I have always been a fan of small dogs: Jack Russell
and Norwich terriers, corgis. For me, big dogs make big
messes. Their wagging tails knock things off the coffee
table; their digestion requires constant clean-up patrol
in the backyard.
So too, with business and government: the bigger the
size, it seems, the bigger the mess. Large banks and
financial institutions contributed to the explosion of
private debt and the consequent financial meltdown of
recent years. BP polluted our off-shore waters.
Government has exploded in size, producing unprecedented
trillion dollar deficits and a debt load nearing 14
trillion dollars, almost as large as the annual output
of the economy.
A sorry record. At least business, despite its
occasional failures, has a record of producing wealth
and prosperity over a long period of time. Government by
contrast produces no wealth and the bigger it gets, the
more it consumes private sector wealth, inhibits
economic growth and compromises individual liberty.
Along the way, it promotes a culture of dependency. It
comes as no surprise that the best real estate market in
the country surrounds Washington D.C. Government has
become the ultimate big dog, the one that walks its
owner rather than the other way around.
Only days away, mid-term elections are expected to
upset the status quo of the last two years. Citizens are
angry and disillusioned. Incumbent Democrats are widely
expected to lose control of the House and several Senate
seats. The President is increasingly being abandoned by
his own party and looks weak. The mood seems to be,
“What we’re doing isn’t working, let’s try something
else.” Animal spirits, so crucial to confidence and
economic prosperity are subdued. We sense a sorrowful
cynicism that regardless of what party calls the shots,
the big dog never changes its habits.
We wrote last quarter that the stock market could
rally even if the economy did not, and so it has. We
interpret anticipation of change in Washington and state
capitals as a contributing factor to improved market
sentiment. Non-financial corporate profits are solid due
to cost cutting and strong balance sheets though growth
is slowing. Meanwhile, strength in emerging and
developing economies bolsters profits of those US
companies that have meaningful international businesses.
But revenue growth, a better sign of domestic economic
activity, remains sluggish. All in all, stock valuations
do not seem excessive so there appears to be room for
prices to advance without much help from the domestic
To be candid, however, it is hard to argue that we
are entering a new bull market. Anyone who reads the
daily papers is aware of how many problems there are.
The Fed fights unemployment
and the weak economy with a policy of artificially
low interest rates funded by newly printed dollars, a
tactic that historically has presaged inflation. The
White House has left the burden of repairing the economy
largely to the Fed by pursuing policies that are
unusually hostile to business.
The economic recovery continues at a slow pace as
predicted by many. In the last month or so, it hit
another speed bump. Mortgage processors allegedly cut
corners in registering mortgage papers during the
housing boom, leaving questions as to who owns the
mortgage liens on foreclosable houses. Without an
adequate paper trail to show who owns what, some
homeowners who have not paid their mortgages for up to
two years are contesting foreclosure. This affects
owners of mortgage-backed securities who want to claim
on their collateral, title companies who insured the
titles of the properties and mortgage servicers who must
deal with the homeowners. The result has been a partial
moratorium on foreclosures by the big banks that own the
servicers. This has set back the nascent housing
recovery. It’s a mess. We find it impossible to know how
this will play out. As a result we have lowered our
exposure to the housing sector.
As clients may have noticed, we have begun to
liquidate holdings in fixed income securities. These
provided reliable income during the bad times and
capital gains as the recovery took hold. The Fed's
beleaguered attempt to spur recovery with easy money has
driven interest rates to levels we feel are
unsustainable over time. As we mentioned above, such a
policy is likely to result in future inflation and a
spike in interest rates. We are probably early in making
this call but it is increasingly likely that in a few
years fixed income prices will be down 15%-20%.
We continue to hold positions in natural resources
and other businesses we think can benefit from recovery
of world-wide demand. In addition we watch political and
economic developments closely trying to find stocks with
a compelling narrative that will protect them in this
era of austerity and uncertainty. But most of all, when
it comes to man's best friend, we recommend small dogs.
* * *
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Form ADV II, which discloses important information in
plain English on how we manage client funds and run our
business. You can find the form (technically a
"replacement brochure") in the "Disclosures" section on
our website at www.prherzig.com. Let us know if you
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requires us to ask clients periodically to advise of any
changes in address, financial circumstances, or
financial objectives. Please let us know if we need to
update any information.
Please read our important notice
about these letters and the securities they mention.