Follow The Bottom Violation
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Jan
16
WHERE HAVE ALL THE VALUE INVESTORS GONE?
“I’d rather be approximately right than precisely wrong…”
– Warren Buffett
With all the energy I’ve been putting into denouncing Treasuries and the dollar, you might think that I, as an investor, tend to focus more on broad asset-classes and indexes rather than individual securities, but nothing could be further from the truth. In fact, until recently my interest in more general markets — commodities, currencies, or indexes was a minor part of my research. At heart, I am a dyed-in-the-wool value/growth investor of the “never sell” ilk. I like to buy great companies and hold them forever. Or, at least I always have… until now.
If it has to do with value investing, you name it and I’ve probably read it — from the entire collection of Berkshire-Hathaway’s annual reports (several times), to every piece of literature by or about Warren Buffett, Charlie Munger, Philip Fisher, and Ben Graham, among countless others. I pride myself on my ability to roll up my sleeves and discover a company’s ability to create wealth — using little or no debt — through the generation of free cash. I have spreadsheets I have been building for almost 20 years, so complex that I have to order special memory so that my computer will run them. From 1998 to 2006, I even ran a small private fund that outperformed 90+% of money managers in the world.
I’ve received a lot of emails over the last few months from friends, colleagues, and readers asking my thoughts on equities in this environment. And my response has surprised them almost universally: I no longer hold any U.S. equity positions — nor have I for some time. In fact, I even liquidated some positions I had held for 15 years. I am very scared of this market.
Yes, I know. Price-to-earnings ratios and dividends are more attractive than they have been in decades. And yes, I also recognize that the classic bear market represents an average of about a 40% loss from the top to the bottom, and that we’ve already covered that in this retreat. Further, I am reminded daily by any number of gurus, analysts, and reporters on CNBC that this may be the buying opportunity of a lifetime. And who am I to say it isn’t? I have been wrong before, and I will be wrong again. But this little voice in the back of my mind keeps reminding me that, somehow, things are different this time.
Make no mistake about it: when I run the numbers on any of the companies I have followed for the last two decades — names like Cisco, Nike, Harley-Davidson, and Microsoft, to name a few — I see bargains I have never seen before. And I’m not looking at earnings, which are too easily manipulable; I’m calculating free cash flow and shoving it into numerous classic price and profitability ratios, like return-on-equity and net-profit-margin, for example. I won’t tolerate phantom numbers, and thus, my analysis gets me as close to the truth as humanly possible — the downside of which, unfortunately, is that most of the time companies which otherwise might seem like bargains are generally exposed as fairly-, or even over-valued.
Lately, however, when I stare at the monitor, my mouth starts to water. I have spent my whole career looking for precisely this type of opportunity, always wondering if one would even appear in my lifetime. And suddenly, here it is.
Or is it?
I have lived through several recessions and market corrections, and while they were painful, I always remained optimistic. I saw the dips in stocks as excellent entry-points, and I availed the markets of their gifts. Likewise, if I held positions going in, I maintained them, or added to them. I never, ever sold. But those downturns seemed more like a function of the normal business cycle, whereas this time, the system seems broken. Banks are failing all over the place, and despite the fact that the government is dumping trillions of dollars of stimulus into the economy, it can’t seem to stem the tide. And it’s not just happening in the United States; it’s happening everywhere.
It is this seemingly systematic failure that has caused me to shift the bulk of my research from individual firms, to the macro-economic conditions that have gotten us where we are today. in the last six months, I have spend countless thousands of hours studying the historical trends of everything from gold, to oil, to stocks, to inflation, to interest rates and fixed-income yields. I feel like an expert of every major financial and economic catastrophe of the last 120 years: from the mid-1880s, to the Great Depression, to the 1970s. I’ve compared scenario after scenario, and frankly, the future doesn’t look very good for U.S. stocks — or, for that matter, the economy as a whole.
Yes, it’s true — based on historical metrics, equities are cheap right now. But you might find it interesting to know that after the initial stock market crash in 1929, stocks were equally “cheap,” or perhaps even “cheaper” — measured by price-to-earnings ratios and dividend yields. Unfortunately, as the economy buckled and ultimately collapsed, earnings and yields collapsed with it. And, of course, lower profitability and yields inevitably led to a multi-year decline in stock prices. From top to bottom, the averages lost 90% of their value from 1929 to 1933.
I’ve written much recently about the $8.5 trillion in stimulus and programs to which the U.S. government has committed itself over the next 24 months. I don’t think most people are aware of the magnitude of that sum; yes, it sounds big, but if you look at it in a historical perspective, its implications are staggering. Basically, the United States government has borrowed and printed — or will borrow and print — more money, in real dollars, than ever before in history. But who will continue to lend to a government that is essentially bankrupt? If you look at a chart of the U.S. monetary base published by the St. Louis (here’s a longer-term graph), it becomes almost vertical in the past year. How will our currency absorb the shock of that sort of inflation? We’ve never been here before, and I fear for the solvency of our nation.
I say this in the context of this article to make a point: I still believe in the innovative and productive capacities of many companies in this country. I don’t believe, no matter what happens, that Microsoft is going to stop making Windows (although I hope the next version is better than Vista). I don’t believe Cisco will stop building networks. I don’t believe Nike will stop making apparel. I do, however, believe that the currency on which they base all of their business is going to fail, and that the prices of the shares of those companies are going to suffer — probably immensely — before it is all over. In fact, I believe every business in the United States is going to have to face the coming currency crisis, and they will all have to make very tough decisions about how to conduct themselves profitably.
As a final thought, I should disclose that I have never been a conspiracy theorist. I have always believed in the American Spirit. I am not only a student of Constitutional history, I am a deep, passionate admirer of it. I count Thomas Jefferson among the most important people ever to have lived, and I believe he would be appalled at what his dream has become.
Until recent years, I believed the United States would lead the world in innovation and productivity for the distant future, but I didn’t think it would do so in co-operation with the bloated, inefficient federal government at its core, but rather in spite of it. Unfortunately, the mother of all Ponzi schemes that started with the Federal Reserve’s inception in 1913 — and all the profligate policies it has implemented in the decades since — has finally reached a crescendo. There is only one solution to the mess we are in, and that is a rapid and relentless reversal of government spending, taxation, and money-creation. Alas, at the very moment we need these things to cease most, our government is issuing more record debt and currency, while initiating unprecedented spending programs.
For the first time in my career, I am betting against the United States and the dollar. The last place I want to put my wealth is in the equities of companies denominated in U.S. dollars. Will I ever buy U.S. stocks again? Undoubtedly! If I’m correct about what’s coming, there will be a lot of pain. But at the end of it, there will also be almost unfathomable opportunity.
My objective is to survive, and to benefit.
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Disclosures: Paco is long TBT, UCO, and gold. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies.
You can buy his novel Discipline wherever books are sold.
2 Comments so far
Partners
Greets.
I’m glad I found your blog, via Seeking Alpha. You express every thought that I have had since I started reading rapaciously about the macroeconomic issues in play, round about, say, September-October 2008.
So I don’t have your financial background, but I’ve reached identical conclusions, right down to gold, commodities, TBT and the (potential for a) dollar collapse.
Perhaps with a hair less confidence in my own opinions.
We also share a disbelief in conspiracy theories otherwise.
Anyhow, a question or two, if you have time or interest in answering.
I envision things happening very quickly once signs of price increases start showing through; either the dollar drops sharply or a serious treasuries selloff begins.
Do you think that the Fed has not anticipated this scenario? They may be prepared to act very very quickly to buy treasuries or buy dollars, no?
The logic with which you argue that that moment will come is impeccable, but I confess I’m not clear on the limits of Fed power (ie. balance sheet/resources) to react.
Second. Don’t you think that doomsday scenarios become less likely as time passes? Banks, if not households, are scrambling to repair their finances. So when interest rates rise, it will be painful but … perhaps not a deathblow, if people have built up a buffer in the meanwhile.
Another very favorable short term development is the fall in the price of oil. Gives people a little breathing room, helps repair those household finances, takes pressure off many different kinds of producers.
Put differently, I was always amazed that the spike in recent years didn’t have more adverse effects on the economy.
Next, would you agree that if a doomsday scenario fails to materialize, gold is not as attractive as other commodities as an investment?
I’m imagining that the ‘race to debase’ plays out with falls in all currencies relative to commodities, but no true currency collapses.
And perhaps with the WTO (or a new Bretton Woods conference) setting new rules governing when governments may intervene in currency markets/purchase treasuries of other sovereign states.
Just throwing that last bit in there for fun.
Next, you say you’re a student of equities, and not a macro-economist by training. How confident are you that you understand the Fed’s actions to date?
I say this because I find my own comprehension of the interplay between Fed and Treasury cloudy in near zero interest rate conditions; and to name a concrete example, I have read that the Fed doesn’t think what it is doing is the same thing as quantitative easing.
Everyone says “printing with abandon” but lowering interest rates and printing money aren’t exactly the same thing.
Turning to TBT, the issue of the limits of Fed power becomes relevant. One obvious cloud over TBT as a short-term investment is that the Fed has vowed to keep interest rates low (in absence of an economic recovery) by buying long-dated treasuries if necessary.
Imagine no recovery and prices rise (stagflation), the dollar tanks _ but the Fed keeps buying those treasuries.
Is that a realistic scenario or possible but unlikely in your view? Or impossible?
Well, that’s enough for now. Look forward to reading your answers, if any. Feel free to summarize!
Regards,
Toby Sterling
“I envision things happening very quickly once signs of price increases start showing through; either the dollar drops sharply or a serious treasuries selloff begins.”
I actually envision both of them happening, and contributing to each other’s instability.
“Do you think that the Fed has not anticipated this scenario? They may be prepared to act very very quickly to buy treasuries or buy dollars, no?”
Well, I think they’ve considered it, but the only way to buy Treasuries is by selling dollars, and vice versa. In the short term, doing one will hurt the other, but in the long term, both Treasuries and the dollar will have to fall — probably dramatically — for all the reasons I’ve written in the last several weeks.
“Next, would you agree that if a doomsday scenario fails to materialize, gold is not as attractive as other commodities as an investment?”
The only thing that will prevent a doomsday scenario is a rapid and extreme reversal of monetary and fiscal policy, and that just isn’t in the cards. I suppose another, widely available currency — like the one I proposed in DISCIPLINE — could save the day, but it’s still going to have to be backed by gold.
Yes, if we could somehow get back to the old ways, in which the dollar could still be inflated, and we could fool everyone into thinking it was really safe, then gold would lose value. Unfortunately, the jig is up; the Keynesian game could only work for so long, and it has run its course.
Have you noticed that no one is really arguing with many of my premises lately?
That’s because you just can’t ignore the fact that dollars are faith-based, and soon that faith HAS to implode; there’s no way around it. What is going to save the dollar? How will the Fed and the Treasury undo the inflation and debt they’ve unleashed? Nobody has an answer — not even the Treasury and the Fed!
Again, how will this be undone? How can we possibly find the resources necessary to undo inflation and debt? By issuing MORE debt? And who will buy it? The Chinese? The Japanese? The Saudis? Or will we pay for it by printing more money?
Do I even have to talk about how foolish THAT would be?
No matter how you look at it, it’s a Ponzi scheme. Yeah, Bernanke knows it. I can’t imagine why he doesn’t resign. Would you want to be blamed for the collapse of the most powerful currency the world has ever known? It’s not totally his fault, of course, but that’s almost certainly how history will remember him.
“…lowering interest rates and printing money aren’t exactly the same thing.”
That’s true, but they’re doing BOTH! We know printing money is bad. And we know lowering interest rates causes the artificial increase in the prices of assets — and THAT’S certainly not good.
I guess it doesn’t matter that the Fed doesn’t think what they’re doing is “quantitative easing.” They could call it “chicken farming,” but it wouldn’t be any less destructive to the dollar and our economy. What is coming is going to be VERY bad.
“One obvious cloud over TBT as a short-term investment is that the Fed has vowed to keep interest rates low (in absence of an economic recovery) by buying long-dated treasuries if necessary.”
I couldn’t agree with you more, and this is something that scares me. Timing is a very difficult skill — or is it an art?
“Imagine no recovery and prices rise (stagflation), the dollar tanks _ but the Fed keeps buying those treasuries.
Is that a realistic scenario or possible but unlikely in your view? Or impossible?”
No, it’s possible in the short run, but it’s certainly not going to be a sustainable as it was in Japan. For two decades you could borrow for almost nothing Unfortunately, we are in a global recession, and borrowing cheap dollars doesn’t automatically mean better returns somewhere else. Further, if the Fed continues to print dollars in order to buy Treasuries, it’s only going to bring the results of such inflation down on our heads that much quicker.