contending for pre-eminence and power…have rendered (persons) much more disposed to vex and oppress each other than to co-operate for their common good….The regulation of these various and interfering interest forms the principal task of modern legislation, and involves (here he accepts) the spirit of party and faction in the necessary and ordinary operations of government….

The inference to which we are brought is, that the causes of faction cannot be removed, and that relief is only to be sought in the means of controlling its effects.

If a faction consists of less than a majority, relief is supplied by the republican principle, which enables the majority to defeat its sinister views by regular (our note) vote. It may clog the administration, it may convulse the society; but it will be unable to execute and mask its violence under the forms of the Constitution.

Speaker Boehner should resolve this legislative crisis by simply acting in a constitutional manner, allowing a simple vote that will negate this “tyranny of the minority.” * This passage also illustrates that U.S. politics has always been raucous; the Founders’ antidote to this was inspired design, motivated by reason.

* The Tea Party, of course, claims that the Affordable Healthcare Act is “tyranny of the majority”. Not so simple; it is established and affirmed law. Their opposition boils down to this, they don’t like it for purely ideological reasons and are trying to thwart it. In which case, democracy also requires the opposition to abide with outcomes they disagree with until the next election. Embattled by Tea Party challenges at the primary level, the Republican representatives of the House are in a state of social hysteria. They can’t even govern themselves, let alone the nation.

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Their attempt to defund the Healthcare Act thwarted, why do the Republicans continue to refuse to pay the government’s bills?

During the Republican presidential primary of 2012, Texas Governor Rick Perry stated the main Republican goal, “…to minimize government.” This is the philosophy of the mythical western frontier *; it is not appropriate for an increasingly complex, globalized society; but 30 to 40 radical House representatives are willing to shut down the government and cause default of the U.S. debt to get their way.

A suspension of the Hastert rule would marginalize that group, immediately enabling a bi-partisan coalition to restore both the government funding and the credit of the United States. The equivalent of this block in the Senate is the filibuster, especially when the senators don’t really have to speak.

Disrupting the Mideast and now threatening to disrupt our government will bring more misfortune. Perhaps, because of unyielding principle ** and their too simple literalism, the radical Republicans lack the judgment to navigate in an complex world. In an essay titled, “Political Judgement,” the political philosopher Isaiah Berlin wrote about luck. “…there is always the part played by pure luck – which, mysteriously enough, men of good judgement seem to enjoy rather more than others. This…is…worth pondering.” Strike “luck” and then add intuition. Strike “intuition” and then add domain expertise. There it is. Socrates would have said the same; people in politics should be expert in the art of governance.

* Forgetting those railroad land grants, also the many government irrigation and power projects that made economic growth possible in the West. This surely illustrates that economic growth doesn’t just happen because taxes are low; it takes planning; government investment; and workforce “skills, dexterity, and judgment.”

** In order to minimize government, the radicals would say a government role in healthcare is always inefficient. We beg to differ. Just look around to see how other countries handle their healthcare at a much lower cost, involving government.

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The German chancellor, Bismarck (1815-1898) once said, “Preventive war is like committing suicide out of fear of death.” This is what a default on U.S. treasuries would bring, not just a large increase in interest rates. Treasuries serve as lending collateral for the entire world’s financial system. Calling the creditworthiness of this collateral into question will place many other financial contracts at question. To preserve the financial system in 2008, the Fed rescued AIG, a company that had written too many contracts to insure unsound mortgage investments.

It is bad business to call the U.S.’s creditworthiness into question; it is also a fundamental mistake. The Three C’s of lending are: Character, Capacity and Collateral. The willingness of foreign investors to lend money to the U.S. depends upon their assessment of the country’s willingness and ability to pay its debts, calling upon the U.S.’s taxing ability.

A 10/8/13 NYT article is titled, “Many in G.O.P. Offer Theory: Default Wouldn’t Be that Bad.” Actually, it would be very bad because that would be calling into question America’s character, or willingness to pay all its debts. The radical Republicans are illogically threatening to create a dangerous short-term credit crisis in order to avoid the more remote possibility of a long-term one. Projected deficits, revenues and entitlements…these are long-range budget issues that can be dealt with reasonably, if disentangled from the social hysteria that threatens the present creditworthiness of the United States.

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10/10/13 The Republican party seems to be trying to find a way to back down from their threat to allow a default on the U.S. debt around Oct. 17. Paul Ryan, chairman of the House Budget Committee, wrote in the 10/8/13 WSJ, “…most of us agree that gradual, structural reforms are better than sudden, arbitrary cuts (in the sequester)…We need to open the federal government. We need to pay our bills today - and make sure we can pay our bills tomorrow. So let’s negotiate an agreement to make modest (we note that word) reforms to entitlement programs and the tax code.” Separately, he then outlined a plan to extend the nation’s debt limit for a limited period of time.

The business (financial) base of the Republican party has discovered they cannot sway the minority radicals of the Tea Party and their political base, but they do control the campaign contributions. The U.S. Chamber of Commerce and numerous CEOs do not like radicalism in the Republican party. They are undoubtedly applying pressure to dilute the Tea Party’s influence. Political revolutions are bad for business, which itself causes change (innovation). Government policy and institutions should be a source of social stability and reform rather than a cause of chaos.

This crisis has turned from confrontation to at least some discussion. Our investment in pipeline master limited partnerships is presently around 16% of total assets. We added 4.5% more to the position, which we will increase until it is around 30% of our portfolio. *

* This is how to handle markets. You establish an initial position at a certain time. Then, if it circumstances begin to develop as you think they might (and if the situation feels right), you add more. In a certain sense, the establishment of that initial position is a statement of intention.

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10/16/13 - The Senate and the House finally agreed to a short-term compromise that will fund the government till January 15 and increase the debt limit through February 7. This measure passed the House 285/144 with a coalition of Democrats and Republicans, 62% of Republicans voting at that late hour against reopening the government and paying U.S. debt.* The present composition of the House is very problematic. A Brookings Institute fellow writes, “…Congress…is the clearest and most present danger in the world to the national security of the United States.”

In the year before the 2014 midterm elections, House legislation will have to be passed by coalitions from both parties. The Speaker should not be able to continue to use the Hastert Rule to block House legislation the radical Republicans don’t like.

There is reason to continue a low-risk investment policy.

* For the first time in U.S. history, a major political party is deeply irrational, caring not for the consequences of what they do.

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10/18/13 - We increased our investment in pipeline limited partnerships to its target of 30% of the portfolio. An additional 20% of the portfolio is shorter-term U.S. treasuries (whose credit has improved). Assuming a 0% yield on cash, this total 50% allocation to income will likely allow the entire portfolio to keep up with inflation. A real rate of return will come from stocks in the future, that are currently overpriced.

This reconsiders the situation above from a wider perspective:

1) Having brought the entire country to a government shutdown and the brink of default, according to a 10/8/13 NBC/WSJ poll, the Republicans have only a 24 percent national approval rating, a new low in the history of the poll. Given the real human and economic costs of the shutdown, another would likely result in the cessation of the radicalized Republicans as a national party.

2) The Republican party has not effectively repositioned its brand. They are now associated with two losers: the Iraq war, an adventure that led to the extreme of international imperialism; and the shutdown, led by the extreme philosophy of minimized government. Seeking either a unilateral nation or a unilateral individual they achieved neither because in a globalized world they lack finesse, a sense of reality, and therefore can’t govern.

3) Not invoking the Hastert Rule would reduce the Tea Party to an outvoted minority, as is the fate of factions under the original intent of the Constitution. The party’s business base, furthermore, prefers them to be moderate Eisenhower Republicans, rather than ideological extremists.

4) The U.S. needs a moderate right party to contribute to the political discussion. As intended by the founders, cooperative diversity makes U.S. democracy possible.

11/1/13 -

In an October, 2013 article, Pimco’s Bill Gross wrote, “We have seen a 3% Treasury yield and a 4 ½% 30-year mortgage rate and the economy peeked its head out of its hole like a groundhog on its special day and decided to go back inside for another metaphorical six weeks. No spring or summer in sight at those yields. The U.S. (and global economy) may have to get used to financially repressive – and therefore low policy rates- for decades to come. (our note)” This will also mean stagnating earnings and therefore stagnating equity prices. ¹

Drawing an imaginary line at a 3% ten year treasury bond yield on this graph: Interest rates were below that line only 18% of the time mainly due to very bad times in the 1930s and then interest rate suppression after W.W. II. Since markets and world events generally do not stay in one place for long, we think it is useful to explore the alternatives that can be affected by government policy.

We explore these alternatives using a four factor table simplified to two factors:

Economic Growth (+) (-)

Interest Rates (+) (I) (II)

Interest Rates (-) //////////////////////////

(I) After some unpleasant readjustments in the stock and bond markets, the stock market increases again with economic growth. Congress reaches some form of budget agreement over taxes and social benefits.

(II) The excess liquidity created by the Fed finally escapes the banking system into the general economy, causing too much money chasing too few goods (inflation) or greatly increasing trade deficits. The Fed will try to remedy this by tightening monetary policy, but their actions would likely disrupt the economy.

This liquidity also creates a new asset bubble, a new stock market crash and even worse economic conditions.

The following discussion is aimed at attaining outcome (I) rather than outcome (II).

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According to classical economic theory, markets with perfect foresight achieve an appropriate level of general savings and investment. In reality, government plays a large role to make specific long-term investments in education, infrastructure and R&D. This excerpt is from our recent article on science and technology:

In “Scalable Innovation” Shteyn (2013, p.p. xxix, xxxv) describes how new technologies affect the pattern of economic development. Quoting Mokyr, “Technological progress has been one of the most potent forces in history in that it has provided society with what economist call a ‘free lunch,’ that is, an increase in output that is not commensurate with the increase in effort and cost necessary to bring it about.” He then writes, “…Invention…is the Big Bang moment. From there on, the universe of innovation expands, creating new ideas, implementations, relationships, opportunities, and so on. In this perspective, innovations (that people use) and technologies...create new spaces (our note) for people and companies to move into and to develop further.” The Internet, developed with the aid of government ², is a perfect example of this. Science and technology have been and should continue to be America's 21st century western frontier. ³

We think real structural changes are necessary in the U.S. to get economic growth restarted at the grass-roots level. Industrial technology is a key component of economic growth.

¹ Value Line blurs the difference between value and momentum investors. The 10/25/13 Value Line currently rates the 3-5 year profit potential of 1700 stocks at 35%, an all time low compared with 185% on 3/9/09. In spite of this market overvaluation, “We still advise some caution, as valuations are high and the market is vulnerable to negative surprises. That said, Wall Street’s resilience in the face of all of this uncertainty remains quite reassuring.” Translated, this means the Fed has delayed the reduction of its asset purchases, and thus monetary tightening. Lacking this major negative catalyst, for the moment, the markets are complacent despite their overvaluation.

To be clearer, the main difference between value and momentum investors is time horizon. Long-term investors are concerned with getting value for their money, just like when buying groceries, because the company fundamentals will reassert themselves. Short-term investors get distracted by the candy aisle.

² CERN in Europe, DARPA and the National Science Foundation in the U.S. – also the universities.

³ The 10/28/13 Barron’s has a cover article discussing, “The Snail Economy.” Real economic growth has averaged more than 3.5% / year since W.W. II. Two key secular economic trends, the size of the working-age population and gains in productivity, are dramatically slowing. This foreshadows a much lower growth rate, “…slicing the postwar rate by about half…for the next two decades.”

These long-term factors matter much more than the current struggles in Washington over the budget balance and social spending.

Productivity is roughly defined as GDP/employment. The article therefore asks for a choice between, “…improved productivity at the expense of middle-class employment or the opposite. One way or the other, GDP growth will most likely suffer. This is just one of the unpalatable trade-offs our government is likely to face over the next two decades in our new era, the Great Stagnation.”

Shteyn (2013) suggests a more optimistic view where people seek, less tradeoffs, but more Silicon Valley’s “Disruptive Innovation.” Carried over into education, infrastructure and R&D that means searching for the best people to become great teachers (they really do make a difference), building farsighted infrastructure and encouraging R&D that is less incremental but more innovative. Innovation breaks existing tradeoffs. Former Treasury Secretary, Larry Summers, points out that if real economic growth were increased by .2% above present government GDP projections (we think around 2.75% real between 2012-2023), over decades, the U.S. “…would entirely eliminate the projected long-term budget gap. Increasing growth, in addition to solving debt problems, would also raise household incomes, increase U.S. economic strength relative to other nations, help state and local governments meet their obligations and prompt investments in research and development.”

This is what really matters. Infighting and a nostalgic ideology won’t create economic growth. That will only occur by taking concrete steps to build the future.

12/1/13 –

The last five years since the Financial Crisis of 2008 have determined whether a deeply distressed economy can recover solely by means of monetary policy. ¹ On 11/25/13 the S&P 500 closed at 1802. The fundamental of economic growth must justify this stock price for the long-term.

Record low interest rates along the entire bond yield curve have been the result of the Fed’s open market trading at the short end, and the Fed’s purchases of treasury bonds and mortgages at the long end. The result has been interest rate suppression in order to encourage economic growth. Due to long-term asset purchases, the Fed’s monetary base (the sum of commercial bank deposits at the central bank and cash, funding financial transactions) has skyrocketed from $818 billion in 2005 to $3.7 trillion in 2013. All this money has kited up the prices of financial assets while having minimal impact on the fundamentals in the real economy that needs restructuring. ²

This may be illustrated by comparing the growth in S&P 500 operating earnings in the six years beginning in 2007 with those of previous six years beginning in 2001. In markets what matters, of course, are expectations about the future. For large companies, markets generally set future market expectations by drawing a straight line with the past. An analysis in the trend of historical earnings is a realistic estimate of what the markets believed, at the time, regardless of the actual outcome in 2008. We then compare the Price/Earnings ratio of the S&P 500 to determine whether the market is overvalued.

S&P 500 Annual Earnings Growth Period Ending P/E Ratio

2001-2007 13.38% 17.78

2007-2013 (Annualized) 4.12% 17.11

Data From: “S&P 500 Operating Earnings per Share,”spindices.com, 10/31/13

This table illustrates that a valuation analysis based on the P/E of stocks alone is incomplete. Consider the present value formula: P/E = 1/(k_e-g) where k_e ³ is the required investment return and g is the perpetual growth rate. This discussion only deals with the assumed growth rate, based on historic data. It illustrates that although the S&P 500’s P/E ratio is very similar for both periods (2001-2007 and 2007-2013), the market’s likely assumed growth rates are very different. There is a massive disparity between the two growth rates. What would justify current market overvaluation is S&P 500 earnings growth suddenly jumping from a 4% new normal growth to a sustained growth of 10-12%, which is highly unlikely. The market is very overvalued relative to earnings growth only because of monetary ease.

The 11/18/13 Barron's interviewed Ben Inker, co-head of asset allocation at a major Boston value manager:

What are your biggest concerns with the stock market?

Our problem is not strictly that it has gone up. Our problem is that the S&P 500 is up this year about 25% to 26% on earnings that are up 3%. So we’ve got a market that is rising because of P/E expansion. That would be OK if the market had started out at eight times earnings, but it didn’t start out there. So we have a market that is trading at an increasingly high P/E at a time when profit margins are already as good as we have ever seen. So the likelihood of strong profit growth from here is pretty dim. That’s a lousy market if the P/E is too high, profits are unlikely to grow strongly and all you can hope for is that the P/E goes up even more. We don’t like investing on that basis.

The level of long-term earnings is much more important than short-term changes in the Fed’s discount rate because, ultimately, it is earnings growth that makes the stock market increase over the long-term. At presently high market overvaluation, we think it is appropriate to adopt a cautious investment attitude. ⁴

Over the long-term, the U.S. economy requires structural reforms. We draw an analogy with a very down-to-earth example, real estate zoning. Real estate zoning exists to prevent the sprawl that free markets would bring to communities, resulting in balanced land uses. Similarly, the pattern of society’s economic development can more generally be determined by its long-term investments in education, research and development; and – most obvious here – infrastructure. In the U.S., free market economic development and the opportunities it brings prospered along the Interstate highways.

¹ Some critics blame the slow pace of economic recovery upon excessive government taxes and regulation. These objections are mainly ideological. In January, 2009 Reinhart and Rogoff published, “The Aftermath of Financial Crises.” They found that there are “broadly similar patterns” in emerging and developed market financial collapses. To quote, “Broadly speaking, financial crises are protracted affairs (our note: even with fiscal policy). More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged…Second, the aftermath of banking crises is associated with profound declines in output and employment…Third, the real value of government debt tends to explode, rising an average of 86% in the major post-World War II episodes. Interestingly the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system…the big drivers of debt increases are the inevitable collapse of tax revenues…as well as often ambitious contracyclical fiscal policies aimed at mitigating the downturn.”

² With ample natural resources and a large and growing population, the United States did not have to strategize its economic growth. By contrast, Germany and many Asian countries with few natural resources had to figure out how to earn their way in the world.

³ Our 11/1/13 discussion essentially deals with long-term interest rates and therefore the required return of stock investors..

⁴ Another issue is how the Fed can manage market expectations as it starts to taper its purchases of securities.

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Excerpt

10/18/13 - We increased our investment in pipeline limited partnerships to its target of 30% of the portfolio. An additional 20% of the portfolio is shorter-term U.S. treasuries (whose credit has improved). Assuming a 0% yield on cash, a total 50% allocation to income will likely allow the entire portfolio to keep up with inflation. A real rate of return will come from stocks in the future, that are currently overpriced.

If (when) long-term interest rates increase, the market values of the limited partnerships will decrease in the short-run; the shares will trade at a higher yield. But, we don’t really care because the partnerships were purchased at a more than acceptable yield of around 6%. Over time, the prices of these partnerships will increase because their earnings and dividends will.

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This 11/27/13 Bloomberg article highlights the economic relationships among productivity, technical innovation, and ultimately earnings growth. Its time to return to the basics, not of easy ideology, but of actual innovation, investment and workforce skills that build the wealth of a modern nation. Its not possible to get there by trading (financial paper) or by raiding (which is not PC).

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An article in the 12/8/13 Financial Times (original version) states the reason for the present market rally; we ask how it could end:

China has long been…exporting and creating money to hold its currency down. The US has been…borrowing to import. (China) got high domestic investment rates and full employment. The (US) got consumption and apparent economic growth (our note: in real estate and services, notably the banking system). And both got rising asset prices.

In this environment the actual price of an asset no longer has anything to do with your qualitative perception of reality: valuations are out, liquidity is in. In the wacky world created by…monetary fidgeting, there is one reason for being long markets and one alone: sovereign nations are printing money and prices are trending. That is it.

A momentum investor might be tempted to take advantage of this. It is a classic investment mistake to jump aboard such markets, believing that it is possible to jump off just at the right time. There is a saying on Wall Street, “Bulls make money. Bears make money. Pigs get....”

In the present U.S. economy, the effect of excess monetary creation on the real economy has been much delayed because all the burden of economic growth has been placed upon monetary policy, creating asset bubbles rather than excess economic growth beyond capacity. The plant, equipment and the worker skills necessary for a sustainably increased economic growth rate were exported abroad in the 1990s. There has since been mainly real estate and financial speculation. If the present situation continues, speculation will increase then there will arise the call for more money, maybe again from crashing financial markets that will demand to be saved.

A much more prudent and effective course of action would be to very gradually reduce monetary stimulus and for Congress to enact the long-term government investments necessary to make the economy more productive. Our next article will describe the difference between political theory and political ideology.

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PRIOR MARKET COMMENTARY