How can an investor profit if the U.S. Economic Empire is crumbling? 1 of 5

Executive Summary:

 In this analysis, the first in a series, we look back to learn how economic decline plays out.

It has been said excessive taxation, inflation and over-regulation felled the Roman Empire’s economy.  Understandably these same economic maladies cause today’s U.S. investors to worry about investment prospects for their investable funds.  Naturally, in an effort to direct advertising dollars their way, media outlets should be expected to play on these worries and run stories suggesting that the end is near. 

 

However the fact that will not be found in a headline title is:  Empires do not just vanish.  Instead empires tend to crumble over a very long period of time; decades, centuries.  The Roman Empire, for example, endured three centuries of economic deterioration before being finally overrun by Barbarians in 476 A.D. 

Our point is: If the U.S. Economic Empire were to follow the Roman path and last another three centuries, many investment opportunities will come and go.  Investors would have to contend with the Roman experience

  • Tax avoidance & evasion schemes multiply
  • Debasing the currency does not induce growth
  • Austerity measures lead to financial crisis only to be relieved when the state made large loans at zero interest in order to provide liquidity
  • Frustrated government officials combat failed regulation with new regulation
  • Higher and higher taxes failed to raise additional revenues because wealthier taxpayers could evade such taxes while the middle class – and its taxpaying capacity – were exterminated

Our investment strategies which will write of in the coming weeks pay consideration to this sequence of decline.  We attempt to find profit in such an environment.

 

Extended commentary – a chronology of decline:

In order to shape an investment theme to adopt in a declining economy, let’s visit events that played out in the Roman decline so that we may consider what the effect might be on our investments.  We are not suggesting the U.S. will necessarily follow this path.  We are suggesting economic decline is not the end of the world and investment opportunities will arise.

Note: We refer to a report Bartlett wrote in 1994 compiling research gathered for the previous one hundred years.  Bartlett’s entire report can be found at:

http://www.cato.org/pubs/journal/cjv14n2-7.html

1. Expansion of social services:

‘The distribution of free grain in Rome remained in effect until the end of the Empire, although baked bread replaced corn in the 3rd century. Under Septimius Severus (193-211 A.D.) free oil was also distributed. Subsequent emperors added, on occasion, free pork and wine’

2. The expansion of the dole is an important reason for the rise of Roman taxes.

‘[Initially] expansion of the money supply did not lead to higher prices. Interest rates also fell to the lowest levels in Roman history in the early part of Augustus’s reign.’ (Sound familiar?)

3. Inflation ensues (a.k.a. the tax on cash balances):

‘Revenue was needed to pay the increasing costs of defense and a growing bureaucracy. However, rather than raise taxes, Nero and subsequent emperors preferred to debase the currency by reducing the precious metal content of coins.’

In the absence of printing presses, Romans reduced precious metals in their coins to inflate their currency.   The silver content in Roman coins was reduced from 90% to 5% by the third century.

4. Government induced Inflation fails to grow tax revenues:

‘Interestingly, the continual debasements did not improve the Empire’s fiscal position. This is because of Gresham’s Law (“bad money drives out good”). People would hoard older, high silver content coins and pay their taxes in those with the least silver. Thus the government’s “real” revenues may have actually fallen.’

5. Government taxes a greater number of citizens in an effort to avoid having to raise the overall tax rate percentage:

‘Although taxes on ordinary Romans were not raised, citizenship was greatly expanded in order to bring more people into the tax net. Taxes on the wealthy, however, were sharply increased, especially those on inheritances and manumissions (freeing of slaves).’

6. Tax evasion stays one step ahead of tax collections:

‘…once the wealthy were no longer able to pay the state’s bills, the burden inexorably fell onto the lower classes, so that average people suffered as well from the deteriorating economic conditions.’

7. Money economy breaks down but the military required funding:

‘The army’s needs required satisfaction above all else, regardless of the consequences to the private economy’

8. The government increases its reach through more regulation

‘Despite the fact that the death penalty applied to violations of the price controls, they were a total failure.’

9. Goods and services are confiscated for taxes as money becomes worthless:

Tax burden exceeds a farmer’s production.  Next, fields became deserted and cultivated land was turned into forest

10. Small landowners, crushed into bankruptcy by the heavy burden of taxation, threw themselves at the mercy of the large landowners, signing on as tenants or even as slaves. (Slaves, of course, paid no taxes.)

 

The decline was complete.  Yet Bartlett writes: “for the bulk of Roman citizens [the fall of Rome] had little impact on their way of life.”

Trends: Should I Stay (Invested) or Should I Go?

Market technicians examining the trend of whether to buy stocks or bonds are presented with a rather clear cut technical landscape

A Blue outlined graph indicates Bond are trending higher.

A Dark Brown outlined graph indicates Stocks are trending higher.

Currently, the stocks uptrend remains intact.

This chart is not viewed as foolproof and intelligent people can debate the merits of technical analysis.  At the same time, many ascribe to technical-based investing and as such could be view as being bullish on stock momentum.  This aforementioned chart is based on simple moving averages stretching back to 1990 and continues to present.  The trend signal is rather impressive in its simplicity.

A Capital Gains Tax Hike: The Blow that toppled Japan in 1990?

C-Span Video Archives: For Good and Evil: The Impact of Taxes

Author Charles Adams suggests a hike in capital gains tax was the silver bullet that slew the mighty Japanese economy of the 1980s.  Many know our interest in analyzing today’s debt-laden economy to Japan circa 1989-1990.  Adams makes his remarks at 30:03 minutes on the embedded video.

Let those of us investors who files taxes in the United States pay particular attention to the capital gains tax rate come January 2011 when the Bush tax cuts expire. Adams claims to have taken two decades to research and write his book.  We will not be hasty to dismiss his capital gains tax warning.

Incidentally, his other remarks on Japan are fascinating for anyone who has not filed taxes in Japan. (26:23 to 30:29 minutes)

For anyone who consider the Tea Partiers of 2010 to be taking anti-government rhetoric to excessive levels,  have a listen to Adam’s recollection of the extent taken by the French populace to “express” their government dissatisfaction. (5:40 minutes)

And the winnah is…

We christen our upgraded site with commentary on a look at the winning investment strategy for the past decade: Market timing.

According to LeCompte’s analysis, the strategy bested buy-and-hold, rebalancing and one momentum strategy.

Click here for a concise overview of the different strategies’ returns and variation.

Fortunately, timing was near and dear to our efforts.   Yet while market timers everywhere congratulate each other, we behold a troubling bit of data.  And while it is true that the market performed with the same variation & records positive returns over half the time throughout the past six decades, the mean return for investors vanished in the past decade.  Some call this the market’s “lost decade” as investors have lost money since the turn of the century (-0.12% per mean monthly return) (ibid)

Our focus for the past six months and the foreseeable future is to concoct an approach for our client’s that will take advantage of our research.  Our goal is simply to post analysis at the dusk of the next market cycle claiming we fingered the winner of the next decade.

Inflation: The Stealth Tax

How will deficits which abound from the U.S. Federal Government’s coffers down to those of the smallest municipality be reconciled?  One can quickly surmise the glimmer in a politician’s eye when the short-term benefits of inflation’s sultry siren falls on his or her ears amidst budgets plagued by rampant Federal spending and tax cuts.  People in power know deficit spending is important business.  For instance, Thomas found that Alan Greenspan’s visits to the White House under Bush have quadrupled since Bush replaced Clinton (deficit spending has characterized the Bush administration). [1]  As with most economic data, inflation figures can be sliced and diced to appear to support just about whatever one’s particular agenda entails.

“Inflation is a stealth tax and has a very efficient built-in collection scheme… everyone holding Dollars is affected and everyone’s purchasing power is diminished, therefore the collection of this ‘tax’ is 100%efficient. And to make it even better, there is no paperwork to fill out, no check to send in, no harassing telephone calls from the tax collector, and the government can continue to print all of the dollars it wants so it can continue a free spending policy.”   –  Stephen Williams in “Cycle Pros”

What’s an investor to do?  “Occasionally successful investing requires inactivity,” Buffett imparted to his devoted flock. [2]   Further, Hanson observes ‘man is hard-wired to appreciate perceived success and feel comfortable with consensus’. [3]   So although inflation may offer modest short-term appeal to politicians, it is easily explained why investors would shrink from investing new dollars given inflation’s less appealing longer-term effect; namely a demonstrable ability to destroy an economy.    But…ah…Grasshopper, attend us when we say that which is bad for the U.S. economy may cloud potential good for U.S. companies.  In the event you happened to take up residence on another planet for the past five years or so, let us acquaint you with the trend of outsourcing as one example of corporations’ productivity.  Outsourcing is a company’s use of resources in a location outside of its native country; usually as a means of increasing profit through a more cost competitive climate.
 
With that said, investors should naturally focus on sectors which have demonstrated profit potential in the face of inflation.  “When it comes to money,” Kilgore advises, “it’s always better to bet on results than potential.” [4]  If history is any guide to the present and if inflation accelerates, the energy sector might reward investors.  Can you say $3 per gallon of gasoline?
 
At the same time, investors should not overlook that if Japan can continue to produce improvements in its economy, U.S. companies may take their outsourced, competitively priced wares abroad.  Don’t forget healthcare.  Recall, many believe the Japanese and European economies pulled the U.S. out of the recessions of 1981-82 and 1990-91 respectively.  So do not discount the possibility of surprises befalling the investment community in the coming quarters even though the specter of inflation may startle one as would a B-2 stealth bomber parked outside one’s window.

Let the Data Do the Talking

An unanticipated and unwelcome development which makes investment analysis more difficult AND less meaningful has emerged: recent changes in economic data released by and compiled by the U.S. government make those reports released after 2003 less meaningful.  Data from early 2004 to present is now littered with statistical adjustments.  For instance, earlier this year, employment and unemployment reporting calculations were altered so future reports now have little relevance to any similar report released prior to January 2, 2004.  Furthermore, in the first week of June the Federal Reserve revised all of its money supply data back to 1998.  Money supply analysis for the past six years was made irrelevant in one release of a report.
 
Does this mean economic reports are any less useful than in the past?  Heavens no.  But it does mean perception, not reality, will bear the weight of meaningful economic analysis for the foreseeable future.  After all it’s not as though economic reporting was an exact science to begin with.  Recently, Lussier ridiculed so-called economic “experts” and their opinions.  He measured Wall Street experts’ forecasts.  The results from data from 1982 to 2003: [5]
 
Their One year nominal GDP forecasts were off by 102%.
Their Two-year nominal GDP forecasts were off by 109%.
Their One-year inflation targets were off by 29%.
Their Two-year inflation targets were off by 41%.
 
Therefore it comes as no surprise that researchers find that consensus is typically useless for handicapping future market pricing and it is the contrarian who may have the best approach to making money in the markets.  We were moved to lessen our dependence on the options markets for future price modeling as the option market’s contribution to price discovery has been found to be as low as 17% on average. [6]   The need to refine one’s forecasting techniques cannot be understated as research finds that macroeconomic factors are unable to explain momentum profits after simple methodological adjustments to take account of microstructure concerns. [7]
 
Forecasting changes as the world changes.  “China has 4,813 cement plants, more than the rest of the world combined, and they still don’t have enough” Wiggin writes.  “Projects like the Three Gorges Dam and Beijing Olympics forced China to gobble up 55% of the world’s supply of cement, 40% of its steel, and 25% of its aluminum.” [8]  We see on this side of the Pacific that GMAC [GM’s financing arm] now “contributes 2 out of every 3 dollars of GM’s profits…with more than half of the financing profits completely unrelated to the auto business” Bonner reports. [9]  Naisbitt wrote of the U.S. morphing from a manufacturing economy to an information economy in his 1970s best-seller Megatrends.  Today, that book would assuredly address the financial economy.  Kasriel calculated “between 1960 and 1984…banks, brokerage firms, finance companies and the like accounted for 12% to 22.5% of total corporate profits”. In 2002, the financial sector contribution reached 44.75%…”[10]

The Jeweler’s Eye

In the next 60 days, America will be covered with reports from the Democratic and the Republican National Conventions, with one sometimes feeling the biggest question might not be how each team of nominees will perform during the revelry.  Instead, the question lurks: will terrorists strike the convention?  If not at the conventions, where will they strike next?
 
We have arrived at a conclusion which will someday be deemed correct or incorrect that terrorism has been institutionalized.  Concern is everywhere and dwells in every bosom across the country.  No one is safe.
 
From an investment perspective, we have taken an initiative over the past quarter to calibrate our applications to analyze securities as though 9-11 did not occur.  For example, we attempted to derive estimates of how much Coca-Cola might have been sold sans disruptions post 9-11.  How many Seniors postponed elective surgeries?  How many vacationers postponed trips to foreign countries due to fear of the terror bogeyman?  We do so not in denial of that God forsaken tragedy that affected thousands of our countrymen.  It must also be stated that we recognize our techniques are rudimentary if not outright inaccurate.  Nevertheless, should another major terror attack be undertaken on U.S. soil, God forbid, we believe the average American (and for our focus: the average American investor) would proceed through the SARA healing process (Shock, Anger, Rejection, Acceptance) more quickly than any of us did after the collapse of the World Trade Center.  In a recent interview with Berkowitz, Buckley stated there is no way the threat posed by extremist and non-consolidated Muslim terrorists compares with that of, say, the threat posed for over forty years by the Soviet Union and their 3,500 nuclear warheads bristling from launching pads aimed at targets in the U.S.11   It is for these reasons that we believe investors may be surprised as growth continues in certain areas of the economy.
 
Of course, fortunes may be made or lost in determining which sectors may experience growth.  We offer one for your consideration: caring for the health of an aging population.
 
Hopefully it comes as little surprise that Health care now constitutes almost 15 percent of the United States’ gross domestic product – or double what it was 30 years ago, according to the Washington Post.  In a report released in April, NACS reported “The per-person cost of health care in the United States has risen to $5,440. That amount is double what is spent in European countries.”[12]
 
It may come as a surprise the extent which health care is a global business.  The New England Journal of Medicine (NEJM) detailed the composition of the International Medical Graduate list with Indian-born graduates constituting over 20% of the whole.[13]
 
Though conventional wisdom may view cardiovascular disease as being assimilated with Americans, the NEJM report illustrated the growth in the incidence of cardiovascular disease in non-Western cultures in the next 15 years. [14] 
 
The same report depicted Cholesterol levels to have increased over 20% during the past 20 years in a study conducted in Beijing. [15]
 
And do not forget diabetes.  “An estimated 170 million people worldwide suffer from diabetes, which is a leading risk factor for cardiovascular disease” Mendoza wrote. “The majority of people with diabetes – roughly 65% — will suffer a heart attack or stroke, a rate that is up to four times higher than in adults without diabetes.” [16]
 
The world’s getting older.  All people will require more care to their health.  Some people will have the money to pay for that care.  Other people will rely on alternate means  to pay for their care.

Sources

1 K. Thomas, University of Pennsylvania Wharton School, Christian Science Monitor, May 2004
2 E. Fry, Daily Reckoning, April 20, 2004
3 V. Hanson, National Review Online, “Our Reptilian Brains,” May 28, 2004
4 T. Kilgore, CBS Marketwatch, May 24, 2004 
5   per Pierre Lussier, Investment Information Provider
6 per Chakravarty, Gueln and Mayhew, “Informed Trading in Stock and Option Markets,”  Journal of Finance, June 2004, p. 1235
7 per Cooper, Gutierrez Jr. and Hameed, “Market States and Momentum,”  Journal of Finance, June 2004, p. 1345
8 per A. Wiggin, Daily Reckoning, June 2, 2004
9 per B. Bonner, Daily Reckoning, June 2, 2004
10 per P. Kasriel, May 6, 2004
11 per W. Buckley Jr. in interview with Jeff Berkowitz
12 per NACS, April 12, 2004
13 per New England Journal of Medicine, June 10, 2004
14  ibid.
15  ibid.
16 per Dr. R. Mendoza, Biotech Report, June 14, 2004

I Joined the Wrong Mob

Around the time of his deportation to Italy, mobster Lucky Luciano granted an interview in which he described a visit to the floor of the New York Stock Exchange. After he visited the floor of the NYSE someone explained to him the role of the floor specialist, he commented, “A terrible thing happened. I realized I’d joined the wrong mob.”

Three years ago, Federal agents commenced a campaign to root out the wrongdoing on Wall Street that Luciano eluded to decades earlier. After the Ebbers, the Sullivans, the Fastows, Quattrones, the Koslowskis and Stewarts now made their way to court, the question is asked: where does Wall Street go from here?

It was not all that long ago when media outlets routinely headlined charges brought against company directors, insiders and some outsiders.  Today, news comes on a somewhat irregular basis that one defendant or another has agreed to pay penalties or serve a prison sentence. Naturally, the aftermath of prison sentences does not have the news sizzle of a real-time guilty plea handed down by the justice system.  However, the consequences may be just important as the verdict itself.  Without having a great deal of quantitative news data due to the exact reason mentioned in the previous sentence (viz. less media attention).  We will gander to say that many more corporate financial reports would pass the “white glove” test today vis-à-vis the number that would have passed, say, in the year 2000. Long remarked that a typical board of directors meeting today finds not only directors in attendance but also the director’s attorney in-tow. [1]

Interestingly enough, investors’ memories proved quite short in terms of scandals unearthed at mutual funds.  “In Dalbar’s scandals study, 75 percent of mutual fund investors could not even name one of the dozens of firms involved  in the scandals. Not one!” [2] 

Of several notions that come from (a) a move to a police state-type environment and (b) investors’ reluctance to concern themselves with wrongdoing, one cannot shake at least one of these notions.

Several years have prompted securities salespeople to promote the notion of – “safe-ness” – in their practices.  Safe is being sold with the caveat that big is better. Case in point, of all the analysts covering the largest U.S. companies

(according to Zack’s), 67% advise a STRONG BUY/BUY, 30% advise a HOLD and 4% a SELL.  It is notable that those professing a belief in the superiority of cash-laden mega companies vis-à-vis alternatives represent such a large portion. Compliments of Mssrs. Ebbers, Fastow, Sullivan et al., the herd has moved to perceived safety.  That, in our opinion, opens up vast territory of “un-promoted” investment amidst improving economic numbers.  “The market rarely accommodates the majority.”

Several years have prompted securities salespeople to promote the notion of – “safe-ness” – in their practices.  Safe is being sold with the caveat that big is better. Case in point, of all the analysts covering the largest U.S. companies (according to Zack’s), 67% advise a STRONG BUY/BUY, 30% advise a HOLD and 4% a SELL.  It is notable that those professing a belief in the superiority of cash-laden mega companies vis-à-vis alternatives represent such a large portion. Compliments of Mssrs. Ebbers, Fastow, Sullivan et al., the herd has moved to perceived safety.  That, in our opinion, opens up vast territory of “un-promoted” investment amidst improving economic numbers.  “The market rarely accommodates the majority.” [3]

Let the Data Do the Talking

Question #1: With oil prices holding the world ‘over a barrel’, why haven’t alternative energy forms taken hold?

It’s not (yet) cost effective. “Using coal, the most common source of electricity in the US today, consumes around four times more energy as the resulting hydrogen can produce.” [5]

Question #2: Does Europe still have anything to offer?  Germany’s unemployment checks in ~ 10% with percentages four times that figure in Eastern Europe.

Consider: Europe’s Research & Development [R&D] (read: the future) shows remarkable strength. Although General Electric’s market capitalization is over five times the size of, say, Siemens, Siemens spending on R&D last year was over three times that of GE’s. In defense and aerospace, the UK’s BAE Systems is roughly one-fifth the size of, say, United Technologies.  Yet BAE’s R&D spending is approximately 3 times that of United Technologies spending on R&D.

Question #3: Are the health care expense and pension woes a real threat to U.S. companies’ balance sheets?

Consider:  These costs can have a profound impact; particularly at larger U.S. companies.  For instance, at Honda Motors “each car costs the company $107 in pension and health care costs. But at GM, the cost is $1,360. You can imagine

what the cost is for Chinese manufacturers.”

In 1964, Republicans were reduced to a minority of 140 as against 295 Democrats.  “There was nowhere to go but up” the Hoover Institute wrote. In 2004, Democrats were reduced to a minority of 203 as against 232 Republicans

To carry recollection a step forward, only four years later Strom Thurmond changes affiliation and moves from the Democratic to the Republican party. In 2004, leading Republicans led by Specter have already begun the move towards the Democratic ideology.

Ten years after reigning as House Minority leader, Gerald Ford found himself in the White House following Watergate.  The important point to drive home is: we ARE NOT necessarily inferring that the Pelosi administration will occupy in the White House in 2014.  What we ARE inferring is: when levels fall to statistically remarkable levels a re-balancing may be in the cards.

We will watch for any significant movement among politicians to fill the vacuum of this majority gap and more importantly the type of platform purported by such potential move.  Washington IS power and if and when power begins to change, we believe, opportunity for investors will present itself.

Sources

Our point for spouting off such seemingly unrelated data is: It is not outlandish should most Arlington Hall Research readers find they were unaware of this data – this makes sense as there has been little media attention on these data points.  Due to this lack of media attention, those readers who DID know one or more of the points mentioned above probably found this information through unconventional sources (trade journals, inside communication, etc.). In our opinion, if pertinent information such as that found above is unknown to most investors, surprises may be likely.  If surprises are likely, it is important for investors to resist the temptation to PREDICT outcomes and instead try to PREDICT THE PROBABILITIES. Even geniuses understand this approach.  For when referring to Heisenberg’s Uncertainty Principle, Einstein’s biographer suggested “all that physicists could hope to predict are probabilities that it will behave in certain ways.” [7]

Question #3: Are the health care expense and pension woes a real threat to U.S. companies’ balance sheets?

Consider:  These costs can have a profound impact; particularly at larger U.S. companies.  For instance, at Honda Motors “each car costs the company $107 in pension and health care costs. But at GM, the cost is $1,360. You can imagine what the cost is for Chinese manufacturers.” [7] The per-person cost of health care in the United States has risen to $5,440, which is double the amount spent in European countries.

Our point for spouting off such seemingly unrelated data is: It is not outlandish should most Arlington Hall Research readers find they were unaware of this data – this makes sense as there has been little media attention on these data points.  Due to this lack of media attention, those readers who DID know one or more of the points mentioned above probably found this information through unconventional sources (trade journals, inside communication, etc.). In our opinion, if pertinent information such as that found above is unknown to most investors, surprises may be likely.  If surprises are likely, it is important for investors to resist the temptation to PREDICT outcomes and instead try to PREDICT THE PROBABILITIES. Even geniuses understand this approach.  For when referring to Heisenberg’s Uncertainty Principle, Einstein’s biographer suggested “all that physicists could hope to predict are probabilities that it will behave in certain ways.”  [8]

 

 The Jeweler’s Eye

Recent economic-related topics that you WILL find covered in-depth at media outlets include: the U.S. budget deficit, Social Security reform, the trade deficit with Asia, U.S. dollar strength, etc.  One item that has appeared to escape attention is a seed that was planted the morning after George Bush declared electoral victory and ushered in his second Presidential administration.  We acknowledge that its consequences are longer-range and not fit for consumption of a media aimed at an audience which revolves on an instant gratification axis. Nevertheless, the situation is remarkable and a severe dichotomy exists in the world’s most powerful city – Washington D.C.  Let’s turn back the clock forty years.

 

2004 Democratic House Minority Leader = 1964 Republican House Minority Leader

In 1964, Republicans were reduced to a minority of 140 as against 295 Democrats.  “There was nowhere to go but up” the Hoover Institute wrote. In 2004, Democrats were reduced to a minority of 203 as against 232 Republicans

 

To carry recollection a step forward, only four years later Strom Thurmond changes affiliation and moves from the Democratic to the Republican party. In 2004, leading Republicans led by Specter have already begun the move towards the Democratic ideology.

Ten years after reigning as House Minority leader, Gerald Ford found himself in the White House following Watergate.  The important point to drive home is: we ARE NOT necessarily inferring that the Pelosi administration will occupy in the White House in 2014.  What we ARE inferring is: when levels fall to statistically remarkable levels a re-balancing may be in the cards.

We will watch for any significant movement among politicians to fill the vacuum of this majority gap and more importantly the type of platform purported by such potential move. Washington IS power and if and when power begins to change, we believe, opportunity for investors will present itself.

 

Sources

1. R. Long interview with R. Arnold
2. P. Farrell, Marktewatch.com, “Zombies”, Sept. 10, 2004
3.  Analyst Recommendations for: GE XOM MSFT PFE C WMT AIG BAC JNJ IBM, Zack’s Investment Research Inc., Jan. 11, 2005, 1:00PM EST
4. M. Hulbert, Marketwatch.com, “The dog that did not bark”, Nov. 11, 2004 
5. P. Norton, “Breakthrough in Hydrogen Production for Fuel Cells”, Nov. 29, 2004
6. MIT Technology review; R&D Scorecard 2004, Dec. 2004
7.  B. Bonner, Daily Reckoning, Sept. 23, 2004
8. .B. Bonner, March 1967 in Einstein: the man and his achievements edited by G.J. Whitrow 

 

The Right Track

120 Second Summary

Will Rogers

“Even if you are on the right track, you’ll get run over if you just sit there.”  – Will Rogers

This advice offered by the always witty Will Rogers reminds us that even if one’s portfolio returns best over 98% of money managers in the world, occasionally, bear markets visit the stark reality of statistical theorems upon you. Accordingly, we have adjusted a few positions in order to set up on what we believe may be the “next” right track.

Let it be said, no investment strategy was ever met with greater investor skepticism than ours to massively deploy funds into treasuries, strips and treasury market funds over the past 18 to 24 months.  Perhaps someday, researchers will derive theorems highlighting how controversial strategies lead to future profit as the potential upside identified by our work was, largely, realized. We were on the “right track.”

Though we still believe this approach will continue to garner fruits of profit, one must pause to remark upon the breathtaking speed at which hostilities concluded in Iraq plus [what appears to be] an upcoming $350 billion federal stimulus to the U.S. economy.  This combined stimulus may represent additional profit potential for investors and we have considered increasing asset backed income securities and selecting diversification abroad though we still avoid a number of U.S. blue chips whose sales continue to descend faster than their stock prices. It will be at another time and place, where the question will be answered: ‘How will the United States Treasury rebound from significant tax cuts sans coincidental spending cuts?’ [1]

Burke offers considerable data to assist in beginning to address this rather complex and unique question (tax cuts sans spending cuts). He submits two possible paths for the market to travel in order for stocks to re-visit attractive valuations relative to fundamental data. His research leans on evidence from the “nowhere” trading range of 1968­1982 and the plummet of 1929-1934. [2]

The biggest dilemma we face is: discovering which of these two paths best matches that which the market will travel in the coming years.  At this time, the data produces statistically insignificant results – viz. you cannot prove returns may outweigh risks. Therefore, we move with caution and construct investment strategies to (1) avoid the perils of EITHER of these two scenarios while (2) striving to outperform market indexes in the process.  In a word, we will determine if we are on the right track.  If we are not, we may find the ‘new’ right track may be our old favorite track. Recall, the trend is your friend until it isn’t.

Let the Data Do the Talking

In April 2003, the S&P 500 posted gains not seen since 1982 and the index posted an impressive increase for the quarter amidst the bear market.  Consequently our relative preference for capital preservation led to our relative quarterly performance slipping vis-à-vis the lofty spread posted in the first quarter. Notwithstanding, we are pleased to report we have maintained relative out-performance in most managed account portfolios over the entire period since we began measuring individual portfolio quarterly performance.

Conservative guidance protected a significant amount of capital vis-à-vis the major market averages for quite some time.  Then, on March 12, 2003, our model registered a signal commensurate with the signal registered on the short-term market bottoms seen in July 2002 and October 2002. We began to redeploy some assets over the quarter.  However, as the signals in July and October 2002 begat rallies which later fizzled coupled with other red flags still waving in the market winds (e.g. over-levered consumers), we opted to measure, not over-allocate, our exposure to market risk as projected market return scenarios remain fraught with significant macroeconomic challenges; some not seen in seventy years (e.g. a geo­synchronous economic downturn).

We are inclined to believe the legal woes permeating the mutual fund industry coupled with the inability of many high net worth investors to diversify, at the best, prevent significant market upside and, at the worst, represent future investor casualties.  A change in these phenomena would be cause for re-evaluation of investment strategies.

More specifically with regard to diversification, an autopsy is performed to address the question: Just how did the median stock market investor lose so much money since 2000?  We think clues were in the data.  Consider:

(a) Individuals hold a disproportionate amount of their retirement plans in the company stock of their employer.[3]

(b) Investors are prone to investing in familiar stocks and ignore portfolio diversification. [4]

The mean U.S. household holds only 4.3 stocks: [valued at $47,334]

The median U.S. household holds only 2.61 stocks: [valued at $16,210]3

[It is commonly accepted that market risk cannot be reduced without at least 10 – 12 stocks.]

Nearly 50% of High-Net Worth Investors cannot diversify into the stock market.  Note, private equity capital was worth more than public equity in the United States as late as 1995 [notice?] and is still of the same order of magnitude today [5]. In addition, “over 45 percent of the net worth of investors with private businesses consists of private equity.  Of this more than 70 percent is concentrated in a single firm.” [6]

Why you may ask is the private business owner important to the public equity markets? Answer: Investors in private businesses hold over 12 percent of the total public equity in the United States.[7]

As fundamental recovery fails to materialize and over $3 trillion in investor assets have been lost while in the custody of mutual funds, the fuel for a new secular bull market remains unidentified. Like an aging magician who cannot perform tricks of old, the Federal Reserve’s 13 attempts at monetary stimulus have come up dry.  Thus, all eyes direct their attention on fiscal stimulus (as noted above).  Maybe $350 Billion can pull the rabbit out of the hat. 

The Jeweler’s Eye

What often occurs is exactly the opposite of what everyone is awaiting or outright expecting. Our work persuades us to believe the battle lines are becoming more pronounced while both “sides” are growing impatient – the bulls grow more bullish and the bears more bearish. For instance, a recent study implies bullishness by correlating bullish days on the market with sunny weather. [9] Using corporate insider activity and sentiment as variables, the editor of Investor’s Intelligence called for a falling market with lows in ‘May or July’ of this year. As most focus on the battle in the U.S. between the bulls and the bears, we scan the horizon for investment opportunities.

We watch the trend of increasing layoffs of high salaried Americans af the first world [10] is the Asianaztion of the first, second and third worlds.

and they are going to the University.

Given the geo-political climate in Asia at the moment, fear rules the day. Nevertheless, the aforementioned charts should open investor’s minds to the potential such trends represent.

A Shortage of Geeks and Nerds on Campus

Engineering graduates are growing scarcer in U.S. Universities. 

and those that are graduating are more likely to be foreign students.

they are increasingly planning to stay in the U.S.

The shift of engineering from the U.S. to foreign countries reinforces the notion of the proliferation of the service economy in the U.S. vis-à-vis that of a manufacturing economy.

and the shift also reinforces topical interests deemed important to U.S. residents.

Awaiting Visibility

Executive Summary:

The pattern that emerges is: American investors face one crisis every year. Obviously, the “Recession of 2001” garners the spotlight today. It was the “Internet Crisis of 2000” and “Y2K Doomsday in 1999”. Currency collapses in Brazil, Russia, and Thailand loomed in prior years. And those Malthusians out there among us extol – Over one million species are extinct! Yet, as Buckley notes, here we are (see “Get On With It”).

We illustrate the consequences of the unresponsive interest rate policymakers (see ‘The Federal Reserve and the Hornet’s Nest). Moreover, float evaporation’s impact on the economy remains the ‘step-child’ of federal economists (see ‘The Fed and the Float’).

Watch for manufacturing and telecommunications to rebound once the final ingredients are put in place (see ‘Is it time to be bullish on manufacturing?’ and ‘Where will the telecommunications sector find cash?’).

The Japanese banking predicament remains a powder keg of the first degree (see ‘A Melting Sheet of Ice’). However, we have reason to believe the crisis may pass without incident (see ‘Japan Speaks Up’) 

The pattern that emerges is: American investors face one crisis every year. Obviously, the “Recession of 2001” garners the spotlight today. It was the “Internet Crisis of 2000” and “Y2K Doomsday in 1999”. Currency collapses in Brazil, Russia, and Thailand loomed in prior years. And those Malthusians out there among us extol – Over one million species are extinct! Yet, as Buckley notes, here we are (see “Get On With It”).

We illustrate the consequences of the unresponsive interest rate policymakers (see ‘The Federal Reserve and the Hornet’s Nest). Moreover, float evaporation’s impact on the economy remains the ‘step-child’ of federal economists (see ‘The Fed and the Float’).

Watch for manufacturing and telecommunications to rebound once the final ingredients are put in place (see ‘Is it time to be bullish on manufacturing?’ and ‘Where will the telecommunications sector find cash?’).

The Japanese banking predicament remains a powder keg of the first degree (see ‘A Melting Sheet of Ice’). However, we have reason to believe the crisis may pass without incident (see ‘Japan Speaks Up’)

Since We Last Spoke

Get On With It

History shows the absence of decisive action frequently prolongs crises. Ironically indecisive action may delay suffering but typically ends with greater total suffering than that predicted with that of pre-emptive decisive action being taken.

The lack of decisive economic goals inherent in the 1970’s Stagflation and the 1930’s Bank Collapse serve as examples in financial policy.

The lack of decisive military goals inherent in the Vietnam and Bosnia conflicts serve as examples in foreign policy.

How can today’s financial markets benefit through understanding these debacles?

The Fed can aggressively loosen money supply and 

Japan can devalue the Yen.

Delayed action here is a thorn twisting in the side of economic growth.

Without either or both of these events transpiring, the broader markets will remain in volatile trading ranges.  At present, we have not identified a catalyst to drive these actions.  Therefore, we have looked to market sectors that may be less affected by this indecisiveness.

The Federal Reserve and the Hornet’s Nest

Feedback indicates our attempts to compare the current stock market and economic conditions to events wholly unrelated to the market meets with your support.  So here we go again.

There is a wall located near our office has the dubious honor of harboring a spring vacation site preferred by local hornets.  Like clockwork, each March a swarm of hornets appears to build a nest much to the chagrin of those of us who travel nearby.  Though we hold no ill feeling towards these hornets, those of us who walk near their nest just as soon see them move elsewhere. Therefore, early each year a pest control firm is contracted to treat the area in an attempt to dissuade the hornets from selecting this nesting site.  The key element to preventing the hornet’s arrival is early action.  If the area is treated in time, the hornets do not appear.  If the contracted pest control firm fails to treat the area before the end of February, we will spend the spring and summer fearing being stung by one of the hornets and, in general, attempting to avoid the unwanted neighbors.  More importantly, should the pest control firm attempt to schedule a meeting once the hornets arrive, a Herculean effort must transpire requiring more resources (viz. more people with more protective equipment and more repellent), more time and, overall, more expense.

To take some literary liberty, the “we” is the market pundit community (viz. economists, market strategists, investment advisors, and shareholders), the “pest control firm” is the Federal Reserve, the “repellent” is aggressive interest rate cutting, and the threat of being stung by “hornets” equates to the threat of stocks dropping in value due to falling earnings in a recession.

Our point? In November 24 of 26 economists polled “called” the Federal Reserve to treat the market with aggressive rate cuts to prevent a recession.  Some felt the treatment should call for a total of 2.5% of interest rate cuts to avoid a spring recession.  The Fed arrived late [January 2001] and with less than ½ of the suggested treatment [a 1.0% rate cut]. The result?  The hornets arrived [the Nasdaq fell in February and the Dow fell in March].

Next Tuesday, the Federal Reserve will explain its suggestion to address the hornet problem.  The Fed may suggest a heavy dose of treatment [additional 1.5% rate cuts].  Or it may conserve its reserve in order to have some treatment on hand to deal with the hornet problem that may spill over into later in the year.

Regardless of the plan of action that is selected, the problem remains – the hornets are in place.  Our response has been to spend more time away from the swarming hornets [place funds in Europe and Asia] and avoid the nest [build near-term cash reserves].

As the economy and earnings improve, or more importantly are perceived as improving, we plan to add to our portfolios in areas likely to lead the market out of its current predicament.  We know from our last issue that as long as the Fed continues to administer treatments [rate cuts] eventually the hornets will disappear (see “7-for-7”, 2001).

The Fed and the Float

Thirty years ago, a tire company’s business manager would guess how many tires to order to meet next year’s sales targets.  If for some reason he were incorrect, millions of tires would pile up in warehouses.  Next, tire inventory reports would indicate recessionary conditions and the Federal Reserve would take action to alter the market through artificial money supply control.  Today, those wild inaccuracies are practically eliminated by, in a word, technology.

Carocella notes corporations can ‘turn on a dime’. When excess inventory is identified, production is shut down immediately.  The recent six-week shut down at the Lincoln Navigator plant serves as an example.

It is precisely those wild swings of days gone by that was deemed the basis for a “hand-on” Federal Reserve.  Per Crane, blending the current efficient corporate model with the dated Fed model makes for a market sell-off that seems more like a sentiment-driven decline more than a fundamental-driven decline.

What We Are Watching 

Is it time to be bullish on manufacturing?

Not yet, there is one more indicator that must turn first.  That indicator is: raw material costs.  When raw material costs reverse, the ingredients for a manufacturing rebound will be in place.

Where will the telecommunications sector find cash?

Next on the list after manufacturing, telecommunications is positioned to profit.  The final ingredient is not raw material costs.  It is cash.  Until these companies can increase their liquidity through mergers or in the capital markets, they will remain under pressure.  Once they raise cash, the possibility of a rebound could be significant.  More specifically, the market potential has not changed since last autumn.  The “last mile” of the high-speed communications network offers a 100-fold growth potential.

Watch investor reaction in “safe havens”

Many stocks have been viewed as ‘good stocks to own’ as they supposedly profit in a post recessionary environment. Some may be impacted by a possible meltdown of the Japanese Yen.  We have issued cautionary items on the housing and financial sector exposure.  Once the devaluation of the Yen has occurred, it appears likely that several stocks will emerge as oversold.  At that time, we will access profit potential in these sectors.

Another signal to the Federal Reserve: Business Inventories

The business inventories, reported earlier this week, may add fuel to the argument for more aggressive rate cuts.

 –1 – 1 = -3: The Compression of the Lending Pool

The impact of tight money supply grows over time.  Although we have not identified the direct relation of tight money supply in 2001 to commercial lending, every day that a business is reluctant to lever itself due to high interest rates is a day that is transformed to a triple loss to the economy.  That is to say, the opportunity cost of one unconsummated business loan results in three setbacks: one to the business, one to the bank and one to both the business and the bank.

First, the company does not expand.  Second, the bank must decrease its risk exposure to maintain quality as market growth projections are decreased by lower lending activity.  Finally, a possible loan tomorrow requires higher collateral.  Both the bank (through increased risk requirements) and the company (through higher costs of borrowing) are dealt a loss.

It is for reasons similar to this that we have experienced setbacks in several growth stock holdings.  Our growth profile necessitates holding only those companies that can prosper in the most difficult credit environment.  Our focus remains on businesses that (1) add productivity to non-growth companies or (2) control a dominant share of a growing market.

Economic Commentary

A Melting Sheet of Ice

We have addressed both concerns about the Japanese financial market and acted to avoid those areas, which may be impacted by a forced devaluation. Arnold believes if devaluation remains unaddressed over an extended period of time, a Japanese stock market at 10,000 is not out of the question.  Longer-term, Japan is probably accelerating China’s move to the post of ‘most important economic force in Asia’.

In order to interpret why this potential crisis poses severe consequences to the world, consider the following:

Young ice hockey players in the North America typically spend their time playing the playing the sport on frozen ponds or lakes.  One of the problems players fear is the impact of the warm sun melting the ice. If the temperature rises to a certain temperature and the supported weight of the players great enough, the ice may crack sending some, and typically all, of the players crashing into the freezing water.  As this scenario has proved fatal on many occasions, it is not surprising that the first sound of a sheet of ice cracking sends a shrill of fear through ALL of those on the ice.  Simply, although only one player may have caused the crack, all are endangered. The first reaction to a loud crack of ice splitting is for everyone on the ice to stop all movement.  If the ice does not split completely through on the first crack (as is typically the case), the players attempt to cautiously move together to get to safety at the edge of the shoreline.  If everyone moves cautiously and no one makes a frantic, self-serving movement, typically all can escape the danger and live to play another day.

So too, the Japanese banking system’s actions, or more appropriately – inaction, has sent out a “loud cracking noise” for all the world’s central banks to hear.  Presently, the central banks are aware of this predicament and working to direct Japan and their own economies to the shoreline and escape the possibility of falling into the freezing water. This fall could be interpreted as a global economic meltdown. 

We have addressed both concerns about the Japanese financial market and acted to avoid those areas, which may be impacted by a forced devaluation. Arnold believes if devaluation remains unaddressed over an extended period of time, a Japanese stock market at 10,000 is not out of the question.  Longer-term, Japan is probably accelerating China’s move to the post of ‘most important economic force in Asia’.

So too, the Japanese banking system’s actions, or more appropriately – inaction, has sent out a “loud cracking noise” for all the world’s central banks to hear.Presently, the central banks are aware of this predicament and working to direct Japan and their own economies to the shoreline and escape the possibility of falling into the freezing water. This fall could be interpreted as a global economic meltdown.

Japan Speaks Up

Yesterday came the most assuring comment out of Japan in six months.  In a country where Mori’s self announced resignation notices remind one of the “Boy Who Cried Wolf” children’s story, the Finance Minister indicated the Japanese government would support the currency, and consequently the economy, in this time of trouble.  This should prevent the world’s central banks from experiencing a global meltdown or as it was above – all the players on the ice pond from crashing through the ice surface.

Note, in the event Japan should renege on this claim, all bets would be off. Without government intervention, the collapse of the Japanese banking system remains a possibility.  Our stance is to wait out the potential crisis and wait until the currency support is ‘signed on the dotted line.’  Once signed, we move forward. 

What we hope to take advantage of:

1) Outsourced manufacturing

Inventory management is the profit motive for outsourced manufacturers. As inventory levels increase, there may be less of a window for profitability on the part of outsourced manufacturers.  Therefore, we have reduced holdings in some of the ‘picks and shovel’ companies in commodity technology businesses.  One must assume that at some point, even those companies selling picks and shovels to the miners and mining companies of the Californian Gold Rush were pushed to expand their services to newer clients.

2) Is Capitulation Necessary for a Bull Market to Return?

Yes, market bears do not turn into market bulls.  A bull market will return when stocks are thrown out the window.  The reason an investor stays in the market is that history shows those who are in the market when capitulation occurs take home the highest profits.

3) Bush: The Tax Cut and Beyond

President Bush campaigns for his tax proposal with increasing energy.  We think many investors are overlooking potential profitability in his areas of interest apart from tax cuts.  In media circles, defense, power, energy and healthcare certainly are taking the back seat to tax cuts.  Once the tax cuts pass or fail, attention to these sectors should increase.