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Our Job: Whether; Market's Job: When

February 13th, 2013

by Bill Smead

of Smead Capital Management

Fellow Investors:

Warren Buffett describes the stock market's purpose as being " a wonderfully efficient mechanism for transferring wealth from the impatient to the patient". We are reminded of this by a series of news reports and commentaries on subjects greatly influenced by basic economics. In today's missive, we consider what the law of supply and demand says about China, oil, and housing in the USA.

Question number one: will China's proliferating debt and Swiss cheese banking system lead to a deep recession/depression and economic cleansing in China?

In a recent report titled, Feeding The Dragon, GMO's Edward Chancellor explains the frailty and danger in China's financial system. Here is his list of problems:

· Excessive credit growth (combined with an epic real estate boom)

· Moral hazard (i.e., the very widespread belief that Beijing has underwritten all bank risk)

· Related-party lending (to local government infrastructure projects)

· Loan forbearance (aka “evergreening” of local government loans)

· De facto financial liberalization (which has accompanied the growth of the shadow banking system)

· Ponzi finance (i.e., the need for rising asset prices to validate wealth management products and trust loans)

· An increase in bank off-balance-sheet exposures (masking a rise in leverage)

· Duration mismatches and roll-over risk (owing to short wealth management product maturities)

· Contagion risk (posed by credit guarantee networks)

· Widespread financial fraud and corruption (from fake valuations on collateral to mis-selling of financial products)

At Smead Capital Management we believe it is not a question of whether China will face a hard landing, it is a question of when. Despite three-plus years of warning from Chancellor, Michael Pettis of Peking University, Jim Chanos, Andy Xie, and others, most investors in the US assume they are wrong or just ignore the risk. Such a myopic view brings to mind Federal Reserve Chairman Alan Greenspan’s 1996 remarks to The American Enterprise Group, where he warned that markets were suffering from "irrational exuberance". He was referring to the building enthusiasm for tech stocks and the US stock market in general. The tech stocks and the S&P 500 index didn't crack until March 10, 2000. However, it would have been wise to heed his warning; US Stocks suffered two 40 percent bear markets, a lost decade, and just recently approached early 2000 levels.

All uninterrupted economic booms culminating in unbalanced use of fixed asset investments have busted in recorded economic history. China's version of economic boom will be no different, in our opinion. Standard and Poor’s reported on the $2.5 trillion of stimulus loans made by the four largest Chinese banks from 2008-2011. They estimated that 30 percent of those loans won’t be repaid. It means that $750 billion of loan write downs are attached to buildings and other infrastructure projects, which have little rent to service debt. If China's four largest banks admitted their existing level of non-performing loans and marked them to the market, we believe they would have negative net worth already. It is interesting that when your regulator is your owner (the government), a blind eye is applied to delinquent loans and property with no rent to service your debts.

Question number two: Will a massive increase in oil supplies, record-setting gas mileage improvements in autos and China's eventual bust cause a big decline in oil prices?

We believe that dramatically lower oil prices are on the way. At the end of 1995, I remember a survey on what mattered to auto buyers. It showed that gas mileage was 24th in importance in a list of 25 automobile attributes. I also remember how popular the seven-passenger Chevy Suburban was for moms with an average of two kids. The gas mileage was about 11 in city and 14 on the highway. The combination of disinterest in mpg and gas guzzling vehicle popularity convinced me that oil prices were ultimately headed higher. A few years later in December of 1998, oil bottomed at $11.28 per barrel of West Texas Intermediate crude oil. It took about the same time to make the turn for oil prices that it did for turning the stock market in the late 1990's.

A recent survey by Consumer Reports showed that gas mileage is at the top of car shopper concerns and Americans have significantly reduced gasoline use for four years. In the survey, 37% of those interviewed thought gas mileage was most important in buying a car. This was followed by quality at 14%. In our opinion, combining the Texas oil boom with the Bakken field/Canadian shale oil boom and you’ll have the Malthusian Peak Oil theorists headed for another crushing defeat. Lower oil prices are a matter of “when” not “whether”, in our view.

Question number three: Will the aging of the “echo boomers” trigger a strong enough housing cycle to return the US economy to normal?

A number of sources have estimated that echo-boomers make up over 25 percent of the US population (people between the ages of 18-35). What do we know about people with and average age of 28? First, they form households. The Department of Labor reported recently that in the year ended September 30, 2012, 1.15 million new households were formed in the US. This was up from an average of 650,000 over the three prior years. As of the 2011 Census, men marry for the first time at an average age of 28.9 and Women marry at the average age of 26.9. Second, the mid- 20’s is the beginning of most of the baby making among married couples in the US. The average age of a first child for married couples in the US was 24.9 in 2009. Third, the baby causes the family to want a stand-alone home. And fourth, the first baby and affordable stand-alone home causes the demand for roomier and multiple automobiles.

We know that the financial meltdown of 2008 and high unemployment of 2009-11 pushed back marriage plans, baby-making, and first-time home buying. We believe it has laid the groundwork for the unleashing of “pent-up” demand for houses and family-oriented vehicles. Housing and autos are the traditional drivers of US economic growth. Blue collar labor is integrally tied to home building, building materials, home furnishing, and auto manufacturing.

This is the first recession in our lifetime whose recovery was not led by housing. In 1977, US census data showed that the US population was around 220 million. Single family housing starts in 1978 were over 1.4 million. In 2011, the US had 315 million people and 430,000 housing starts. The overhanging supply of foreclosed homes is disappearing as housing starts are exceeded by household formation. Therefore, we believe it is only a question of “when” single family housing starts exceed one million and not a question of “whether”.

In summary, we at Smead Capital Management believe that China will land hard, oil will decline in price and housing will make a comeback. We don’t get to know exactly when and will remain diligently patient for the markets to render their timing. We believe that the US economy is the place to be the next five to ten years and domestically-oriented common stocks will outperform those predicated on continued success for the emerging markets like China.

Best Wishes,

William Smead

The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

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