Enter Text here

Oh Euro, My Euro (circa 2011)

Oh euro, my euro, ’twas said your time had come,
You’d withstood all the early flack, your doubters seemed undone;
With francs a ghost, with liras toast, and deutschmarks just a mem’ry,
Around the globe, your worth was sold, in circles monetary.
But now, alas, that time has past,
A new day has arrived,
With traders asking could it be
The euro won’t survive?
 
Oh euro, once mighty, the money pack outpaced,
You made Dutch guilders disappear, pesetas you replaced;
With you baguettes were freely bought, with you paella ordered,
‘Twas heralded no exchange rates, a Europe without borders.
Good euro, hope bringer
Have you become unsound?
You’re even trading lower now
Than the beat up British pound!
 
The euro keeps on falling, it cannot find its legs,
Its strength has got so faded that it breaks through all the pegs;
The thinking here is changing fast,
As the richer lands gets rolled,
Could this have been a pretty dream,
One greatly oversold?                                                   Michael Silverstein

 

 

 

“We have two classes of forecasters. Those who don’t know – and those who don’t know they don’t know.”  John Kenneth Galbraith

 

I have remarked in prior first-quarter newsletters that, somehow, this is about the only time of year when most people reflect on the past, ponder the present, and plan/predict the future. The new year always brings with it the crystal-ball question, “Cliff, where do you see the markets over the next year?” Like most market pundits I am tempted to answer with absolute numbers, but experience has taught me that these types of predictions tend to prove me far smarter or dumber than I deserve. There are, however, several themes we have identified that will affect our asset-allocation discipline for 2012. As I commented in November, the market risks are geopolitical and the sentiment is driven by government policies. Our themes for 2012:

 

• Germany’s Euro
• Inflation versus Deflation
• Election Year
• It Isn’t All Bad

 

Doing Nothing – Nothing Done: for the year 2011, stocks basically broke even, although the 37 days where the Dow was plus or minus 200 points certainly made for a wild ride.

By now, equity investors should be getting used to the volatility. Looking at the S&P 500 Index returns over the last 11 years indicates that we are in the midst of a long-term secular bear market, and while in it we will experience pockets of bull and bear runs. From a valuation perspective, if we are to experience a severe market downturn from here, then it will begin at a forward P/E level of 11.8, by historical standards a cheap valuation. Considering that the market low of March 9, 2009 had a forward P/E of 10.3 then the odds of a severe stock decline from here do not seem that high. However, I cannot ignore that the credit super-cycle of debt expansion over the past sixty years ended in 2008. The problems of Europe and the US are attributable to the tremendous amount of debt that is now choking our ability to grow and that threatens the solvency of countries and a fractional banking system that is built on trust. The black cloud of deleveraging will continue to hang over the heads of investors until government policies are put in place to ensure solvency of the euro and fiscal responsibility in the US. Emotions trump valuations in this environment.  

 

Germany’s Euro

 

“We are asking the nations of Europe between whom rivers of blood have flowed to forget the feuds of a thousand years.”  Winston Churchill

Europe has an solvency issue, not a liquidity issue. There are insolvent banks backing insolvent countries and insolvent countries propping up insolvent banks. In my opinion, a money manager’s chances of success or failure in 2012 will be dominated by whether he or she correctly assesses Europe. Will or will not Germany have the resolve to rescue the euro, and under what terms? We have been and are still witnessing a giant game of chicken, with Germany versus the Western world in an attempt to turn a European problem into a potential global financial Armageddon. Germany well understands that they either pay up by moving to a full fiscal union or continue to kick the proverbial can toward an expanded role for the European Central Bank that Germany will eventually control. After creating the euro in 1992, Germany has successfully done in 20 years what it failed to do in 60 years and two world wars: conquer all of Europe.

 

The Armageddon case is created by the financial leadership of the euro zone doing nothing in order that nothing gets done. But if nothing is done, investors and bankers will lose their trust in the weaker countries and financial institutions. The results will be a credit freeze and runs on banks and/or countries as investors attempt to get their money out before a bank is nationalized or borders are shut down. There will be a 1930’s style depression for all of Europe and a certain decline in global GDP; neither the West nor the East will be immune from the fallout. Germany’s willingness to push the default envelope to the edge of bursting is risking an unmitigated disaster of colossal proportions. 

 

Our assessment is that Germany eventually pays up, by either (a) creating a eurobond where all euro countries assume joint responsibility for the debts of the continent or (b) supporting the ECB as central banker, with the same type of liberty to print money that the US Federal Reserve enjoys. Although German Chancellor Merkel has stated that neither of these ideas is permissible, the alternative is far worse. A euro zone breakup would create a currency crisis, global stock declines of 30% or more, a global recession, and legal chaos with the unwinding of contracts that were entered into based on the existence of the euro. As my friend John Mauldin says, there are no easy choices from here; just hard and harder. Therefore you have the following two camps in which to base your 2012 investment position:

 

• Camp Optimist

 

• Euro zone is maintained
• Global GDP grows 3-5%
• Europe has a mild recession
• Financial contagion is limited
• US and other nations continue stimulus policies

 

• Camp Pessimist

 

• Germany loses the game of chicken; euro breaks apart
• Widespread financial crisis from the detonation of the neutron bomb of the financial world: credit default swaps
• US ceases stimulus programs in favor of more austerity
• Global recession

 

Inflation versus Deflation

 

 

For the record, CPI has been reported on a monthly basis since 1919. The index has been revised several times through the years, in 1940, 1953, 1964, 1978, and lastly in 1995. The changes approved by Congress in 1995 eliminated food and energy from the “core inflation” calculation, and therefore the chart above provides both “headline” and “core” inflation numbers.

 

The combination of global wage competition and deleveraging is keeping a lid on the inflation statistics, even as governments globally continue to expand fiat currencies via the printing press, in the attempt to monetize their debts.

 

 

The chart above shows the expansion of US money supply as measured by M2, which encompasses M1 plus savings, time deposits, overnight repos, and noninstitutional money market accounts. Since the beginning of the financial crisis the US has increased the money supply by almost 30% in less than four years. And yet the velocity of money, which is the average frequency with which money is spent over a period of time, has fallen from 1.89 to 1.60 during the same period, as demonstrated in the chart below. 

 

These graphs are telling us that much of the Federal Reserve’s expansion/stimulus policies have been focused on recapitalizing what has become a zombie banking system here in the US. Regardless of the amount of money available, the banks are not lending, as the regulators are essentially running the banks. Whether we want to admit it or not, the expansionary powers given to the government as a result of Dodd-Frank are choking private industry’s ability to grow and expand, because companies cannot obtain credit from traditional bank sources. My friends in the private-equity and mezzanine-debt arena indicate that the volume of high-quality financial needs from private businesses is growing at an exponential rate. Private-equity and mezz-debt funds are becoming the sources of capital that used to be the domain of the small to mid-sized banks. I would recommend that accredited investors look into these alternatives, if you do not already employ either strategy.

 

In the short term, deflation will continue to rule, as our system rids itself of the excess debt accumulated during the debt super-cycle. However, as Reinhart and Rogoff reminded us in the book This Time Is Different, governments cannot continue to aggressively expand debt and print money without consequences at some point. From David Rhodes and Daniel Stelter:

 

It is also a matter of trust. Take, for example, the history of hyperinflation in Germany in the early 1920s. The German Reichsbank funded the government with newly printed money for several years without causing inflation. But once the public lost trust in money, people started to spend it fast. This led to higher demand and an inflationary spiral. Today the velocity of money in the U.S. is at an all-time low of 5.7. If the number of times a dollar circulates per year to make purchases returned to the long-term average of 17.7, price levels in the U.S. would rise by 294 percent over that period — unless the Federal Reserve simultaneously reduced its balance sheet by $1.8 trillion. Some inflation is probably attractive to those seeking to reduce debt levels. The problem is stopping the inflation genie once it has left the bottle.

 

For this reason I continue to recommend an allocation to commodity-driven assets.

 

 

 

 

Election Year

 

The democracy will cease to exist when you take away from those who are willing to work and give to those who would not.  Thomas Jefferson

 

For the record, I have become apolitical as it relates to my faith in our polarized Congress and President to do anything other than get re-elected. The polarized government creates problems at a time when we need leadership and policy changes. Without tough choices we will probably experience stalemate: Doing Nothing – Nothing Done. The European crisis is the fallout of socialistic systems where governments (Greece, Italy, etc) could borrow unprecedented amounts of money to pay for promises on which they could not deliver. The current rates of US spending on health care, Social Security, and the military are simply unsustainable. The following graph demonstrates the polarization of our political system that dares a Congressman or Senator to cross their party line.

 

In my opinion, the introduction of term limits would improve the system by eliminating the constant need for re-election. Representatives who know their terms are ending are far more likely to cross the aisle of Democrat versus Republican and do what is right for the country. Our problems are fixable, and we have a road map in Simpson-Bowles, introduced a year ago. However, if our representatives continue to vote 90% or more along party lines and leadership remains too idealistic, the US will remain in a stalemate.

 

It Isn’t All Bad

 

Despite the problems of the euro, the continued printing of fiat currency by central bankers, and a US government at the helm of a rudderless ship, the corporate world continues to bang out profits and capitalize on global growth. Looking at the following charts one would assess that the large multinational US corporations will survive regardless of what happens in Europe or the US.

 

 

 

Corporate cash is at all-time highs and dividend-payout ratios are the lowest in ten years; and if governement would get out of the way, we would see a return of capital expenditures. I make the argument that with valuations at these levels, high-quality US multinational corporations with strong dividend histories will prove a better investment over the next five years than a ten-year or thirty-year treasury. In the short term, with the potential for euro breakdown and other geopolitical risks, the flight to safety in US treasuries may enable bonds to outperform stocks. During this time, fear will trump valuations. Long-term (3-5 years), equities outperform treasuries. 

 

Mutual fund flows are indicative of individual investor moves, as opposed to institutions. Individual investors typically make investment decisions based more on emotion than an investment discipline. In a recent Dalbar Inc. study, they looked at returns of the S&P 500 from 1987 to 2007 and found that stocks had an annualized return of 11.81%. During the same time period, Dalbar found that the returns of an average individual investor in S&P 500-type funds was a mere 4.7%. Why? Emotion. Investors buy and sell funds based on market swings and chase last quarter’s hottest fund. Disciplined investors, on the other hand, make money when others sell in a panic. Here at Excelsia, we view the mutual fund flow chart as one of many indicators that leads us to favor stocks over bonds at this time.

 

A key component of our Tactical Asset Allocation investment discipline at Excelsia is that we use forecasted returns for the asset classes, as opposed to historical averages, in developing our allocations. A key feature of the forecasting process is defining where we are in the interest-rate/inflation cycle. The chart below shows how we define the inflation cycle in four quadrants and compare the returns of bonds, stocks, cash, and commodities during various types of inflation cycles. We are in a low and rising inflation cycle now, which should bode well for stocks and commodities – the caveat being Europe and the potential for another global financial crisis. As I said at the beginning, assess Europe accurately and your returns will outperform in 2012.

 

 

 

Closing Comments

 

“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.”  Abraham Maslow

 

People make mistakes when they invest. They do so as a result of bias in their judgment, or by mistaking their perceptions as reality. There are several basic mistakes:

 

• Excessive optimism – Most investors tend to exaggerate the positive and minimize the negative.
• Overconfidence – Leads investors to overstate their knowledge, underestimate risks, and exaggerate their ability to control the situation.
• Cognitive dissonance – Investors often operate with incredible levels of denial.
• Heuristic rules – Rules of thumb that we employ for dealing with the daily information deluge, through evaluations based on how closely a situation, person, etc. resembles someone or something, rather than examining or questioning what is actually in front of us; i.e., we “frame” and/or “anchor” the event/person/action.

 

Freud once said, “Thinking is rehearsing.” What he meant was that after you accumulate the data and analyze the opportunities, you need to take action. In the world of investing there is no substitute for taking action. Savvy investors make rational and prudent decisions based on facts and understand the risks inherent in their decisions. Each of you will always read about someone who made more money than you last year; always. The critical factor to ask is, what amount of risk was taken for the performance? Losses are inherent in any investment process; the key is to limit the size of the loss. Case in point would be John Paulson’s Advantage Plus Fund. In the crisis of 2008 the fund made billions off the mortgage crisis, and his fund grew from $5 billion to over $35 billion as institutions and individuals alike flooded the fund with dollars. According to Reuters, the Advantage Fund was down 52%, as of December 1, for the year 2011. Ouch.

 

I know that our investment process of Tactical Asset Allocation has produced consistent returns over time. I know that, from a psychological standpoint, during down markets you want your returns to be absolute and during up markets you want your returns to be relative. I assure you that we at Excelsia will remain disciplined in our process during what promises to be another turbulent year.

 

 

 

(c) Excelsia Investment Advisors

www.excelsia.com