• Home
  • About
  • Team
  • Contacts
  • Blog

The Balance of Payments

  1. Home
  2. Blog
  3. The Balance of Payme ...

Portfolio manager’s Letter February 2004

I have written a couple of times recently about the amount of political distortions that dominate the subject of America’s trade deficit. One final comment in the general form of a summation, and I promise I will not bore you with the subject any further. What have I learned about the trade deficit since I started writing on the subject?

First of all, I have arrived at the conclusion that 98% of the noise about the subject is politics. Now when I hear some talk about the twin deficits or American profligacy, I look to see where the author is coming from. It is mostly either some politician trying to get elected to something; or some businessman or labor leader whose ox has been gored by foreign competition, and is looking to the government to bail his ass out.

There is no question that the dollar was, and probably still is overvalued. But the reason for this has nothing to do with American consumers desire to own an infinite number of flat panel TV screens. The dollar is over valued not because of our desire to buy, but because of rest of the world’s desire to sell to us.

The trade deficit exists because of the power of the American consumer, and while it is likely that currency markets will remain volatile, and may even perhaps get violently more so in the near term, the underlying factors that are the cause of this overvaluation of the dollar are not likely to change in our lifetime.

What do I have to support these conclusions? One thing is the current market for US treasury securities. Last month there were two big auctions of treasury securities. The demand at the auctions was so strong that interest rates went down about 25 basis points. So who is buying all these bonds, and why? The rumor is that 40% to 50% of the bonds sold where purchased by the Bank of Japan. Why does the Japanese Central Bank need all this low-yield American paper?

Japan has been going through a twelve-year economic contraction and has recently experienced the beginnings of a recovery. The American economy is getting stronger and we are starting to buy a lot of stuff from Japan. US dollars are flowing into Japan and as the dollars flow in, a lot of them end up in Japan’s central bank, the BOJ. The BOJ can sell those dollars or the can hold them. The problem is, if the bank dumps the dollars, it drives the price of the dollar down relative to yen.

The last thing that Japan needs right now is a weak dollar. A weak dollar makes Japanese goods more expensive for the American consumer. With the American economy the only large economy showing much life right now, if the Americans stop buying, the Japanese economy goes back in the toilet and existing Japanese politicians will be looking for a new line of work.

But it is not just the Japanese, In the last three months of 2003, foreign central bank holdings of US government securities grew by 37.4%. Two weeks ago the Russian Central Bank announced that it was buying dollars. The dollar has declined 12% in the last year relative to the Ruble and Vladimir Putin thinks it important that Americans should not have to face a cost increase for their Stolichnaya Vodka (thanks Vladimir).

The Power of the American Consumer

The US has a trade deficit because the dollar has been overvalued for a long time. It has been over valued because foreign central banks like it that way. When they get dollars, and to the extent that they can, they hold on to them (use them to buy US treasury securities). The foreign central banks like it that way because the local politicians like it that way.

Everyone wants to sell to the American market. If you have a product and you aspire to world-class status for that product, you have to be able to sell successfully in our market place. Without a share of the American market it is difficult to generate enough revenue to achieve the economies of scale that you need to compete in the international market place.

Assuming that some or all of this is true, what does it mean, and what are the consequences? Well I would not expect that the long-term trend will change much. It is likely that the dollar will stay weak or even decline further, but because foreign companies are still going to want to sell their products to our market.

The dollar is not likely to decline to the point that our current account deficit will disappear. The dollar is likely to remain overvalued because the rest of the world would prefer that it does. The short term may be more interesting. The imbalances have become so glaring that it has attracted a lot of currency speculators, and history tells us that once the speculators start to smell blood, central banks can get crushed.

In the unlikely event that the dollar were to suddenly fall to the level where its trade deficit would be eliminated, the pain would be much greater over-seas than it would be here. In the US prices would increase for imported goods, but this negative would be off-set for us by increased profitability for companies that export and a rapid increase in employment in the manufacturing sector.

On the other hand, countries that sell goods to us have benefited from the strong dollar because it makes their products cheaper, and a sharp drop in the dollar, if maintained for a long period, would see rising unemployment in industries that rely heavily on the American market. Profitability of companies that sell to us would fall and if the decline was sustained, it could lead to debt defaults and bankruptcies.

As for the stock market, I personally will stay away from large financial institutions like J.P. Morgan Chase, BOA, or Citibank because of the off-chance that currency traders might set off a small nuclear accident in the derivatives market. But I was going to stay away from those stocks anyway (derivatives-related to real estate mortgages are probably a much bigger threat). On the positive side, it is probably time to start looking for companies that will benefit from rising commodity prices and lessoned foreign competition.

“Skating on Thin Ice”

Last year, despite his view that the market was overvalued Jeremy Grantham correctly predicted that the market would rally. He is looking for another up year this year, but after that he sees a return of the bear. If you do not want to read the whole thing here are the highlights:

“As a new devotee of the presidential cycle, I think we can count on a high probability of a relatively stable stock market year. The value of the market, which on a 1-year basis never matters as much as sensible investors would like, simply does not matter at all in year three, but in year four, it has an almost normal effect and obviously at 25 times normal profit margins, this is a very overpriced market. However, the stimulus program was profound and the economy has responded and this momentum is an obvious positive.”

In other words presidential politics trump value when it comes to guessing at the direction of the market in the third and fourth year of our presidential election cycle.

“On average, value stocks (or low growth) also have their best year in year four; perhaps just making up for year three’s overdoing it with growth stocks. My conclusion is that the economy, profits, and the market are likely to do quite well or better in the first half, and less well in the second half, as the stimulus runs out and the over pricing of the market is felt.”

2005 and 2006 are likely to be the time when the problems caused by too much pre-election financial ease and the resultant asset bubbles will likely turn the stock market into a black hole. The outlook for 2004 is not bad, but the market is very overpriced and all predictors look bad for next year and the year after.

“The purist’s investment position is clear: the market is overpriced and investors should duck! The problem with this strategy, as we have all painfully learned over and over again, is that an overpriced market can really run, and this overpriced market has quite a lot going for it in the near term … “I am confident — but far from certain — that the long-term problems already discussed, which will affect every country, lie out beyond the next 6 months and probably this year.”

The thing that bothers me is that I almost completely agree with this view and when the people running big money agree with me, I start to get nervous. In the second part of this article Grantham discusses factors the effect the direction of the market on a short-term (one year) basis and finds three strong predictive indicators:

  • The Presidential Cycle
  • The January Effect
  • Value (Price to 10-year trailing earnings)

While this may sound superficial, the article is an interesting read, and Grantham is no slouch. 2003 saw his company GMO increase its assets under management from $23 billion to $54 billion.

The Value of “Value”

An interesting aside to his study is that “Value” analysis is a lot weaker predictor of one year performance than it used to be.

“The decline in predictive power in the last 30 years is disturbing to worshipers of mean reversion.” (Value investors) … “What is going on here? Is value, surprisingly, being used so much that it is losing its power … This raises an important, but not too surprising issue: to win on value, you must be prepared for increasing noise and greater pain and time on average before you win.”

Warren Buffett has been successful for a number of reasons, but for most of his career he has been an outlier doing things differently than the Wall Street herds. In the last ten years he has become much more widely known and his teachings much more popular with investors big and small. What impact this will have on the new and future practitioners of value investing is at this point an open question.

02/01/2004



Leave a Reply Cancel Reply

Your email address will not be published.


Comment


Name

Email

Url


Blog Archive

2020

  • The Stock Market

2019

  • Behavioral Investing

2018

  • Trumped
  • Warren Buffett vs Wall Street
  • Globalism, 1982-2000 Bull Market

2017

  • Volatility Underlying Calm Market
  • What’s new with CB&I?
  • Passive Investing
  • Economic Cycles
  • Current Stock Market 2017 Comment

2016

  • Global Plastics Summit Highlights
  • Value Investing vs Index Investing
  • How to Play an Index Bubble
  • Successful Investors
  • Is the Market Overvalued?
  • Operating Earnings
  • Article by investment manager in Bay Hill Living
  • Building Foundation

2015

  • 3G Culture – Dream Big
  • Myopic Loss Aversion
  • CBI Nuclear Energy
  • St Joe Company
  • What’s in a Word? Plastics.
  • Are Bonds Safer Than Stocks?

2014

  • Chicago Bridge and Iron
  • CAMEX 2014
  • Global Economy October 2014
  • Fluor Corporation
  • Interesting Quotes from Daily Journal Annual Meeting
  • The Daily Journal Annual Meeting
  • Albemarle Corporation
  • Triumph Group
  • The American Energy Revolution
  • Singapore

2013

  • St Joe Company Update
  • Hedge Fund Managers
  • Triumph Group Inc.
  • Bitter Brew
  • An Antifragile Portfolio

2012

  • Leucadia National Corporation
  • This Time it is Different
  • Successful traders psychology
  • St Joe Company
  • Learning from Pain

2011

  • Long Cycles – Part II
  • Long Cycle
  • Nasty Month for Market
  • Make a Buck with Fortescue Metals Group
  • Berkshire Hathaway Look Through Earnings
  • St Joe Company Inc
  • Successful Investment Management
  • A Look Into Latin American Market
  • The Mother of all Quarters
  • 2010 Investment year results

2010

  • Fault Lines
  • US Market 2010
  • Berkshire Hathaway Third Quarter 2010
  • The Stock Market 2010
  • Berkshire Hathaway Second Quarter 2010
  • Berkshire Hathaway Performance
  • Long Term Greedy
  • Goldman Sachs
  • Berkadia and Leucadia
  • USG corporation
  • Berkshire Hathaway 2009 2010
  • Why Capitalism Works

2009

  • The Lords of Finance
  • The $44 Billion Dollar Train Set
  • Berkshire Hathaway 3rd Quarter 2009
  • Career Risk for Investment Manager
  • Berkshire Hathaway financial statements
  • Berkshire Hathaway Preferred Stock
  • Moral Hazard
  • Credit Default Swap
  • The Shadow Banking System
  • Learning Things the Hard Way
  • Our C-System
  • 2008 Investment results

2008

  • Investment Risk
  • Bear Markets
  • Generational Events
  • Orange sheets – Money is doing better
  • Inflation Not The Problem
  • Tipping Point
  • Long Term Capital Management
  • Financial Insurance
  • Western Refining Inc
  • Berkshire Hathaway Year To Date
  • Berkshire Hathaway Cash Flow
  • 2007 investment results

2007

  • Investment results 4th Quarter 2007
  • Greenspan on Inflation
  • Berkshire Hathaway Third Quarter 2007
  • Berkshire Hathaway Operating income 2007
  • Berkshire Hathaway Hedge Fund
  • Leveraged Buyouts
  • Stability Unstable
  • Weak Dollar
  • Berkshire Hathaway Chairman’s Letter
  • Steel Dynamics
  • Breakwater Resources
  • 2006 Investment year results

2006

  • New Investment Stocks
  • Equitas
  • Berkshire Hathaway Third Quarter 2006
  • Hurricane Synergy
  • Berkshire Hathaway Second Quarter 2006
  • Fat Pitch
  • Perfectly Obvious
  • Berkshire Hathaway Growth Rate
  • Berkshire Hathaway First Quarter 2006
  • Berkshire Hathaway Annual Report 2006
  • Inflation Is
  • 2005 Investment year results

2005

  • Exogenous Events
  • The Easy Money
  • Look-Through Earnings
  • High-Risk Mortgages
  • Unintended Consequences
  • Rydex Ursa Fund
  • Warren Buffett Premium
  • Private Equity
  • Latticework Mental Models
  • Buffett’s Lackluster Performance
  • 2004 Investment year results
  • Professor Smith’s Second Bubble

2004

  • Hedging Currency Disaster
  • Risk Assessment
  • Too Many Bears
  • The Chinese Century?
  • Patterned Irrationality
  • Timber
  • Costco’s Cash
  • Physics Envy by Charlie Munger
  • Asset Allocation Berkshire Hathaway
  • The Balance of Payments
  • 2003 Investment year results

2003

  • Hedge Funds
  • The trade deficit is not debt
  • Secular Bear Market
  • Which Index Funds?
  • A Different Drummer
  • Costco’s Float
  • The Power of Float
  • Berkshire Hathaway Annual Meeting 2003
  • Psychology of Human Misjudgment
  • Sitting on the Sidelines
  • Berkshire Hathaway intrinsic value
  • 2002 Investment year results

2002

  • Insurance company Moats
  • Bond Bubble
  • Berkshire Hathaway Cash Flow 2002
  • Behavioral Economics
  • The Bear Market 2002
  • Greenspan Put
  • Second Quarter Cash Flow at Berkshire Hathaway
  • Berkshire Hathaway Annual Meeting 2002
  • Red Wire – Green Wire
  • Stupid FED Tricks
  • The Bottom Line
  • 2001 Investment year results

2001

  • Don’t Fight the FED
  • Buy and Hold? – It all Depends
  • Ben Laden and Berkshire Hathaway
  • The Dinosaurs Dance
  • Costco Moat
  • Bubble Watching
  • Sit on your Ass investing
  • Berkshire Hathaway Annual Meeting 2001
  • Carnival Cruise Lines
  • 450000 Square Ft Furniture Store
  • Lunch Money Indicators – Annual report
  • Other People’s Money

2000

  • Bear Tracks
  • Build It and Money Will Come
  • Efficient Stock Market
  • Style Drift
  • Lunch Money Indicators – Options
  • Identifying Problems
  • Small Retail Stocks
  • Charlie Munger comments
  • Big Al and the Bubble Machine
  • Berkshire Hathaway Cheap
  • Index Funds
  • 16 rules for investment success
Make an appointment or contact us by phone: +1 (689) 246 49 49
© 1999 - 2022 Losch Management Company
Support by Global AGM