Download Steve`s 1st Quarter Commentary 2014

Commentary
by Steve Henningsen
April 2014
The Band Plays On
“Reality isn’t the way you wish things to be, or the way they appear to be, but the way they actually are.”
–Robert J. Ringer. Motivational speaker
“When you believe in things that you don’t understand, then you suffer.”
–Steve Wonder, Superstition
My son’s middle school band was invited to play at Disney World last month, which allowed us
one more family vacation to visit the Magic Kingdom. Definitely not the place to be in March,
when it seemed like everyone else had the same school break, but we had no control over the
timing of the trip.
Disney World is always a bittersweet visit for me. While it was magical as a kid and enjoyable
now (seeing it through my children’s eyes), the chaos of the crowds and the ridiculous expense
of the park is enough to make me wish I could have doused myself in pixie dust and flown away.
Fortunately, as we sat at dinner in Epcot’s France pavilion (or as my son called it, fake-France),
my family agreed it would be our last visit; for we prefer to experience authentic people and
cultures.
The most enjoyable park experience for me was visiting the museum of Walt Disney himself.
He was a remarkable fellow and watching a short movie biography about him reminded me how
one person can make a difference. Disney made fantasies come true for generations of children
and judging from the diversity of the crowd, his magic has spread worldwide.
I’m not sure when in children’s development they realize the good guy doesn’t always win or not
every little girl gets to grow up to be a princess. At some point though, children’s naiveté
begins to fade alongside their colorful storybooks and is replaced by the hard, gray lines of
reality. I’ve watched this transformation in my own children over the past several years.
Fortunately, fantasy still exists in the world of older children; it’s just tied to darker characters
like wizards, vampires and zombies. (Is it just me who thinks it interesting, from a sociological
time-stamp, that kids currently seem to be drawn to stories involving dystopia – e.g., Divergent,
Hunger Games, The Maze Runner, etc.?)
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Adult Fantasyland
“There is a growing gap between the financial markets and the real economy.”
– Seth Klarman, The Baupost Group
In adulthood, make-believe and imagination can be
beneficial, or dangerous if misapplied. Advantageous if
you’re a writer thinking up the next blockbuster movie.
Potentially harmful if you’re in the financial services
industry and blindly believing each word uttered by Federal
Reserve governors or IMF officials. Seth Klarman, who is quoted above, is arguably one of the
best investors of our generation and, in his latest shareholder letter, he compares today’s
investment environment to the movie, The Truman Show. For those who haven’t seen it, the
movie is about a man who lives in a fake world, where everything around him is constructed by
others, until one day he discovers the truth.
And oh, why can't we let it be
And see thru the hole in this wall of confusion
I just can't help the feeling I'm
Living a life of illusion
–Joe Walsh, Life of Illusion
Mr. Klarman seems to believe that central bankers’ ultra-loose monetary policy has
manufactured an investment fantasyland, lulling investors into a world of ever rising stock prices
without risk. “All the Trumans – the economists, fund managers, traders, market pundits – know
at some level that the environment in which they operate is not what it seems on the surface, but
the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so
irresistible, that no one wants it to end.”
To be fair, he does note some positive development in the economy (reduced deficits, increasing
energy independence, housing recovery, etc.) but then goes on to write this:
But if you have the worry gene, if you’re more focused on downside than upside, if you’re more
interested in return of capital than return on capital, if you have any sense of market history, then
there’s more than enough to be concerned about. A policy of near-zero short-term interest rates
continues to distort reality with unknown but worrisome long-term consequences. Even as the
Fed begins to taper, the announced plan is so mild and contingent – one pundit called it “taperlite” – that we can draw no legitimate conclusions about the Fed’s ability to end QE without
severe consequences. Fiscal stimulus, in the form of sizable deficits, has propped up the
consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay
on juiced corporate earnings? Pretty clearly, lower than otherwise. Yet Robert Schiller’s
cyclically adjusted P/E valuation is over 25, a level exceeded only three times before – prior to
the 1929, 2000 and 2007 market crashes. Indeed, on almost any metric, the U.S. equity market is
historically quite expensive… The overall picture is one of growing risk and inadequate potential
return almost everywhere one looks.
In my opinion, the central banks have created this “distorted reality,” an artificial-investment
utopia, where risk is banished to the dark forest and stock prices incessantly rise up to the cottoncandy clouds, but what happens when the spell is broken? What happens when, as in The
Truman Show, we find out it’s all an illusion?
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“There is only one difference between a bad economist and a good one: the bad economist confines himself to
the visible effect; the good economist takes into account both the effect that can be seen and those effects that must
be foreseen.”
–Frédéric Bastiat, 19th Century French economist
Besides its creator, what fascinates me about Disney World is
how the park was constructed. There are two “worlds” in Walt
Disney World; above ground and below. As Mr. Bastiat would
say, there’s the seen and unseen. The story goes that old Walt
saw a cowboy from Frontierland meandering through
Tomorrowland at his first park in California – Disneyland. He
didn’t want his employees (cast members) walking around between theme areas and confusing
the kiddos sense of reality. So when he designed Disney World, he had an underground floor
with tunnels built, so that cast members could travel from one area of the park to another without
being seen. Since Florida is basically at sea level, with the water table very shallow, he built the
first floor of the park first and then covered it with dirt from the excavation of the lagoon. So
although most don’t realize it, when you walk down Disney World’s Main Street, you are really
walking 15 feet above the ground!
“The few who understand the system will either be so interested in its profits or be so dependent upon
its favours that there will be no opposition from that class, while on the other hand, the great body of
people, mentally incapable of comprehending the tremendous advantage that capital derives from the
system, will bear its burdens without complaint, and perhaps without even suspecting that the system is
inimical to their interests.”
-The Rothschild brothers of London writing to associates in New York, 1863.
The Rothchilds were talking about the banking system, but I would argue that this monetary
malignancy has now metastasized to the rest of the financial system. Just as there are two
Disney Worlds, there are two financial systems – the seen and the unseen. The visible economic
world shown by the Wall Street Journal, Financial Times and other financial media outlets; and
the invisible, smaller world where insiders, politicians and powerful elitists work to control
outcomes to their favor. Lately, however, Main Street investors are finally awakening to the fact
that the system has been used against them. In the past year, several lawsuits against the banks
involving the manipulation of currencies, commodities, mortgages and interest rates (LIBOR)
have been filed. Now Wall Street is defending itself from a type of High Frequency Trading
(HFT) practice that, albeit possibly legal, is clearly theft.
“It is of the nature of faith to ignore contrary evidence. The current faith in central banking overlooks overwhelming
evidence that central bankers are fallible and that their policies helped create the conditions that led to the financial
crisis of 2008. But once the crisis hit, central bankers were the only gods available to worship; so rather than
demonize them, markets ran into their loving arms. Faith is a fragile thing though. It can be shaken. And it only has
to be shaken for a brief moment in a global financial system home to $700 trillion of derivatives and hundreds of
trillions of other forms of debt to do serious damage. The same central bankers in whom markets are placing so
much faith today are the same policy makers who failed to foresee the credit bubble that almost destroyed the global
economy in 2008.”
–Michael Lewitt, April’s The Credit Strategist
By far the biggest puppeteers of the financial system are the central banks, as their policies have
directly assisted their masters (the banks) while leaving citizens with paltry interest rates,
currency debasement and increased government debt burdens. The fairytale the Federal Reserve
likes to tell is how it was simply acting as our monetary knight in shining armor by riding into
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town to slay the debt dragon that had caused the villagers’ financial system to seize up in 2008.
What they can’t seem to admit is that their own policies helped to create the monster in the first
place. The other thing rarely mentioned is that the dragon was never killed. They just fed it
more debt to pacify it for the short-term, thus making it more powerful. From 2007 to 2013,
government borrowing jumped from 62% to 79% according to the IMF. Global debt now
exceeds $100 Trillion! That’s one fat dragon!
“The debts that keep growing with no intent upon paying anyone back are draining the national productivity and
turning the people into economic slaves. The standard of living has declined and it now takes two incomes to survive
where one use to be just fine. Women won the right to work and lost the right to stay home.
The promises that you save for the future have collapsed into dust as interest rates have been driven lower making
savings utterly worthless. There is no such thing as saving and living off your fixed income. The elderly are being
driven back into the work force and the whole ideas that a generation believed in are vanishing before their eyes.”
–Martin Armstrong, economist and financial historian
The reality is that the world does not have the productive capacity to pay off this debt. The
governments have instead either rolled maturing debt forward or issued more debt. Puerto Rico
is a perfect example. I believe they are insolvent beyond hope, as the island has $71 billion of
debt and not enough economic activity to come close to paying it off. However, that didn’t stop
Wall Street bankers from recently making big underwriting fees by helping them issue additional
bonds to cover some short-term obligations and put off their bankruptcy a few more years.
While Wall Street trumpets new highs for the stock market, I am reminded of the great
economist, Dr. Kurt Richebächer, who wrote the following many years ago, “You can't build
lasting stock market gains or solid GDP growth on debt. Because debt cannot expand forever.
Sooner or later, it must stabilize and then it must contract. When that happens, all the positive
features of debt become negative features. Instead of borrowing and spending more, people
must spend less and pay off past debt. Instead of adding to corporate sales and profits, they
subtract from them. Instead of driving up asset prices, they push them down.”
I’m tired of waitin’ for tomorrow to come
Or that train to come roarin’ ’round the bend
I got a new suit of clothes a pretty red rose
And a woman I can call my friend
These are better days baby
Yeah there’s better days shining through
–Bruce Springsteen, Better Days
Monetary Phoenix?
My belief is that sometime in the next few years investors will be shaken into
financial reality as the debt dragon reemerges, thus forcing our monetary knight
to finally act and rid us of its burden through debt consolidation and/or
depreciation. Rising from the economic ashes (I’ll explain the magazine cover
in my next commentary) may be a new global monetary system.
Until then, the band plays on.
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Gold
I will not personally comment on gold this quarter, (I’m sure you’re shocked!) but leave you
with these two thoughts:
"The desire of gold is not for gold. It is for the means of freedom and benefit...
For what avail the plough or sail, or land or life, if freedom fail?"
–Ralph Waldo Emerson
“Gold has been all over the place after opening the year on strength and is now 5% below its recent closing high of
1,367.07/oz. reached on March 17. I will merely repeat here what I write every month – we will look back on these
prices and shake our heads if we didn’t add to our gold holdings. The world is facing the monetization of an epic
amount of debt and the price of gold will rise sharply when that happens to levels that most people can barely
imagine.”
–Michael Lewitt, April’s The Credit Strategist
Portfolio Ponderings
“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is
no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear
markets. I've known many men who were right at exactly the right time, and began buying or selling stocks when
prices were at the very level which should show the greatest profit. And their experience invariably matched mine-that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.”
–Reminiscences of a Stock Operator, Jesse Lauriston Livermore.
Mr. Livermore’s advice paid off this quarter, as “sitting-tight” helped the actively managed
portfolios. Although we gave back some of February’s large gains in March, we ended the
quarter having exceeded our benchmark’s return.
I expect a much more volatile year in 2014, because economic data has been coming in uneven
and the Federal Reserve has begun reducing its QE program. Although Chairmen Bernanke, and
now Chair Yellen, have stated that this is not the equivalent of a “tightening” of monetary policy,
I believe it is, as someone else must step in to buy the Treasury and mortgage bonds they have
been purchasing and accumulating on the Fed’s balance sheet. The big question is whether the
Fed will continue to reduce its monthly QE buying program if the economy slows during the
second half of the year.
“Intelligent captains sail uncharted waters with extra caution and high alert; only fools think that each mile they
sail without sinking the vessel further demonstrates that they are wise and the naysayers were fools. This is a
formula for destruction.”
–Paul Elliot, investment manager
Although there are some equity positions I wish to purchase, for now my derriere rests firmly
upon my hands.
This commentary is provided for informational purposes only and is subject to change without notice. This material should be considered for
informational purposes only and should not be considered as investment advice or as a recommendation for a particular strategy or investment.
Individuals should consult with their advisor regarding specific advice and the applicability of this information to their circumstances. Statements
concerning market trends are based on current financial and economic conditions, which will fluctuate. Information contained herein has been
obtained from sources believed to be reliable, but are not guaranteed. Any portfolio used as an example in this commentary is one that we
believe to be representative of a typical client portfolio but we caution that individual performance can, and will likely, vary from the sample. All
investments contain risk and may lose value, and past performance may not be indicative of future results.
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