Letter - July 2012





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Still Muddling Through

For the third year in a row, early expectations for accelerating growth were dashed as winter changed to spring. Once again the US economy started out strongly only to decelerate unexpectedly. Accordingly, the stock market responded to dashed expectations by selling off from early highs as it did in 2010 and 2011. Volatility has returned, too, with numerous triple digit swings in the Dow Jones Index, up and down. Commenting on the New England climate, a 19th century wit is said to have said, “If you don’t like the weather, wait a minute.” We would say, “ If you don’t like the market, wait a minute.”

Investors are skittish and by now everyone is familiar with the reasons. Uncertainty remains high. Investors, those in the stock market as well as businesses, do not know what taxes will look like in 2013. The presidential election race is close though President Obama and Mr. Romney present radically different programs for what ails the economy and for the role of government in our lives. Europe is struggling with the potential collapse of the Euro; its economy is sinking into recession. Growth has been decelerating in China, crimping worldwide demand. One can make a prediction about how things will develop and perhaps be correct but the reality is that the future is unknowable and uncertain. And the markets dislike uncertainty.

Nonetheless, the market ended June with a rousing one-day 2.5% rally as tentative indications emerged that the Euro-zone would create a fiscal union. In such a union, the strong northern countries would be able to restrain the budgets of the weak southern ones in return for backing the debt of weak banks and sovereign states. Maybe this is the start of something good. But we have seen this movie before and it remains to be seen if real and meaningful policies can be put in place in the face of political opposition. The Germans do not like the idea that their hard earned wealth is to be used to bail out profligate states like Greece.

Part of our strategy has been to invest in multinational companies with low valuations that can improve with the US and international economy. This strategy has admittedly been somewhat disappointing to-date. Since the economic downturn of 2007-09, the US economy has only been able to grow at the most tepid of paces. Growth has been too slow to improve the unemployment rate much. Now, European growth is poised to go negative. As a result, corporations are starting to guide future earnings estimates down, a negative for their stocks. The positive is that stocks are not in general that highly priced. If Europe can get its act together, they are a bargain. For longer-term horizons, investing in stocks at these levels is the best place to be. But patience may continue to be needed. Muddling through the economic crisis could take more time than we would like.

Thoughts on gold. It is not clear at present that the weak banks in the Euro-zone will weather the current storm. Should a rush to withdraw deposits from weak banks develop, the dollar would be a beneficiary in a flight to safety. However, the US dollar is not as secure in the medium run as it might seem in the short run. Looming future deficits funded by borrowing undermines the value of the dollar. We suggest that a run on the banks would create demand for gold. Unlike the paper money the value of which relies on the ability of the government to successfully tax, borrow or print, gold is the only monetary asset that has no corresponding liability. We have raised our exposure to gold mining shares somewhat in the theory that a quickly rising gold price resulting from a flight to safety would benefit the gold miners disproportionately.

One of the bright spots in the US economy is the explosion of drilling for oil and natural gas. Technological advances have enabled oil and gas companies to extract previously uneconomic shale oil and gas at a profit. This newfound resource is having a profound impact on industry. The US is now a net exporter of refined petroleum products coming out of the Gulf coast. New petrochemical plants are being built in the Gulf and Pennsylvania to use cheap natural gas, making the US a low cost producer. A steel plant is going up in the upper Midwest to provide drilling pipe to drillers in North Dakota. All this new activity creates jobs and generates economic growth.

Ironically, for investors in natural gas, the industry success has been too much of a good thing. Excess supply has driven the price of gas dramatically lower in the last nine months. While the oil price is set globally, natural gas is determined by local markets. “Stranded” gas at $2.80/mcf is now selling at a historically high discount to oil and to the $15-$20/mcf gas sells for in Asia and Europe. This creates a tremendous competitive advantage for the US.

While investors have been stung by low prices amidst an oversupply of natural gas, we believe excess supply and low prices are a relatively short-term phenomenon. The cure for low gas prices is a low natural gas price that leads to higher demand. This year alone has seen a dramatic increase in electricity generated by natural gas. We mentioned above an increase in demand from the petrochemical industry. There is some movement to retrofit interstate trucking fleets to run on natural gas.

Now is the time to be invested in natural gas.


Tom Herzig


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