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Quarterly Newsletter - October 2011
The stock market now feels like it did in 2008 and 2009. It is violently volatile and one has the thought that it
could just fall off the edge of the world – go down and then stay down for a very long time. This time the fear
factor is, if possible, even larger than in ‘09 – first because ‘09 is a very recent memory and second because
potential banking and sovereign failures in Europe are clearly bigger in magnitude than a bankruptcy of
Lehman Brothers. What does this mean for markets and what is the proper response to this? On the one hand a
European failure would cause worldwide confusion and panic. But on the other hand the equity markets, here
and in Europe, are very much cheaper than they were in 2007. For the first time since the 1950's the dividend
yield on the S&P 500 is higher than the ten year Treasury yield and the European dividend yield is higher yet.
This really is a generational buying opportunity – just as 2008 was. Stocks only get this cheap when people are
really frightened, as they certainly are now. And please remember that the decade of the 1950's was a more
dangerous time than now – with Soviet power on the rise and the definite possibility of a nuclear war. We do
need to keep some kind of perspective here – whatever may happen from this we are not going to start World
War III. This issue of cheapness and gumption - the willingness to step up and purchase when it is scary to do
so - is very important. Stocks simply do not get this cheap unless people are real scared – and therefore are just
not willing to buy. What we have here is a buyers' strike. Frightened and desperate sellers have to move prices
down in big steps, to induce buyers to step in – and this is what these gigantic and very fast market drops are
about. Scared sellers and sticky buyers. Buyers who insist on getting a real deal, given how risky the world is
now. Stocks are cheap. But they are only cheap if you buy them, or hold the ones you already own. If someone
sells them now, out of fear or regret that they had not sold them earlier – then obviously they are not buying
them. This is not a deep and profound thought. It is hard to both sell and buy at the same time. Nor are we the
only people buying stocks now. One must remember that for every share sold that same share is bought by
someone else. In the recent MarketWatch article “Why you should buy Europe now” a hedge fund manager,
Crispin Odey, explains why he has been aggressively buying European equities: “It may be confusing to find
someone who believes that a crisis is on its way but is also happy to buy equities ahead of the crisis,…My
reason is that the worries have been there so long, the causes are so obvious and the valuations are so cheap
that this is a case of buying early. For me the crisis will bring resolution and with it higher prices.” The article
continues: Yet Europe today certainly passes the most obvious test for a contrarian: Everyone else is too afraid
to invest. Imagine a portfolio manager trying to make the argument to an investment committee. Imagine a
financial adviser trying to explain it to Mrs. Jones. Indeed – as we are trying to do. But – what if we have a
worldwide economic collapse – caused perhaps by a general failure of the European financial system. What
then? First, the odds of this are extremely low. And second, it is impossible to predict if this would be an
inflationary or a deflationary event. It would doubtless be both, alternating back and forth. The European
Central Bank would almost certainly respond to such a failure by aggressively printing money. It is therefore
very important to understand both the power and the limits of unconventional monetary policy. In the U.S. and
Europe there are budget problems, i.e. political problems. The markets know that long-term government
expenditures are unfunded. This causes investors to worry that these expenditures might eventually be paid for
by simply printing money. This concern about long-term inflation risks has produced a much less aggressive
monetary policy by the Federal Reserve and European Central Bank than is possible. Long-term budget control
is critically important exactly because firm funded budgets put a cap on long-term inflationary expectations.
With this in place a more inflationary short term monetary policy could be followed. Aggressive monetary
policy is a tool not yet used. So what does this mean for markets? As politicians deal with funding and/or
cutting our long-term commitments and central banks try to walk a tight rope of just enough money creation,
markets will fluctuate (sometimes wildly) between inflation and deflation fears. And what is the proper
investment response to these markets? Bonds defend against deflation and stocks against inflation. Therefore,
in our opinion, a diversified portfolio that is rebalanced as fears of inflation and deflation move around is the
only solution to the current uncertainty. As stocks fall we will sell bonds and buy stocks. Markets are now
awash in panic. But the sweep of history is clear albeit easily forgotten in times of crisis. In 1950 only 31% of
the world's population lived in a democracy. That number is now over 58%. Democracies and new capital
markets boost world living standards (and therefore returns to stock holders) and reduce war. Of course
markets and market participants can and do make mistakes. But markets and democratic capitalism are the
only way to manage a modern complex economy and society. Nothing happening now changes that in the
least. Jim, Dean & John
Post date: 2011-10-15 15:49:21
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