“Investments for Intelligent Investors”

Monthly Letter to Our Clients and Friends

Saved by the bell – Research - Christina Romer – Ben Bernanke – Our Outlook

                                                                                                                Complimentary Copy

Kendall J. Anderson, CFA

April 5, 2009

Saved by the bell

London England, March 1565: an old man is sitting quietly in a graveyard when he hears the faint sound of a bell ringing in the distance.  As he makes his way through the cemetery he becomes anxious, hoping that what he hears is just a little wind.  As he gets a bit closer to the sound, however, he knows it is not the wind but is instead the desperate ringing of a bell by a poor soul buried six feet under.  So our old man grabs his shovel and goes to work and one more poor soul is “saved by the bell”.

The bell was necessary in London during those times, as it was known that 1 of every 25 individuals was buried alive.  The bell was the ultimate safety net against a mistake which would truly make a bad ending for more than a few.  Today our economy has its own bell, and it has been ringing loudly, calling for the old man working the graveyard shift to grab his shovel and get to work.  The old man started digging seven months ago and his efforts are beginning to pay off.  The buried owners of common stocks are beginning to breathe a little fresh air.  The S&P 500 started the month with a decline of 10%, hitting bottom on March 9th.  Since then all measures have been positive, and not by just a little, but rather with a powerful surge that carried the S&P 500 up by 18% to provide the best monthly return since the 1930’s.    

The “old man” working the graveyard shift is Ben Bernanke, Chairman of our Federal Reserve, who has an assistant and confidant in the Chairman of the Council of Economic Advisors, Christina Romer.  This month we will be sharing with you a good deal of information about these two individuals, but before we do I wanted to give you some insight into our research operations and let you know why we spend effort on trying to understand the belief systems of Mr. Bernanke and Chairman Romer. 

Research

The payoff from all investment activity is only gained in the future.  The past is simply the past, and although we can gain some insight into the future from history, the results of all of our work today will only be realized tomorrow.  Our basic research, therefore, has to be steeped in analysis of the present as well as changes that will produce results tomorrow.   Both Justin and I spend the majority of our research efforts on three primary areas of interest. 

The first area is the least time consuming thanks to the power of modern technology.  With the use of a data base and a computer we can calculate an estimate to answer this question: “What should we expect to earn given the price we pay for a business and the expected growth of the business over the next few years?”  With this earnings estimate we can then easily compare this to the interest payment we would receive on the alternative choice for our money: a loan to our federal government.   This is the fundamental work needed to guide our basic asset allocation decision.

The second area is much harder and has more to do with psychology than with number crunching.  Since prices are set by supply and demand, the research in step two involves trying to determine the current demand and what can and will change demand in the future.   There are many industries where demand is somewhat easy to determine (Utilities and Consumer Staples), but with most, demand is subject to multiple factors and is therefore not so easily determined.   If we look at the big picture, the market in its entirety, the drivers of demand are determined by emotions and changes in emotion from euphoria to despair.  Emotions produce the huge volatility of daily prices that we experience. This area of our research is the one that I personally enjoy the most. It is the most challenging, but we have greatly improved in our results mostly because of the efforts of Justin, my number one research assistant.  For the first couple of years Justin worked with us, his primary efforts were to complete part one of our research efforts: number crunching.  During the last couple of years, however, he has continued to crunch numbers, but his investment experience and his excitement about the future of this business and this country come through loud and clear in our daily research meetings.  It is our discussions about the drivers of demand, the mood of the market, and the important points of interest that have an impact on change which make our meetings exciting. I will also add that these discussions open my stubborn eyes to a better understanding of my generation which currently controls over 70% of all the wealth in our country.  Justin’s understanding of both the present “baby boomers” as well as the next generation adds a tremendous amount of knowledge to our research efforts for understanding the drivers of demand.

The first step in our research efforts places us squarely in the present, and step two gives us insight and direction for the next twelve to eighteen months.  Step three gives us the framework for structuring portfolios over the next economic cycle which can last for years.  This work is based on a belief that over long periods of time market prices will correctly adjust to the present value and at a minimum will produce nominal returns directly related to the nominal growth of our economy.  When most economists discuss growth, they are more concerned with “real growth,” which is simply nominal growth less the amount of growth due to “inflation”.  While this concept is nice, when it comes to me and you and real life, if prices are higher, we simply need more dollars to spend.   Having zero real growth is okay as long as my dollars are able to buy the same amount of goodies as always.   

Monetary growth was at one time regulated by the “gold standard”.   Today monetary growth is in the hands of our Federal Reserve, which is directed by Ben Bernanke.   The Federal Reserve is in theory independent of our politicians, but most of us know that what Congress creates, Congress can take away, which does carry some weight with the voting members of the Fed. 

When it comes to the ear of our current President, Christina Romer, the Chair of the Council of Economic Advisors, is the first to be heard.   Since both Bernanke and Romer are in a position which will have a long-term impact on the future nominal growth of our economy, understanding their beliefs is absolutely essential for the development of our long-term theme. 

Christina Romer

Let’s begin with Dr. Romer.  She is well known as an expert on the Great Depression and in 1992 published a paper entitled “What Ended the Great Depression?” The introduction to her paper tells us her thoughts on what saved our economy from complete destruction:

“This paper examines the role of aggregate-demand stimulus in ending the Great Depression.  Plausible estimates of the effect of fiscal and monetary changes indicate that nearly all the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion.  A huge gold inflow in the mid- and late 1930s swelled the money stock and stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods.  That monetary developments were crucial to the recovery implies that self-correction played little role in the growth of real output between 1933 and 1942”.

Here we have the words of one of the most influential individuals with a direct circuit to the President of the United States stating that without a doubt monetary policy, not fiscal policy, pulled us out of the Great Depression.  The New Deal, like the current stimulus package, did not and will not have what it takes to brighten our future.  In her conclusion, she states: “Monetary developments were a crucial source of the recovery of the U.S. economy from the Great Depression.  Fiscal policy, in contrast, contributed almost nothing to the recovery before 1942.”  Maybe Dr. Romer is quietly whispering in the ear of our President every time Ben Bernanke introduces a new program to create more money, “It’s alright Mr. President, let him create a few more dollars, it will be okay.”

Ben Bernanke

It is common knowledge that Dr. Bernanke is one of the greatest scholars on the causes and cures of the Great Depression.  Do his views mirror those of Dr. Romer?  Dr. Bernanke has had numerous speeches and publications which we can use to help us understand his beliefs. What Dr. Bernanke stated in January 2000 concerning Japan not only gives us insight into his beliefs, but also gives us a roadmap into his actions.  It would be worthwhile for each of you to read his entire speech, entitled Japanese Monetary Policy:  A Case of Self-Induced Paralysis? but here I will just highlight a few words:

“I tend to agree with the conventional wisdom that attributes much of Japan’s current dilemma to exceptionally poor monetary policy-making over the past fifteen years.  Among the more important monetary-policy mistakes were 1) the failure to tighten policy during 1987-1989, despite evidence of growing inflationary pressures, a failure that contributed to the development of the “bubble economy”; 2) the apparent attempt to “prick” the stock market bubble in 1989-91, which helped to induce an asset-price crash; and 3) the failure to ease adequately during the 1991-1994 period, as asset prices, the banking system and the economy declined precipitously”.

“Having pushed monetary ease to its seeming limit, (the Bank of Japan set the call rate, their equivalent of the Fed Funds Rate, at zero – my words) what more could the BOJ do?  Isn’t Japan stuck in what Keynes call a “liquidity trap”?

“I will argue here that, to the contrary, there is much that the Bank of Japan, in cooperation with other government agencies, could do to help promote economic recovery in Japan”.

“The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows:  Money, unlike other forms of government debt, pays zero interest and has infinite maturity.  The monetary authorities can issue as much money as they like.  Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets.  This is manifestly impossible in equilibrium.  Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero”.

These few statements are extremely important to understand.  Dr. Bernanke believes an unlimited amount of money can be created and that at some point this will raise prices.  We are in full agreement with these words.  Second, he fully believes that when inflation begins interest rates will increase and additional actions can be taken to reduce the money supply.

He has outlined his theoretical plan to solve the “Keynes Liquidity Trap” and the lost decade.  Has he been implementing this plan?  I can say without a doubt that yes, he has.  Interest rates are, for all purposes, at zero. The Federal Reserve has expanded its balance sheet by more than a $1 trillion and promises to add as much as needed to reignite growth.  Bernanke knows that this action will ultimately lead to a period of inflation.  There is no doubt in my mind that when this happens, he will abruptly put on the brakes.

Our Outlook

We have laid out the three steps of our research process, so let’s take a moment to review each and then put them together for our outlook over the next year.

Step 1.  Our quantitative work indicates that at the current prices of the S&P 500, we should expect a growth on our capital from business results of 8.47% with a dividend payment of 3.2%, for a total return of 11.67.  As a reminder, this is calculated as if there is no market for our business and is simply a mathematical approach drawn from our computer models and our expectation of actual future growth and dividend payments.  Interest rates, on the other hand, are, as Dr. Bernanke says, pushed to their limit: zero. 

Step 2.  The best indicator of short-term demand for stocks or bonds is simply the market price itself.  Beginning on March 10th, something shifted and brought people back to common stocks.  As the market increases in price, the demand will also increase. 

Step 3.  Monetary policy has exploded.  Dr. Bernanke, with the reassurance of Dr. Romer, will continue to increase the availability of money until inflation begins.  This process of massive expansion began about a year ago and is finding its way into the economy.  The real increases in this supply began late last year and accelerated over the past few months.  The end result will be increased asset prices and ultimately an increase in interest rates.

Our quantitative work indicates that a bargain is available in common stocks relative to the amount of interest paid on our deposits.  Our view on the current state of investor psychology indicates a change in demand from a period of tremendous fear to a period of guarded optimism favoring common stocks.  Finally, the monetary policies in place by Dr. Bernanke and reinforced by Dr. Romer are beginning to filter into our economy and will continue for at least a year or two.  In conclusion, we should maintain a commitment to common stocks in favor of bonds and further maintain short maturities (two years or less) for those that require the comfort and safety of fixed income investment.

Some Final Notes

We are making a few changes around our office and hope that these transition periods do not cause any inconveniences.  We will be installing a new phone system in April.  It took me a year or so to learn how to use the last one, so I’m hoping this time will be a little easier.

We have installed a new CRM program which keeps track of all our to-do sorts of things.  I am sure that we may make a mistake or two on appointments, and not because we are lazy, but because I will sooner or later mess up the system and fail to record something-or-other.  If this happens, feel free to call me computer illiterate or something else more appropriate for the situation.

We continue to post timely commentaries on our web site as well as some third party articles we find important enough to share with you.  I am amazed at how many of you, as well as others around the world, take the time to visit our site and continue to return to it.  Both Justin and I hope we are providing useful information and are honored by your visits.  

Until next time,

Kendall J. Anderson, CFA

Anderson Griggs & Company, Inc., doing business as Anderson Griggs Portfolio Management is a registered investment adviser with the US Securities & Exchange Commission.  Pursuant to laws and regulations Anderson Griggs also maintains notice filing with several individual state regulators including North and South Carolina.  Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirement for advisors.  This letter has been sent to you for information purposes only and is not an offer of investment advice.  The purpose of this letter is to provide information about us.  We will only render advice after we deliver our Form ADV Part II to a client in an authorized jurisdiction and receive a properly executed investment Management Agreement.  Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs Investment Objective, individual account, or index.  The authors of publications are expressing general opinions and commentary.  They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation.  Anderson Griggs Portfolio Management’s office is located at 113 E. Main St., Suite 310, Rock Hill, SC  29730.  The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874.

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