Safehaven Mavens

We can go where we want to
A place where they will never find
We can act like we come from out of this world
Leave the real one far behind
--Men Without Hats

Another thrust to record lows for Treasury yields this am.

10 yr rates now below 1.6%.

position in BOND

Gimme Shelter

Oh, a storm is threatening
My very life today
If I don't get some shelter
Lord, I'm gonna fade away
--Rolling Stones

Standout action this am in Treasuries. EU flames have both Treasuries and Bunds catching big bids.

10 yr yields have broken below 1.7%. Record low.

In retrospect, seemingly ugly headfake on bond bears two months back...

position in BOND, SPX

Wisdom of Warrenbonds

"I heard that about you. You like to work alone."
--Ice Man (Top Gun)

John Hussman once again reinforces his message of overvalued, overleveraged markets that must 'clear' before real progress can be made. He thinks that perhaps that will occur in 2012. Implied, I think, is that stock prices would need to significantly decline.

I also like his analogy of Eurobonds to 'Warrenbonds." Suppose 9 broke people approached Warren Buffett that they would all get together and issue Warrenbonds to fund the activities of the ten. The activities would be backed by the assets of the consortium which, in this case, would be WB's assets. 90% of the 'group' would agree on the wisdom of this idea, and WB would be criticized as the lone, selfish holdout.

WB would never agree to such a plan unless he could impose strict controls over the activities of the others. Of course, the 9 broke people would be unlikely to consent to such loss of sovereignty, so the Warrenbond idea never gets off the ground.

Same for Eurobonds.

I might add that this analogy bears some resemblance to modern democracy and class warfare arguments.

position in SPX

Adding Some Equities

Give me a chance
Give me a sign
I'll show her anytime
Su-Sussudio
--Phil Collins

While my macro outlook remains decidedly bearish, I have been buying some equities over the past months. Nothing crazy. Currently, my net stock exposure is about 4% of total liquid assets (19% long minus 15% index short). If we should happen to sell off hard over the next few months, I may take that exposure up to ~25%.

Various factors are making me more sanguine toward equities, including:

Financial repression. This is the label being assigned to global policies that are forcing interest rates toward zero for the foreseeable future. Suppressed interest rates discourage traditional forms of saving. As such, dividend paying stocks, particularly those of large cap low beta names such as Johnson & Johnson (JNJ) and Procter & Gamble (PG), look increasingly attractive. Many of these stocks yield 3% or more, which easily beats the payout on multi-year CDs. Moreover, they tend to hold their value pretty well in general stock downdrafts. Yes, principal is still at risk, but I'm increasingly comfortable holding a few of my favorite divendend payers here as income generators.

Inflation hedge. If you review this site's archives, you'll find many posts discussing inflation vs deflation. I've generally favored a 'deflation before big inflation' sequence. It is becoming increasingly apparent to me, however, that I might have it backwards. Tendency of central banks to print aggressively to avoid any economic pain suggests that Big Inflation may precede the ultimate deflationary bust. Think Weimar. While stocks may not keep up with real assets like gold in such a scenario, they will likely hold up better than cash.

Decent value. I'm actually seeing decent value in a few of my favorite names (i.e., well branded, cash rich, high margin, strong competitive position stalwarts). JNJ seems reasonably priced. In tech, Cisco (CSCO) and Applied Materials (AMAT) look interesting. After the recent downdraft in the miners, Pan American Silver (PAAS) popped up on my radar as well. I don't have to torture my discounted cash flow models to find value here. One limitation, however, is that the basis for my cash flow modeling is the last 3-4 years of financial performance--a period that has been generous to US corporations. As John Hussman has frequently stressed, using the past few years of historical performance to forecast future performance is likely to over-estimate future cash flow generating capacities. While I'm in full agreement, my valuation models are pretty conservative in their assumptions, making me comfortable with taking initial positions in some of my favorite names.

Yes, there is downside risk here, which is why I'm only 4% net long stock at present. Because lower prices reduce that risk, I'll likely use price weakness (if/when) to add to my fave names.

positions in AMAT, CSCO, JNJ, PAAS, PG, SPX, gold

EU Discounting Mechanism

I don't want to wait for our lives to be over
I want to know right now what will it be
--Paula Cole

There is some belief that the European situation has been so broadly reported that markets have factored in most of the outcomes. Thus, when some 'resolution' actually occurs, it may largely be a nonevent for the markets.

Perhaps, but efficient discounting requires certain conditions to be present. One is that the information available can be interpreted as to its meaning. Stated differently, available information must permit various possible outcomes and their values to be forecast. Not sure this condition is present for the EU. Each day I read new interpretations of the Greek crisis alone. The leveraged, interconnected nature of global economies and financial systems make it difficult to grasp what will happen.

Another condition that must be present is the understanding of risk and reward associated with the decision. Market partipants must understand the penalties associated with being wrong, and the benefits associated with being right.

Through their past interventions, policymakers have skewed the risk/reward relationship far away from the one present in free markets. Poor decisions have largely been bailed out.

To the extent that market participants expect another round of bailouts, then they may be prone to take on more risk than they would in unhampered markets.

Stated differently, moral hazard may be impairing the discounting mechanism, causing unwise decisions to be made in front pending EU outcomes.

Government is Force

"So why didn't you break his thumb like I told you? When you don't do what I tell you to do, you make me look bad."
--Gazzo (Rocky)

Rose Wilder Lane reminds us that government is force, pure and simple. It is interesting to ponder why this truth is not put forth in the earliest of class studies concerning government.

In a free society, limited government (i.e., a small amount of institutional force) is necessary in order to protect property rights. Specialists in the use of force are hired to help individuals protect their property, broadly construed to include life and wherewithal to produce as well as accumulated property, against assault.

Were this limited government not in place, then there would be anarchy. Under conditions of anarchy, individuals are less free because they must spend lots of time merely defending their property.

The Framers understood that, given the axiomatic human tendency to seek satisfaction using less effort, government would be seen by many as a mechanism for acquiring wealth without having to engage in productive work. The Constitution was therefore established to limit the powers of government so that people could not use government as tool for expropriation.

Today, the Constitution is broadly ignored as special interest groups (SIGs) of all shapes and sizes engage in the behavior that the Framers sought to prohibit--the use of government as a wealth appropriation tool.

It therefore follows that proponents of modern government are proponents of force. No different, really, from crime bosses that enlist strong armed muscle to do their dirty work.

Questions of Fairness

It ain't no use, we're headed for disaster
Our minds say 'no,' but our hearts are talking faster
--Donnie Iris

A favorite word of the Left is fairness. People need to pay their fair share. People need a fair shot. Naturally, in all such rhetorical contexts, fairness implies gains for Leftist interests.

It should come as no surprise that hearing the word fairness drives reflexive reactions in some folks to protect their wallets.

To justify governmental policies driven by fairness arguments, people on the Left have several questions to answer, including:

a) How do you define fairness?
b) Are there other definitions of fairness?
c) Why should your definition of fairness be accepted over others?
d) How do you justify the use of force to impose your definition of fairness on others?

Framing answers in the context of the Constitution would also be insightful.

Saving Despite Zero Yield

Maybe some day
Saved by zero
I'll be more together
--The Fixx

Although the unhampered free market ideal seemingly grows more distant by the day, forces that government free markets are still at work. This is because free market forces are grounded in natural laws that cannot be eliminated by edict.

Recent behavior of individuals to save more in the face of near zero interest rates provides an example. Policymakers have driven down rates in hopes that people will seek more risk and borrow. But multi-decade orgies of borrowing and spending facilitated by past low interest rate regimes have saddled many individuals with excessive debt and low savings.

As such, people are now feeling the urge (market forces) to spend less and save more despite low yields on savings instruments. Indeed, the above graph shows that savings rates have ticked up since the onset of the recession--which perplexes some policymakers to no end because they have been pressing interest rates lower during this period. Falling money velocities, at multi-decade lows, corroborate greater propensity to hoard cash.

When people feel the need to save more resources for a rainy day, there is perhaps no minimum interest rate that deters individuals from doing things that improve their capacities to survive and prosper (the law of purposeful self-interested behavior).

Markets perpetually seek proper balance between risk and reward. When policymakers detour this journey off its natural path, market forces intensify to move the relationship back into natural balance. The more extreme the excursion, the greater the influence of market forces to rebalance the system.

Private Equity Goes Public

"The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right, or you get eliminated."
--Gordon Gekko (Wall Street)

'Private equity' has been thrust into the forefront because Republican presidential hopeful Mitt Romney used to head Bain Capital, a large private equity firm. Private equity firms amass capital (which may be equity or debt financed) and take ownership stakes in businesses. Usually, although not always, these ownership stakes result in the companies going private if they were not already so.

While they sometimes invest in nascent industries and enterprises, private equity firms are more prone to scour mature industries for under-performing companies with commensurately low valuations. By purchasing controlling ownership stakes, private equity firms then act to make operations more productive. If the productivity improvements are successful, then profits are likely to rise. With rising profits come rising valuations. The benefits of higher valuation may then be realized by selling part or all of the company to another private owner, taking the company public (IPO), or operating the company as an ongoing concern.

Of course, it is also possible that the investment does not work out, in which case the private equity firm may either sell the company at a loss, file for bankruptcy, or operate the company as an ongoing concern.

From an investment perspective, private equity is considered an 'alternative asset class.' Alternative investments are asset classes with potential to produce returns that are uncorrelated to conventional stock and bond returns. Other alternative asset classes include commodities, venture capital, and hedge funds. As investors have become more sophisticated, alternative assets have become a popular way to diversify portfolios, particularly among institutional investors (e.g., pension funds, endowments). Portfolio managers have thus poured oceans of capital into private equity funds. Private equity funds under management are estimated at $2+ trillion dollars.

Thus, many Americans, particularly those with defined benefit plans, have ownership stakes in private equity.

There is good reason for this. The social value of private equity operations is that they improve efficiency of scarce economic resources. Unproductive operations squander economic resources, which drags down general standard of living. Reconfiguring under-performing operations toward more productive ends creates more output per unit of input. Inputs such as labor or materials that are no longer needed in the streamlined operations can subsequently seek more productive uses. Society is better off. This missive includes a partial review of research confirming the benefits of private equity operations.

Unfortunately, what captures the attention of many are the layoffs that often occur during productivity improvement efforts. Predictably, the Obama administration has jumped on this bandwagon, painting candidate Romney as a heartless soul who shuts down factories in pursuit of profits. With notable exceptions, the media happily play along.

Hazlitt has eloquently explained the error (a chronic one at that) of this line of thought.

To be sure, there are problems with the private equity model as currently practiced. Artificially cheap credit offered by central banks provides a level of funding for private equity projects unavailable if borrowing were based market-determined interest rates. Moreover, suppressed yields on more conservative investment vehicles has more portfolio managers seeking riskier positions, thereby showering private equity projects with far more funds than they otherwise would. Finally, the gigantic degree of leverage in the credit-induced financial system shrinks investment time horizon, making private equity operators and their investors more sensitive to short term outcomes than they would be in a less leveraged world.

In short, government intervention has surely inflated private equity projects far beyond their 'natural' reach. It has also made private equity investors less patient--i.e., more prone to prematurely pull the plug on projects might produce better results if given more time.

Of course, few government officials or mainstream media outlets are likely to take on this facet of private equity...

I do wonder whether the president may be unwittingly digging a hole for himself by attacking the idea of private equity operations. If Romney counters correctly, then the debate could morph into the merits of unhampered markets seeking the best use of scarce resources vs socialized markets that shelter and encourage under-performance.

American most desperately needs a full-throated debate on this issue. Perhaps private equity has 'funded' such a debate.

Reversal of Fortune

So take that look out of here, it doesn't fit you
Because it's happened doesn't mean you've been discarded
--Big Country

Mining bulls may have gotten their 'blowoff low' signal that a low may be in. Many stocks reversed hard last week on good volume.

Nice follow thru in many of the shares today. For example, NEM pierced its multi-week downtrend, suggesting a change of course.

This action was all the more impressive in that the precious metals themselves did not do much today.

position in NEM