Portfolio manager’s Letter December 2005
Bill Seidman was on CNBC last week, and when asked how the market was going to do next year, he replied that it would probably do alright baring any exogenous events. So the exogenous events are the economist’s “cop-out”. (My forecast would have been correct if it had not been for the exogenous events. But since whatever happened was not predictable, it was not in my model). If it weren’t for these exogenous events, the economists would always be right.
Back in November the Federal Reserve Chairman was on capital hill to testify to the joint economic committee. In response to a question about inflation, Greenspan answered that:
“the inflation rate properly measured, at this particular stage has been very close to zero for a very long period of time”.
This seems a curious claim to make at a time when it has been announced that the year-over-year rise of the CPI was 4.6%, and the core rate was increasing at 2.2%. Greenspan may believe that inflation properly measured is close to zero, but a month ago I was paying $2.75 for a gallon of gas, the Orlando newspaper keeps telling me that home prices in Orlando are 45% higher than they were a year ago, and the price of gold is up 17%.
I know, I know … that is not how the economists measure inflation — but I live in a house and drive a car. The thought has occurred to me that maybe what “properly measured” means to Alan is not the same thing that it means to me. The FED has apparently decided that inflation is the CPI ex everything that goes up. Judging by the bond market, were long rates are hanging at around 4.5%, there a great many people with a lot of money who agree with the chairman: inflation is close to zero.
If inflation were running at 4.6%, why would investors be willing to commit money to a long term paper that pays only 4.50%? Indeed the FED has managed to keep inflation in check for “for a very long period”, and the overwhelming view of economists and just about everyone else is that they will be able to continue to do so baring exogenous events.
So my guess as to exogenous events that no one, not economists, not hedge funds, or equity managers have in their models is a return to rapid inflation. I am not saying it will happen, or even that it is highly likely, but if it did, it would blow a lot of economic models about fifty feet out of the water and develop all sorts of funny kinks in the financial markets.
So why worry about inflation or other exogenous events? Hasn’t the FED (as Greenspan so gleefully claims) been able to keep a check on inflation in the past? The problem is, I am not sure the past matters. I do not think you can extrapolate anything we know about domestic monetary policy. Inflation is caused by too much money in the system. The FED may control our money supply, but it has no power over foreign central banks or exogenous events.
M2 is up 3.9% in the last twelve months, which is very moderate growth, but the same cannot be said for the rest of the world. James Grant says the EU money supply is up 13%, and for China and India, the estimates are somewhere between 20% and 30%.
In the world today does it really matter what the name is on the paper? Yuan, Yen, Euro, Won, or Dollars, they are all exchangeable and transferable to anywhere in the world overnight. There is lots of evidence that the world is awash in cash, yet no one is worried about a serious inflation. Central bankers’ crystal balls are not any better than anybody else’s’. And given that they are heroes when the have the printing presses running and bums when they tighten, I see no reason that we should be surprised by another nasty bout of inflation.
Warren Buffett has been predicting for years that inflation was not going away as long as politicians are running the world. Predict anything long enough and sooner or later you are going to be right.
The flow of other countries’ money into the US bond market has sparked a dandy inflation in our real estate market, and has probably also helped with the equity bubble, and exogenous events. Simultaneously, this flow has generated solid proof that the FED can no longer control our long term interest rates.
Incredibly neither the FED nor anyone else makes any attempt to track the world money supply, presumably on the theory that since they cannot do any thing about it, ignorance is bliss. The situation is similar to the 30s in a way. The problem then was the money supply was contracting, thus turning a recession into a depression; unfortunately no one figured this out till Milton Friedman first measured the money supply in his book on monetary policy in the 1960’s.
So we are flying blind as usual. No matter how accurate or inaccurate the FED’s measure of inflation is. It does not matter. It can only measure what is going on today and there are always exogenous events. At the same time, money in circulation can build-up for years before inflation takes off.
In the 60s, LBJ set the stage for inflation with the escalation of the Vietnam War and the War on Poverty, but it was five years or more before inflation started to kick in earnest. If it returns, inflation will be slow in coming, and will probably not happen till long after Greenspan has said, “goodbye, goodbye”. Still, the possibility is real, and investors should watch for the signs.
The current bull market that began in January of 2003 is now about three years old, and by traditional standards would be considered to be getting a bit long of tooth. Re-enforcing this view is the fact that most of the gain was in the first 12 months of the rally. Whereas for the last two years the market has mostly been range bound. Currently there is a division of opinion between the bulls who feel the market is ready to break out of its trading range and ascend skyward and the bears who claim that the sky is about to fall in, because of exogenous events.
As you can see by looking at your portfolio, my views tend to lean more to the latter argument. Reinforcing the bearish argument are several signs that the bull is aging. Most of the money that was been made this year was in high risk and illiquid stocks (small cap, technology, and emerging markets).
This is generally a sign that the hot money is moving toward risk to stretch their returns, and this to some extent, reminds me of 1999 – 2000. Market sentiment indicators indicate investors are heavily bullish — a condition that often signals a market top. These technical indicators indicate a dangerous market and warrant a reasonable level of caution. There is always the possibility of exogenous events.
Ignoring the market itself, there are plenty of economic problems to worry about, most of which I have been writing about for the last year:
Despite all this, it is always possible that the economy will muddle, though, there will be no exogenous events and the market will continue higher. At some point, we may have to return to a more bullish position. Still, for the time being, we will remain cautious with large cash positions and with Losch Management Company’s long position in Berkshire Hathaway hedged with the Rydex positions. While our caution may penalize our company’s relative performance in the short run as it did in 1999, the risk level now is too high to justify being more fully invested because of the danger of exogenous events.
With FED tightening the screws steadily now since the summer of 2002, and recent indications that air has started to come out of real estate, we may know if the wheels are going to come all the way off fairly soon.