Golf - Celebration - Inflation - Deflation - Beware of Crooks

Golf - Celebration - Inflation - Deflation - Beware of Crooks  (Printer Friendly Version)

Kendall Anderson, CFA July 5, 2008

Just a few weeks ago my wife, my in-laws and I took a short trip to High Point, NC for a very special event: the induction of my brother in-law, Greg Reynolds, into Golf's Senior Amateur Hall of Fame. This was not the first Hall of Fame induction for Greg. He was also inducted into the Michigan Golf Hall of Fame in 2003 and the Greater Flint area Sports Hall of Fame in 2004. Greg has played in over 30 USGA events, and he captured the 2002 USGA Senior Amateur Championship and placed second in the same event in 2004.

I met Greg while he was still dating my wife Kathy's sister. He had never played a round of golf, and in fact I can't remember him even talking about golf until after he moved to Michigan to work for General Motors. I myself tried playing once and it was one of the most frustrating activities I have ever attempted.   It seems you can never have a perfect game: each hole is different, each round is different, and in fact each swing is different. Yet the game goes on, and the only thing that counts is the final score: the total score of all the strokes, good and bad.

Greg must have some natural ability in playing the game. However, I don't believe natural ability is what earned him the recognition of his fellow golfers, nor is it what earned him the national championship or the Hall of Fame. I believe it was his deep desire to play the best he could, and also his ability to overlook the volatility of his rounds knowing that, while each stroke was important, it was only the final total score that counted.

It's the knowledge that the total score, independent of the bad drive or the missed putt, is what counts in the end. In this light, golf is very similar to investing in stocks and bonds. Volatility is part of the game and cannot be avoided if you are looking at keeping up with the markets. June was a very difficult month for anyone who is invested in common stocks. It is easy, given what has happened to our stocks, to ask ourselves, "Shouldn't we be doing something about this?"

DALBAR (a research firm concentrating on mutual funds and their investors) has shown in study after study that individual investors are their own worst enemy. Their last study on mutual fund investor behavior covered a twenty year period ending on December 31, 2007, and reported that the average equity fund investor earned an annualized return that trailed the returns of the S&P 500 by over 7% per year. This 156% underperformance was directly related to switching funds and strategy over the years. In other words, when the market was most volatile, the average investor believed it was important to "do something about it," and therefore switched from stocks to bonds or cash after negative volatility and to stocks after stocks have produced positive volatility. This is the exact opposite of what we know should be done: Change may be necessary, but your decision should be made with the final score in mind, not today's market price.

It's time to celebrate America!

July 4^th marked the 232^nd birthday of this great country. In this time of political election process, market turmoil, international unrest, an economy that feels as if it is in a recession, a falling dollar and rising inflation, it is time to refresh our memory of where we stand in this world. Let's start with a review of Europe.

Britain's housing market is a full year behind our own problems. Their political parties are in complete disarray without ideas on what to change. Their problems are not going to be solved quickly and will most likely take longer to solve than our own.

France is seeing a brain drain of young people as the 18 to 25 year olds are leaving the country for other parts of the world. Why not? The unemployment rate for this group is almost equal to their age. The overall rate of unemployment has been close to 9% for the past five years. The country is living though strike after strike and the civil unrest that comes along with lack of jobs.

Italy has forever been unable to find a government that works unless it is full of dishonest politicians. Their economy is driven by an underground economy estimated at 27% of the GDP. It's no wonder that they have averaged growth of only 0.66% for the past five years.

Spain, with government spending exceeding 2/5^th of GDP, is quickly trying to destroy their decade of growth and revert back towards the previous socialist beliefs that kept them poor for years.

Germany can be considered the shinning light of Europe. They have just announced their lowest unemployment rate in sixteen years. This sounds great, but that lowest rate is 7.5% down from 8.8% last year. This is not something to be proud of.

Lets move on to Russia. The country is the world's second largest exporter of oil and with the prices at $140+ per barrel they seem to be riding high and mighty. They are flexing their economic muscles against the European neighbors and their former Soviet Union members south. Putting all your eggs in one basket, especially a basket filled with a single commodity, will ultimately result in a big disappointment. This alone will come back to haunt Russia in the future. However, their long term problem is that the country has one of the lowest birth rates in the developed world. Their health system is falling apart with no answer for the large increase in the number of middle aged males dying from alcohol-related problems. And immigration is not the answer: who wants to move to Russia?

Moving on to China: The recent earthquake in China has exposed just how weak China is. The country's health plan covers about 8% of the population, and those covered live in the cities, not in the hinter lands where the average family income is less than $1000 per year. The buildings are made for quick occupancy, not safety, and an emergency system is non-existent. We will spend more time on China in future letters, but I need to mention one more thing about China. You may recall that our daughter Libby spent some time in China. The item that stood out to me from her conversations about Chinese cities is that "they smelled".   Do you think that pollution is a problem?

What about the United States? Yes, our unemployment rate has increased. At 5½% it's the highest in quite some time, but it is still one of the best in the world. And yes, we are in the middle of a housing downturn, but from recent data, prices are firming and the excess inventory of unsold homes is declining. Our stock markets are seeing the downside of volatility, but interest rates are low and our financial institutions have accepted the mistakes made over the past few years and are rebuilding their financial positions. Our citizens are in the process of rebuilding their own financial position by recognizing that debt is something that has to be repaid. All of this shows that our culture is intact with democracy, human freedom, a rising life expectancy, reduced pollution, increased educational opportunities for all, a strong two party political system that offers checks and balances against intrusion on individual rights, and a growing population of young and energetic individuals that understand, seek, and are able to reach the American dream. This assures us that the Country will continue to prosper and lead the world for decades to come. I can think of no better place to invest my hard earned capital than in companies who serve the needs of the great American citizen.

Inflation

The first four months of this year were dominated by fear of a financial meltdown. By May the Federal Reserves' aggressive steps to stem this crisis were taking affect and the US stock market was recovering. Then, in late May, the President of the Dallas Fed, Richard Fisher, and the President of the Minneapolis Fed, Gary Stern, warned in speeches on the same day that interest rate increases might be needed before long in order to curb inflation. On June 4^th, Chairman Ben Bernanke, in a speech at Harvard, confirmed the Fed's responsibility to achieve price stability over the medium term. On June 9^th he said "Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy." He then said that the FOMC "will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation."

The markets took these statements at face value and quickly did an about face, expecting the Fed to start raising rates instead of lowering them. Mortgage rates rose, stock prices declined and many Fed watchers now believe that the threat of stagflation (high inflation with an economy that is stagnant) is real. Notice that it only took the idea that inflation was accelerating to create an immediate impact on the markets. Malcolm D Knight, the General Manager of Bank for International Settlements (the central banker to the central bankers of the world - Thanks to John Mauldin via Simon Hunt for sharing this quote) added to the fear with this statement:

"We appear to be entering a period of serious stagflation with sharply rising expected and actual inflation combined with large downside risks to growth and employment.... I would argue that what we are seeing is an acceleration of expected consumer price inflation in the context of a sharp expansion in global liquidity. It is hardly surprising that the prices of those commodities, such as oil, for which the short-run price elasticities of supply and demand are low, move upwards strongly when there is a rise in expected general inflation. The oil market is a very convenient vehicle to speculate on expectations of higher levels of general price inflation. Hence my view is that the 40% jump in oil prices that has occurred over the past few months - roughly the period during which financial conditions have been loosened sharply - is a reflection of the expectations of either an acceleration of global inflation, or a depreciation of the US dollar, or some combination of the two".

Because investment success depends on an ability to anticipate the future and then take action to benefit from this forward thinking, actual inflation figures are less important for the short-term direction of markets than any anticipation of what will be the inflation in the future. If you want to learn in detail about how we measure inflation in this country, visit the Bureau of Labor Statistics (BLS), the official guardian and calculator of the nations Consumer Price Index at www.bls.gov/cpi. It is here that a drove of statisticians and analysts poor over surveys to determine and publish an official rate of change in price levels that has an immediate effect on almost each and every one of us in some form or another. For those of you who are receiving a social security check you are reminded of this every year. For those under a state or federal retirement system you may look forward to a cost-of-living adjustment to your pension. For those lucky enough to be employed in an organization that calculates its wages paid under some formula based on a change in the price index your paycheck may reflect the change. If you happen to be a renter of property, your lease may include an automatic payment adjustment to reflect any change as reported by the BLS.

As an investor, inflation has a very real impact that does not favor the owners of capital, i.e. you as a shareholder or lender of capital through ownership of debt (bonds, certificates of deposits, notes, etc.). As a lender of capital, you surely would want to receive a higher interest payment on your loan for the use of your money if you believed that, a year from now, your interest payments would buy less than they do today. If you knew, as an owner of capital (stock holder), that your cost would be higher a year from now, you would not be able to increase your share price in the market place because your profits would surely decrease relative to any cost increases. Because rents are also charged based on what an owner could reasonably receive if he or she sold his or her real estate and lent the funds for interest, an increase in interest rates would have the same effect as common stock prices: a decrease in value.

Mr. Bernanke and Mr. Knight both understand that it is the expectation of a change of inflation that is far more important in setting prices than past experience. In fact, a readjustment of investor belief in higher inflation would continue to depress prices. In June, common stock prices dropped about 10% worldwide. Our thoughts are that this is a direct reflection of an anticipated change in inflation. This anticipation, we believe, is a bit premature. Stock prices have declined too fast, especially if this decline is based on fear of rising inflation.

Deflation

I am sure you would like to know why we believe this. The answer is that there are too many deflationary factors at work. We all know that the current fear of inflation is directly related to energy and food prices. The funny thing about energy and food prices is that they will self correct with a reduction in demand and/or an increase in supply. Having grown up in farm country I know how farmers react to higher prices: they plant more. By this time next year, I fully believe that the world's farmers (Absent a world-wide drought) will increase production beyond current demand. And as for energy, each of you have probably thought about or are actively taking steps to reduce your demand. You probably think about conservation daily, and discuss it with your friends and neighbors. Also, we have forces at work that are pushing for an increase in the supply of energy, be it through oil drilling, coal gasification, wind-power, solar-power, nuclear or any other form that is currently possible. As these forces take hold, we believe the current level of oil prices will decline, and of course, lower energy prices are deflationary.

Changes in the supply and demand positions of food and energy are not the only deflationary factors at work today, either. Many years ago I was taught that inflation is driven either by increasing cost being passed on (cost-push), or by too many dollars chasing too few goods (demand pull), and that it was based almost exclusively on US producers and consumers. As you know, we are no longer a self-contained island of economic activity: we as Americans have been net importers of foreign produced goods and services. This trade deficit, along with the need to finance this deficit with foreign lending, increases cost and thus has an impact on inflation. This trade imbalance has for years been dominated by consumer goods. This has changed over the past few years and it is now dominated by oil imports, which represent approximately 60% of our trade deficit (up from 30% over the past decade). Our trade deficit has run at about 6% of GDP for some time. If we do the math (0.70 x 0.06 = 0.042 v. 0.40 x 0.06 = 0.024) we can see that we have reduced our spending on non-oil imported items by over 40%. This reduction in consumer spending (or demand) will naturally reduce prices over time.

We are all aware of the housing situation and the de-leveraging of banks, consumers, and businesses. We in the United States have been seeing the results of this de-leveraging for the past year. The rest of the world, especially England and Western Europe, are just now entering the worst of times. This will extend the de-leveraging to banks and consumer borrowers worldwide. These forces are real, and, along with the self-corrected nature of the cost of energy, I can easily see inflation levels dropping from the current 4% to 2% in less than twelve months. Only time will tell if this is correct.

Beware of Crooks

In March of 2006 the Wall Street Transcript printed an interview they had conducted with me in the prior month. The following question was placed before me: "You have spent 25 years managing money and seeing a lot of changes in this industry. What are the challenges ahead?" My response: "Obviously, there are always going to be challenges, but I think we really need to be concerned with those areas of the marketplace that seem to be in big demand all at once. And I am alluding to the hedge fund industry and alternative investments that are just growing by leaps and bounds. Any time that happens, there is such a huge reward for a promoter. Take hedge funds, for example. Of course, the fees may be coming down, but historically, it has been 2% management fee and 20% of the profit. Any time big money is available to somebody for a product that the public demands without knowledge of what they are buying, you are going to end up with a problem, because that income alone is going to bring some crooks out of the woodwork, and that's going to create a disaster at some point in time. We have seen that throughout time."

Well, I am disappointed: either those who read my interview paid very little attention to it, or else no one read my interview! Last month we had three headline events concerning hedge funds. First, in our own state of South Carolina, Al Parish, the former Charleston Southern University economics professor, was convicted of fraud. He'll be spending a lot of time under the care of his jailers. His business partner, Wayne Cassaday, a Certified Financial Planner (CFP) and operator of the Christian ideals investment advisor Battery Wealth Management, is finding his way in court, driven there by a lot of angry clients. Second, Samuel Israel, convicted hedge fund manager, went missing after scrawling a suicide note on his car. He is personally responsible for $450 million in investor losses. And finally, Matthew Tannin and Ralph Cioffi, former Bear Stearns' hedge fund managers, were taken into custody to face criminal charges due to the collapse of the two hedge funds they managed. These are headlines... but the real fact is that hundreds of billions of dollars have been lost by individuals who believed that there is such a thing as a free lunch. There is not! If something sounds too good to be true and there is a lopsided payoff to the promoter, just say thank you and run as fast as you can in the other direction.

Until next time,   Kendall J. Anderson, CFA

Anderson Griggs Portfolio Management