Letter - July 2013

 

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Paroxysm

In mid-June, Fed Chairman Bernanke gave a press conference in which he discussed the conditions for tapering back and eventually ending monetary easing. The bond and stock markets reacted with a paroxysm. Markets worldwide sold off feverishly. In truth, we were surprised at the ferocity of the moves. Where was the new information to make markets move? Why the surprise? Many, including ourselves, had been writing for a good deal of time that bonds were vulnerable to rising interest rates as the Fed was unlikely or unable to keep rates artificially low forever. It is striking that the markets did not better discount this inevitability.

Soon after the press conference, members of the Fed were rolled out, one by one, to assuage investors with calming assurances that monetary easing was contingent upon the economy and employment growing more robustly. The implied idea was that if the economy got strong enough, it would support the stock market even in the face of rising interest rates. Indeed, the recent, encouraging employment figures suggest that this may be the likely outcome. For the time being, the coordinated, full court press has quieted the markets’ nerves.

There seems to be a consensus that the economy will begin to accelerate into 2014 and unemployment will continue to trend down, a good thing. But noticeably absent (despite the easy money policy at the Fed) is the willingness of companies to buy more machinery and expand capacity, that is, to increase capital expenditures. Instead, many have been buying back large quantities of their own stock. This boosts earnings per share, rewarding shareholders, even though revenues and aggregate profit growth are sluggish. Others are raising dividends, providing more up-front cash income for their investors. Apple recently borrowed a huge amount of money at record low rates in order to pay a large dividend to its stockholders. This is good for investors but provides limited stimulus for the real economy, which as a result is likely to grow more slowly than in past recoveries.

The question of the day is: How is the Fed’s easy money policy working? The answer: Not so well. The Fed has been buying government and mortgage debt in unprecedented size from the banks in order to keep interest rates low. The cash that the banks get from selling to the Fed is supposed to go towards increased loans. However, a combination of slack corporate demand and higher credit standards particularly for mortgages has created a situation where excess liquidity does not circulate through the economy. Regulatory issues and an excess of caution (the banks have been demonized for poor risk management) have contributed to slow loan growth. Consequently, the banks deposit their excess cash at the Federal Reserve instead of lending it to business and homebuyers. This is what John Maynard Keynes called the “liquidity trap.” Despite the low level of interest rates, a combination of a limited availability of credit and a limited demand for credit has restricted growth.

Between last November and May of this year, stocks and bonds rallied smartly as stimulus meant for the economy went into financial assets instead. After a sharp selloff in June, stocks have recovered to their May highs while bonds remain depressed, taking their cue from a perceived shift in the Fed’s easy money policy noted above. In order for stocks to continue higher, corporate revenue growth will have to accelerate. This will require a faster growing economy. A failure of the Fed’s easy money to stimulate growth would be bad for the stock market. We are in uncharted waters. Be prepared for more market paroxysms.

Meanwhile, bonds continue to be unattractive. Interest rates are unnaturally low (and prices unnaturally high) due to the repression of rates to artificially low levels by the Fed’s easy money policy (Fed buying pushes up prices thus lowering yields). While rates may rally or sell off from these levels in the short-term, the long-term trend is up and bond prices down.

One puzzling and interesting development during the previous quarter is the sharp sell-off in gold and the absence of inflation despite the unprecedented printing of money by the Fed. One observation is that inflation has been constrained by the long-term trend towards globalization, which has directed economic activity to countries that have lower labor costs. This benefits consumers and constrains inflation by keeping prices low. Walmart could not offer "Every Day Low Prices" without free trade.

That inflation has remained low is also due to excess capacity in labor markets, which keeps wages low. So far, the unemployment rate remains stubbornly high and the percentage of the population that is working is near historic lows. There is currently no fear of wage inflation in the US labor markets.

Since November 2012, gold has declined 30% but we believe it is still in a long-term bull market. There is a precedent for this. In 1975-1976, gold fell 50% from $200/oz to $100/oz before surging 800% in the ensuing years as inflation came surging back. We are not suggesting such a surge in gold again. However, we do believe that eventually the Fed’s unprecedented printing of money will be reflected in higher inflation and a higher price of gold in the not too distant future. Investors should not sell gold or gold mining shares at this time.

Tom Herzig


 

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