Letter - March 2013

 

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Damn the Torpedoes, Full Speed Ahead

So said Admiral Farragut, perhaps apocryphally, as he swept into Mobile Bay in 1864 to capture a Confederate port. Investors would have been wise to heed his words and example over the last number of years as they fought the battles of Bear Stearns, Lehman Brothers, Greece, the Euro melt-down, the fiscal cliff and now the battle of Cyprus.

Investors finally seem to get it. Policy fatigue has set in. Over the past four years, many investors focused on policy decisions in Washington as a reason to sell. A dysfunctional Congress appeared to be the gang who couldn’t shoot straight. Now the investors seem to have come to the conclusion, that as long as the Fed keeps money cheap, policy in Congress does not matter much. “Let's get on with our lives”, the market seems to be saying. If AT&T yields 5% and ten-year treasuries yield 2%, let’s not get too analytical about it; AT&T gets my money.

The market had a good year in 2012 and is off to a good start in 2013. The notion that stocks with growth and/or high dividend yields is the place to be is starting to go mainstream. This is luring individual investors reluctantly back into the market. It is a slow process but could underpin the market for some time.

In each of the past three years, the market has rallied into the spring only to be followed by a sharp sell-off. Could this be the fourth year in a row to follow suit? It is not unimaginable given the advances so far this year and the abundant macro problems still unresolved. But longer term, we feel that the flow of money will continue into stocks. If there is a bubble forming, it is in its nascent stage. Mr. Bernanke is on record at a recent press conference saying that stocks remain safely within a historical range of valuation. Some even predict that there could be a “melt-up” in stocks should investors fearful of missing a market surge capitulate and pile into stocks indiscriminately.

The crise du jour, Cyprus, is an interesting situation. The banking system there grew to extraordinary size for such a tiny country on the back of huge Russian deposits. These deposits in turn were invested in Greek government bonds, which collapsed in price as it became clear Greece was broke. This subsequently wiped out the capital of the Cypriot banks along with a substantial part of depositors' money forcing the banks to close or otherwise face a panic of withdrawals. Pity the poor Cypriots who are limited to withdrawals of only about €150 a day, that is, if they can find an ATM that has any cash available. Commercial transactions and trade are grinding to a halt.

Any banking system is built on a foundation of trust. Depositors need to have the confidence that they can access their money on demand. If that trust is violated and depositors seek to withdraw their money all at the same time, the system is unable to deliver and shuts down. The situation in Cyprus is sure to be a wake-up call to depositors in weak European banks, particularly Spanish and Italian ones. So far, contagion has not spread beyond Cyprus, the argument being that the country is too small to do damage to the Euro zone. But trust and confidence are fragile qualities. The system remains vulnerable.

During periods when confidence erodes demand for gold typically grows. Gold is a safe haven asset that investors seek because it is money that exists outside of the financial system. Banks generally do not take gold deposits and lend against them as they do with cash deposits. We continue to hold investments in shares of gold mining companies as a hedge against an erosion of confidence in both the soundness of banks and the purchasing power of paper money.

In the meanwhile, we continue to follow the advice of the good Admiral Farragut, though we remain watchful for bubble valuations that easy money may encourage.

* * *

The SEC requires us each year to offer to clients our Form ADV Part 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 would like us to mail you a hard copy.

Tom Herzig


 

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