Of Mice and Men
Corby Asset Management
By Michael Shamosh
July 3, 2012
We have all spent our share of time at amusement parks. We always marvel at the degree of engineering required to subject the human body to stresses not present in our ordinary day. These stresses can be thrilling or exhilarating, or frightening and painful, depending on your emotional framework. Those screams mean something.
Investing is often described as similar to riding a roller coaster, where the rapid ups and downs can subject one’s emotional framework to feelings of exhilaration, fear, and pain. In this newsletter, we liken it to a ride called the Wild Mouse, one you might have spent some time on in your youth. The Wild Mouse, as we remember it, was a type of roller coaster where one sat in a car that held two people, unlike the traditional multi car coaster. The cars were wider than the narrow track so you had the feeling of being suspended in mid-air. The track wasn’t visible from your seat so the twists, turns and drops came suddenly and subjected the rider to forces that were magnified even though the ride’s speed wasn’t all that fast. It was the seeming suddenness of the moves and their unpredictable nature that provided the thrills. A philosophizing parent might use the ride as a metaphor for life: you don’t know what’s coming, so hang on and enjoy the ride. For investors, it’s often more a matter or endurance than of enjoyment.
Unlike the Wild Mouse ride, a traditional coaster provides a line of sight into the drops and turns. You can see where you are going and the thrill is as much from the anticipation as from the movement. But investing is more like the Wild Mouse than a traditional coaster, where the views from our small car don’t allow much preparation for the next move. They arrive by surprise unless one carefully views the track beforehand and commits the layout to memory.
The Twists and the Turns
In the very recent past we have witnessed another in an endless series of market twists and turns based on monetary policy as set by the Federal Reserve. Here is the chart of the Standard and Poor’s 500 index over the previous two months.
Standard and Poor’s 500 Index: May 1, 2012 to Today
After a ride down in May, as economic reports disappointed investors, we began the ride up in June as speculation developed that the Federal Reserve would pursue a third round of “quantitative easing,” which is basically opening up their electronic wallet to go shopping for bonds in the banking system. The injection of cash promotes speculation and, at least in the first two rounds, raised asset prices. One could argue that these cash interventions distort asset prices and raise the prices of commodities, thus picking the winners (those who own the assets) and the losers (those who are hurt by higher food and fuel prices).
The speculation didn’t end well, as the policy of the central bank was a “wait and see” on new asset purchases (QE3), while continuing with the program known as “Operation Twist” (another form of price controls on the Treasury bond market). Essentially, the Federal Reserve has opted for this policy of selling the short-term bonds in their portfolio and buying long-term bonds, thus “twisting” the yield curve down at the longer maturities. This was not what the speculators had hoped for, and the indices went down sharply after the Federal Reserve announced an extension of this policy on June 20th. More recently, developments in Europe are creating sharp twists of their own.
One doesn’t know what some government might do next. In the past we have made it clear that the financial crisis of 2008 ushered in a period of greater centralization of the economy as policy makers attempt to avoid the pain of market adjustments by tinkering with various policies. The fundamental economic backdrop is one where prices of many goods and services are soft. This is somewhat different from the period in the 1970s where inflation was the dominant theme. Then too we had a series of policies that attempted to thwart the natural market forces. There were “WIN” buttons, (whip inflation now), and wage and price controls that were used in an attempt to centrally manage these primary forces. None of this worked, and it took the pain of seriously high interest rates and a recession, followed by deregulation, to ultimately subdue the problem. The end result was two decades of prosperity.
In the 1970s you could earn a very high return from a money fund or a short term bond. It took until 1986 for Regulation Q to be repealed, an act that had regulated deposit rates since 1933. We live with the consequences of those decisions today as banks compete for deposits via an apparently competitive rate structure. We say apparently because the rate structure is now largely set at the central level using the mechanism of operation twist and the policy of keeping short-term interest rates at zero percent.
The lack of yield from these traditional risk-free investments is forcing investors to make the choice between sleeping well and riding the Wild Mouse. Many are choosing to leave the park altogether, and are withdrawing or finding solace in structured products like annuities. This is understandable, as our investing generation has seen its share of sharp dips and gut wrenching curves during its time. Now many just want off the ride.
Keeping Your Hands Inside the Vehicle
The fact is, as soon as you started saving you bought your ticket to a ride on the Wild Mouse. You can try to get off, but you only increase the chances of injury. Today’s money system is unfixed by tangible assets. The prevailing central planning theme is to tax financial assets by keeping returns below the rate of inflation. A bank account maintains nominal value but declines in real value when the inflation rate is greater than the deposit rate. This helps governments and banks, arguably the two most financially mismanaged sectors of our economy. The elected version of this duo appears wedded to spending money it doesn’t have while the other maintains its share of the nation’s product by continually threatening us with financial disaster unless we pay up.
All this government and financial intrusion warps and frustrates the market’s job of pricing risk. In a previous letter we wrote about the growing lack of a risk-free rate as a measuring stick. By absorbing the risk of failed institutions and the deleveraging process in our economy, the government has become a source of risk itself.
Building a Faster Mouse
By creating new money used to purchase government debt issued to fund the U.S.’s large deficit, the central bank has increased the chances for a bout of inflation. Perhaps that is what the authorities want, since a large debt load can be reduced by inflation in real terms. All that is needed is a bit of velocity for the inflation to set in. Velocity is the rate at which money in circulation is used for purchasing goods and services. Essentially, it is a measure of turnover of the nation’s money stock. In ebullient economic times, it rises as people feel more prosperous and spend. Think about the late 1990s. In depressed economic times, spending diminishes and there is the “money in the mattress” syndrome. Think today. The chart below tells the story.
Velocity of Money M2 Money Supply: 1959 to Today
1960 1970 1980 1990 2000 2010 *2012*
You can see that the velocity of money today is at a 60 year low. It might stay here for a while, but when it moves up there will be a great deal of money entering into an economy that is not prepared for it, and that could push the Wild Mouse to a speed too great for its track. Inflation could rise dramatically. We wish we could predict when this might happen, but instead we can only tell you that unless the current system is reformed, we see it as the most likely outcome.
Of Mice & Men
The financial and money system as it is currently structured does not permit one to stand around and watch forever. We wish we could offer investors a product that provided with certainty a clear and concise path to emotional peace and financial prosperity. The fact is, to generate any return, one has to take risk. If you do not want risk, the only thing currently offered to you is a negative real return on your savings.
In the recent past we have invested in natural resources, as the growth sectors of the world, (mostly China and India), consumed them to build infrastructure as they modernized their countries. While reliable information is difficult to attain on these nations, we note that their stock markets have fallen along with their reported economic growth rates. With that, commodity prices have fallen, a typical occurrence during a cyclical downturn. We did reduce our energy holdings, mainly in the natural gas area, as there was a rapid price decline following the warm winter coupled with the technology of fracking which produced a serious glut.
Energy extraction was always a technology driven industry, but the new methods being developed today could possibly be the beginning of a structural change that could produce cheap energy in this country for many years. There are many environmental concerns and the wells can still decline rapidly, but nevertheless, the promise of cheap and abundant energy might be a new source of vigor for future economic growth if it continues to develop on this track. At this time the electric power industry is switching from coal to gas rather quickly where it can, thus sucking down some of the surplus gas supply. According to the Energy Information Administration, utilities were generating about 20% of their power from natural gas just last year at this time. That percentage has now increased to 30% and is rising rapidly still. While natural gas storage levels remain about 26% higher than last year at this time, the economy, as it is apt to do, has found more use for natural gas, easing the glut a bit for now.
We have held onto some of our Canadian energy holdings as we still see value in owning large supplies of oil in private, politically reliable places. This is important as countries recognize the strategic nature of petroleum reserves. Recently Repsol, a large Spanish oil company, had its operations in Argentina expropriated. Fracking can release oil from shale and other domestic sources, but that is not yet being accomplished in large amounts. Still, we like the potential of this technology and recently purchased a European company that makes the fluid necessary for fracking. There are also some service companies that perform the fracking and cleanup, but for now we feel more compelled to own the resource while we monitor this area closely for new investment opportunities.
The current economic softness in the U.S., which may be a precursor to an economic recession, is being masked by developments in Europe. One can read the daily pronouncements, listen to the rumors, and feel a bit better about living on this side of the ocean. Yet you cannot simply trust feelings when it comes to investing. Everybody is entitled to their own feelings, but not their own facts. While it is true that the European economy and currency system are a mess, it is also true that several hundred million people are getting up each day, turning on lights, eating and going about their business of living. Many of Europe’s basic businesses are selling at discounts to tangible value. They may get cheaper on sentiment but one should never use current sentiment or pricing and assume that it will last. You are seeing them near their worst and, when the situation is cleaned up, their businesses will suddenly appear better. We are gradually adding there, albeit slowly, as we view the yields and valuation of quality businesses there to be better than most elsewhere at the moment. One of our recent additions is a holding company whose assets are composed of the equities of other European companies. One can purchase the company at a discount of roughly 25% to its liquidation value. We’ve purchased utilities and chemical companies as well. That may sound boring but it’s basic. We are well aware of the currency issues but we believe the assets of these businesses have value independent of any currency regime. That being said, currency fluctuations over the short-term will add volatility to the prices of these businesses in dollar terms, so a good amount of patience is required while the situation with the Euro gets sorted out.
Wealth is built brick by brick over a period of years and not necessarily in time frames that always suit our needs. The monetary injections in this country have created a casino-like market, where quick money could be made by investing in the latest bubble and where we are left to pick from what we see as a highly priced market. The best long-term managers look for value and are patient. Investors would love a quick fix, but managers can never “know” what the next hot thing might be, or what will increase in price and when with any degree of certainty. So our strategy is to use cash flow as the short-term reward, something that we can reasonably rely on, and to generate that cash flow through assets that we expect will appreciate over time. The patient, gradual approach we take is slow-moving traffic but keeps us from chasing someone else’s tail and risk getting trapped.
Not every time period can be profitable even when the major indices rise for a time. That can be the result of the performance of a few stocks or groups of stocks in the index that have outsized weightings. If we own a sector that is not in favor at the time, or undergoes a shift in sentiment, our performance will be less than the averages as it has been recently. We do not like underperforming, and we certainly do not like to have losses, but we believe that investing success is not made by going where things are hot at the moment, but rather where investors need to be over the years. Given what we see happening globally, we prefer to stay patient and be a bit more defensive while we wait for opportunities to present themselves.
We hope you realize that we are riding the metaphorical “Wild Mouse”, and are not on the ground watching. You pay for a ticket with your patience and fortitude. Watching costs nothing. In the end you get what you pay for.
We thank all of our investors for your patience, trust, and continued faith in our management.
Portfolio Manager and Chief Investment Strategist
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