by Christopher Sumner and Tony Allison, PFS Group. October 27, 2004
Mike Hartman is not feeling well lately and we want to wish him our best. Mike’s editorials have been excellent and a great source of information. Mike’s work often addresses the fixed income market and we would like to make some comments later regarding recent events to honor one of our respected writers.
As the new guys at Puplava Securities, we’re honored to write for a website from which we both learned many important concepts in the past. Jim’s (Puplava) comments were greatly beneficial when we were at a larger and more traditional investment firm. At the time we questioned traditional investment methodologies at larger broker/dealer firms that often failed to identify many areas of opportunity (value) as well as potential risks for a variety of reasons. It is human nature to resist change and we saw many larger institutions (like ours at the time) suffering from a group mentality that we believe is ineffective in identifying structural change or new secular trends.
As a value investor it's common to see value in asset classes based upon sound fundamental research where much of the public investment community follows trends long after the cycle has changed. This can be seen in the psychology of investment advisors accepting the current US government, corporate and personal debt levels as status quo while not noting the recent rise in tangible assets or "things." Jim Puplava’s The Next Big Thing was the first of many editorials that opened our eyes. You could say Jim’s show led to a crossroads event in our professional investment careers.
Modern Portfolio Theory Measured In An Inflated Currency
The summer of 2002 was a time when fear was gripping the markets. During this time we began to look at investments from a value perspective (Graham/Dodd) rather than the scientific or “sophisticated” asset allocation models widely accepted by many advisors and clients today. We questioned the accepted investment thesis as we observed fixed income returns (not including the asset value lost by most stocks) that were wiped out in nominal terms as the US dollar fell relative to most currencies and commodities. The investment thesis of many larger firms today subscribes to a strategy focusing on past mathematical results rather than fundamental analysis and identification of intrinsic value.
Harry Markowitz published his doctoral thesis in 1952 and later received a Nobel Prize in economics in 1990 for his work (now known as Modern Portfolio Theory) defining risk as a standard deviation of expected returns. Without getting into the specifics of this theory we can see that historical returns are often quantified in U.S. dollars. A “Monte-Carlo” simulation analyzing the past 20 years would not recognize that the U.S. currency is backed by a nation that has gone from net creditor status in 1984 to history’s largest debtor nation today, or the relationship between interest rates, deficits and foreign exchange rates.
We’d love to play golf and sleep soundly with the comfort of a standardized theory watching over us, but in today’s markets MPT is not exactly working. The S&P 500 Index is trading roughly around the same level as 7 years ago, with dividends and potential bond returns wiped out by a depreciating US dollar and inflation. Therefore we believe history may show that an investment thesis focusing on past mathematical results rather than fundamental analysis and intrinsic value may be the least conservative strategy.
“The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.” ~ Warren Buffett
How does this trend in investment management at traditional or larger firms relate to your strategies? Simple. Potential opportunities in other asset classes exist because they may have been overlooked by Modern Portfolio Theory. Natural gas may be going up from rising demand, decreasing supply and inflation. Thus an investment in this area has performed well (Amex Natural Gas Index - $XNG) because the investor sees intrinsic value rather than “non-correlation” to another asset class. Today the S&P Barra Growth Index holds just over 1% in energy. Do you think the chart below looks like a growth trend?
The study of markets reveals a history of intervention, speculation and collaboration. A theory written in 1952 may not be able to explain the levels of US debt held by foreigners despite the poor fundamental economic condition of the US government and many of its corporations and citizens. At the end of the day any stockbroker, manager or advisor (whatever the term) is paid either a commission or fee with the assumption of managing risk – seeking assets that may have more intrinsic value in the future. An objective advisor should openly consider all asset classes (not just financial assets (i.e. art, real estate, stamps, coins, etc…) as part of a complete portfolio.
Consider Your Source
Jim Puplava has discussed many of the investment banking firms “pumping and dumping” the junior mining stocks in the gold sector. The mass psychology among financial advisors or research from traditional sources should additionally be questioned if given from a source that may benefit significantly from underwriting debt or equities. It is important for investors to recognize the potential conflict of interest when looking at any opportunity. This means you do not necessarily have to question the integrity of the individual recommending a potential opportunity (mortgage broker, financial advisor, real estate agent, business partner, etc…) but rather their consideration of the environment and their competence (acceptance of a theory or asset class without proper due diligence),
“The ability to say no is a tremendous advantage for an investor.” ~Warren Buffett
Anyone seeking safety and income in today’s market should consider the fundamental environment. Our comments regarding our experience and the investment thesis readily accepted at larger firms are not intended to slander those institutions but rather to aid the smaller investor to question the suitability of investments which may have significant interest rate risk, credit risk or currency risk.
During this past summer, Chris received a recommendation to purchase municipal bonds by his former firm as California debt had been “upgraded” by the S&P. Given the record low rates (unbelievable bond prices) and significant levels of California debt in the inventories of firms that underwrite the new issues, one may naturally ask the following questions:
- Does the State benefit from restructuring new debt at the current low yields?
- If bond prices seem high does this aid the holder to move the existing inventory?
- How is the economic situation of the municipality (Credit Risk)?
- What type of pressure will rising interest rates have on this bond (Interest Rate Risk)?
- My bond will pay me tax-free dollars. What is the projected rate of inflation over x-years?
Mike Hoy’s editorial “The Coming Bond Debacle” gives us a pretty good historical precedent for the significant losses bond owners suffered in the later 1970’s. However, today’s investors face potential risks that may dwarf the losses Mike references in his editorial. In the 1970’s the US was a creditor nation with significantly less leverage in our financial system. One might not be able to even comprehend the quantity of derivatives in the system, but it doesn’t take a rocket scientist to envision the potential risks to other highly interest rate sensitive areas like real estate.
History In The Making
Mike Hartman routinely commented on the new issues of government debt to prospective buyers. The U.S. Treasury is auctioning significant new issues of debt on a routine basis. The Fed can also continue to monetize debt (federalreserve.gov) in the short term but in the long run no player is bigger than the market.
Summary: Any allocation seeking “safety of principal” or “income” in US dollar denominated bonds (especially with longer maturities) may present an extreme amount of risk to an unknowing investor. A sixty four year old couple may see much of their wealth confiscated due to interest rate risk, credit risk and most importantly currency risk. A “modern” portfolio theory (possibly an oxymoron in the future) may not explain why the 10-year Treasury bond is selling at these prices (low rates) given the deficits, falling U$D and new highs in commodities (inflation).
We feel investors will look back at the following four charts and see what could be a “sophisticated” or “conservative” strategy (based upon a certain type of model) to be the most dangerous choice. We believe the conservative strategy is to consider “alternative” asset classes such as energy, water, food, gold or silver investments to protect your wealth from excessive debt in the US financial system.
Will we see the 10-year Treasury bond yield test 3.7%? If we do, we guarantee we’ll get a newsletter telling us the bond market looks “deflationary”… The history of manias has taught us events in the short term may be significantly inefficient (not believer’s in the Efficient Market Theory) thus owning a 10-year US denominated bond may be totally mad, much the same as paying $700K for a home near our office in San Diego. Any “Advisor” who doesn’t see the potential risk/opportunity in the following charts may be watching too many “reality” shows:
Many “contrarians” writing investment newsletters will tell you to trade and make numerous short-term calls regarding many market movements. In the end the big picture is paper (U$D) has been falling relative to tangible assets and the bond market is showing surprising strength despite record crude oil prices (among other indicators). Remember, there is a clear difference between a trader and an investor. Few people can successfully trade their entire positions, so a prudent investor should consider core positions in investments that they see having intrinsic value in the future.
Changes Ahead: Greed Back To Fear
We addressed the summer of 2002 for a specific reason. Anybody invested in traditional broad market stock funds was seeing significant selling pressure resulting in fear (note VIX in 2002). A “Wealth Management Advisor” investing OPM (other people’s money) might not have noticed the stealth bull market in tangible assets, when the inflation calculations may be inaccurate due to historical modeling or government statistics that might also be less than accurate.
“Be fearful when others are greedy and greedy only when others are fearful.” ~ Warren Buffett
In the end we agree with likes of Warren Buffett, Jim Puplava, John Embry, Marc Faber, Jim Rogers, etc… All these men have written issue editorials warning of the potential risks to the financial system and currency risk (U$D). These forward-looking individuals, seeking a conservative way to protect their wealth or the wealth of their clients or shareholders, have outlined the risks we see ahead. These rare individuals seek conservative ways to capitalize from inevitable changes. The only question is whether other investors or advisors will learn and capitalize from change rather than resist change.
The following chart clearly illustrates our fear for an "economy that is driven entirely by credit… Because of the drastic ramifications of contracting credit, the Federal Reserve will always favor credit expansion.” 
Understanding Wall Street: Psychological Public Change Towards Safety Of Principal
When completing our training we noted a box of old books being set aside for the recycling bin. Unfortunately, we only took one copy of this book first published in 1978 (Understanding Wall Street by Jeffrey B. Little and Lucien Rhodes). Many of the topics covered today are considered to be “outdated” or no longer considered suitable by the larger investment firms. We did notice a couple of interesting areas, which relate to this editorial, which I hope, might highlight some of the challenges when solely relying on advice within the Wall Street hype:
“Treasury Bill ~ Smallest degree of risk. Only the government has the power to print money. The return is usually just enough to offset inflation.”
“Savings Accounts ~ Greater risk than government bonds, although funds are insured by the government. Little protection against higher rates of inflation.”
“Selection and Timing ~ To be successful on Wall Street, every investor must find a satisfactory combination of two key variables – investment selection and timing.”
“The CRB Index, along with the prices of gold, silver, and oil, are also excellent indicators for measuring inflation” (in addition to the CPI and PPI).
Three key points were noted from much of this book:
- You can see the authors still remembered the higher inflation rates of the ‘70’s and early ‘80’s. Many financial texts today rarely consider the words “print money.”
- The book has a separate chapter for gold and silver. Today precious metals are considered “speculative” and the psychology evidently changed as the commodity chart was removed from page C1 (Money and Investing) of the Wall Street Journal (no longer showing the $CRB going up visually) this past winter.
- Today’s allocation strategies contradict statements in this book (market timing). It appears from the chart below asset allocation is readily accepted rather than “stock selection” or as we like to say “thinking.”
Source: "Determinants of Portfolio Performance", Brinson, Hood & Beebower, Financial Analysts Journal
Financial cycles change much like the seasons and the “experts” aren’t always on Wall Street. Chris met a guy in his gym telling me to “buy gold” in 2001 and thought he was a mad man at the time. Eventually his thesis and fundamental reasons seemed overwhelming. When the bulk of advisors are speaking of currency debasement or gold funds we’ll soon have to look at locking in gains, but for now the asset class is largely considered “not suitable” or “non correlating” by a large group of experts who may have been watching cartoons like “Rocky and Bullwinkle” during the last commodity bull market in the 1970’s.
The current anomaly in bond prices and inflation may not last long. New readers should review Jim Puplava’s Storm Watch Updates and his editorials titled The Perfect Financial Storm – Financial Storms Heading For The U.S. Economy. Jim often uses an analogy of the perfect storm from a sailor’s perspective. Anyone who’s been out to sea knows the motto of the U.S. Coast Guard is Semper Paratus or “always ready”.
We see ourselves helping our clients to be ready for a potential inflationary storm that may also see eventual deflation in anything associated with excessive debt levels. Much like the US Coast Guard, we hope to help those in harms way. The foundations of historical models or theories may not account for the coming challenges to a currency or excessive debt levels. Many elderly people seeking wealth preservation may get lost in the hype and current complacency given today’s anomalies. You can trade but we feel it’s important to understand today’s economic fundamentals and accumulate a position of assets, which historically protect and preserve wealth during financial storms.
The initial phase of the bull market in “things” has begun. Are you ready for the next leg?
There is no shortage of interesting events going on in the world today. The big story today was "plunge" of oil prices and "surge" of stocks. How nice before the elections. The Associated (collaborated?) Press ran stories entitled "Oil Prices Plunge on U.S. Inventories" and "Stocks Extend Rally As Oil Prices Plummet." Looking at Ike Iossif's charts yesterday I can only assume the term "Extend Rally" relates to some other index than the S&P Large Caps or the Dow Jones Industrial Average because we don't see an "extended rally."
It appears U.S. Commerce Secretary Don Evans also has informed us, "There's no reason to be alarmed about the trade deficit." However, Reuters did report the "The government said last month the shortfall in the current account -- the broadest trade measure since it adds investment flows -- hit a record $166.18 billion in the second quarter."
Finally, the Fed got into the mix as well (why not during this critical week) and reported "U.S. Economic Growth Is Continuing In Spite of Rising Energy Costs." It's nice the Fed isn't worried, but the beige book did quote "Firms across the nation also expressed concern about higher input costs, particularly for energy and petroleum-based products, metals, and construction materials."
Interesting when we see the following headlines:
P&G, Unilever Facing Rising Prices - Associated Press – Wed 1:45 pm ET
Conoco Phillips Reports Jump in Earnings - Associated Press - Wed 1:34 pm ET
Blue Chips extended the "two day rally" and the Dow Jones Industrial Average closed above the 10,000 mark for the first time since Oct. 13, up 113.55 points, or 1.2 percent, at 10,002.03. Today was the second consecutive day of triple-digit gains for the blue chip barometer - the last time that happened was early May 2003. The Standard & Poor's 500 added 14.31 points, or 1.3 percent, to 1,125.40.
We suppose anything is possible (Red Sox winning tonight's game would be a blessing to a native from the Bay State) in the short term as we might see more stories from the press or Wall Street experts explaining how it's different this time. We hope you enjoy the short-term spin but keep your eyes on the larger picture (charts above).
Lost in all this optimism is "Iran Threatens To End Nuclear Talks" by SUSANNA LOOF, Associated Press writer citing Iran's "supreme leader threatened to pull out of negotiations if European countries press their demand for total suspension of uranium enrichment." At the risk of sounding like preachers of "Doom & Gloom" we'll leave you with one final Buffett tenant:
"It is optimism that is the enemy of the rational buyer." ~ Warren Buffett
Speaking of the Coast Guard, their website cites the following historical event 7 years ago today: 27 October, 1997- "The crew of the CGC Baranof confiscated two .50-caliber sniper rifles, ammunition and other military supplies that were allegedly to be used in an assassination attempt against Cuban President Fidel Castro. Four Cuban exiles were arrested for illegal possession of firearms after the 46-foot La Esperanza was ordered into Aguadilla, Puerto Rico, by the Baranof. There a search of the vessel turned up the weapons. One suspect confessed that the sniper rifles were to be used to assassinate Castro on his arrival on Venezuela's Margarita Island for the Ibero-American Summit Conference. A magistrate in the U.S. District Court in San Juan later dismissed the charge of conspiracy to assassinate Castro but let the charges of illegal importation of firearms and making false statements stand."
This historical event is interesting given the following story yesterday:
Tue Oct 26, 7:30 PM ET
By ANITA SNOW, Associated Press Writer
HAVANA - Communist Cuba said "adios" to the Yankee dollar that shored up its struggling economy for a decade, launching a two-week process Tuesday to eliminate the U.S. currency from circulation in its stores and businesses in response to stepped-up American sanctions.
Go Red Sox (Chris)!
 Jim Puplava, The “Carry Trade Economy” - Borrowing Short - Investing Long, Aug 4th, 2004
Christopher Sumner & Tony Allison
© 2004 Christopher Sumner