Thoughts on the Big Picture
Most of the questions I've gotten lately can be summarized like this:
What do you think about the recent comments of (insert name here) on the state of the economy or stock market?
First, a couple of points for the benefit of newer investors:
1 - I tend to agree with money manager Peter Lynch, who once said that if you spend 13 minutes a year thinking about economics, you will have wasted 10 minutes.
2 - My investing philosophy is “bottoms-up” rather than “top-down.” That means I look for potential investments one-by-one, based on a company's financial statements. Top-down investors attempt to forecast the country's economic growth rate, then figure out which industries look most promising, then attempt to isolate the best companies in that industry…and then, ultimately, invest in a few of them.
In my opinion, there are simply way too many ways to screw up using a top-down approach. However, most of Wall Street invests that way. The humans, anyway. Which brings me to…
3 - About 70% of all trades on the Street these days are done by computers. And the average holding period of a stock in 2010 was just 22 seconds. Seriously. Welcome to the age of high frequency algorithmic trading.
To summarize, despite the fact that economics is much more opinion than science, many investors continue to base decisions on notoriously unreliable projections. It's also more important than ever to think long-term about investing, or else you are competing against computers that are size of your house. If you are investing for days instead of years, when you meet those computers, they are going to beat you.
Also - it's not my intention to increase your anxiety in the below. There's more than enough of that already going around. But it's risk and fear I've been hearing the most about lately, and I suppose those are slightly more serious subjects than, say, the weiner of Weiner.
Okay, time for some thoughts. So, grab a hot dog. Maybe a pickle.
Where We Are
My current take on the economy, and this recent stock market drop, can be summarized as follows:
While the strength of this economic recovery has been disappointing, I am not worried about the recent string of soft economic numbers that sparked this latest sell-off. Economic growth won't be great for the U.S. this year, but it won't be worth losing sleep over, either. We have some fiscal, monetary and economic challenges ahead of us, to be sure, but they are cones on the track, not a brick wall.
It also strikes me, if I may, as either naīve or narcissistic to think that we aren't going to hit a few rough spots as we emerge from the greatest financial crisis that all of us have ever seen. This is one of those spots.
The recent soft economic data can be explained in large part by two things: high oil prices and a global supply chain disruption stemming from a massive earthquake and near nuclear meltdown that temporarily paralyzed the world's third largest economy. Ford, for instance, announced last week that the March Japanese quake reduced U.S. supply by as much as 400,000 vehicles last quarter. That's going to leave a mark. Fortunately, those issues are being resolved. More on unemployment in a bit.
Here are the unequivocally positive factors which make me think this recent stock market sell-off will soon find a floor:
1 - The large U.S. businesses that make up the stock market are in very good financial shape. Earnings are quite strong and balance sheets look solid.
2 - We have shed a lot of debt. Household liabilities have declined by over $1 trillion since the peak a few years ago. According to one economist, in July 2008, Americans owned 425 million credit cards. In March of this year, that number had fallen to 320 million cards. This is also good.
3 - Credit has been improving. Banks are lending more, and small businesses are finally benefitting from that, too.
4 - Fiscal and monetary policy remains favorable for growth.
5 - Even the large cap companies we own in Tarpon are head-scratchingly cheap. And if some of the leading, highest quality businesses in America are this undervalued, investors will show up.
So there are a number of positive factors that are getting overshadowed by, in my opinion, overblown headline risks.
That said, it is certainly easy to get discouraged these days - about everything from the economy to the state of political discourse to the unusual weather. But by investing in the stock market, it is important to keep in mind that your goal is straightforward:
To intelligently bear risk for profit.
Never mind quantitative easing, debt-to-GDP ratios, and credit default swap spreads in Europe. Think about it like this:
In any environment where there are a lot of risks to bear - assuming the real risks are actually less than what is feared, and that those risks are being borne as intelligently as possible - then the end result should ultimately be, well, a lot of profit.
Let's assume that we are bearing those risks intelligently in the Tarpon Folio. Specifically, our companies are fundamentally undervalued with ample margins of safety and possess sustainable competitive advantages or represent asymmetric special situation investments; we are not using leverage; we are not short any securities; we are not excessively concentrated; and we avoid buying silly things like LinkedIn shares.
So then the question becomes, “Are the actual risks we are facing more or less than the common perception of those risks?”
I believe that the real risks we face are, in almost every case, significantly less than the consensus belief. Let's look at the risks mentioned in some of your emails.
Out of the Corner of My Eye
First, here are risks that I monitor passively:
1. The fiscal woes of state and local governments.
The coming layoffs and/or budget cutbacks at municipalities all over the U.S. unequivocally represent another near-term drag on the economy. But at this point in the cycle, they shouldn't be a surprise to anyone, either. So while most economists seem to believe states' woes could knock 0.30% to 0.40% off U.S. GDP growth this year, that alone won't be enough to derail the broader recovery. I see no analytical reason to challenge the consensus here.
2. High unemployment.
The current level of unemployment we have in the U.S. is distressingly high, and it, too, is a drag on the economy. But unemployment is not something I worry about in terms of representing a high-probability risk to our portfolio companies per se.
I also don't buy the argument that we're suffering from structural unemployment, or a permanent mismatch between worker's skills and employers' needs. I'm just not seeing entire industries with abnormal amounts of unemployed people compared to each other. Unfortunately, high unemployment has really been across the board, except for the obvious spike in the construction industry - but I'd argue the housing bubble caused that boom to begin with. So, on a more normalized basis, the data just doesn't show structural unemployment problems. Not now, anyway.
And if high unemployment is due to tepid demand for, well, everything - especially housing - then the silver lining is that the unemployment picture will begin to look brighter as the economy grows and new businesses are created.
So while unemployment is grim, it also appears to be slowly trending down over time - although not nearly as smoothly or quickly as any of us would like.
3. High oil prices.
At about $130 a barrel, oil prices will become a significant tax on the consumer that will seriously impact economic growth. Sustained high oil prices could result in an economic stagnation similar to that of the 1970s, or, even worse, tip the economy back into recession. Also pernicious is the negative psychological impact high oil prices have on general confidence in the economy.
The rise in oil prices earlier this year, however, was correlated to unrest in the Middle East and the decline in the dollar - perhaps with a little speculation mixed in to boot. It was temporarily troublesome in that it effectively negated the 2% payroll tax cut enacted last year; for a brief period it was as if we just pumped those savings right into our gas tanks. Fortunately, as those oil prices have declined more recently, so have the risks to our economic growth.
Currently the worldwide demand for oil is about 88 million barrels a day. The difference between what the world can produce and what it uses - “spare production capacity” - is close to 5 million barrels a day. In 2008, that difference was only about 1 million barrels difference. So the world can produce more additional oil now - 5x more - than it could three years ago, which is another reason we shouldn't fear a return to the $147 a barrel oil of three years ago this summer.
There will be a significant long-term structural shift in oil markets, though, in the form of growing demand from China and other emerging countries. That we own several E&P (exploration and production) companies in Tarpon which will benefit from higher oil prices probably best summarizes my own thoughts on the long-term outlook there.
But current oil prices represent more annoyance at the pump than risk in the portfolio.
Worth a Few More Looks
Here are some other risks I watch more closely:
4. The ability of China to engineer a soft landing.
It's no secret that economic growth in China has been proceeding at a high rate for some time. There are some unsettling signs, however, that China is in the later stages of a property bubble that could be quite messy if/when it pops. To stay ahead of it, the Chinese government needs to tighten its own monetary policy in an attempt to slow growth and reduce inflation pressures. And given the tight links between the U.S. and Chinese economies - we'd be pinched by a rise in the cost of Chinese goods, to start - this bears some watching.
That said, it is hard to envision an outcome so poor in China that it would cause us to permanently lose money in Tarpon. And the irony of some of those temporarily soft economic numbers here in the U.S. is that lower demand for Chinese goods should enable that government to continue to successfully battle inflation.
So, I think it's wise to keep an eye on potential problems in China, but I see nothing right now that merits making any changes to the portfolio. And I'll be the first to concede that there is a reasonable chance I am blowing my own concerns here out of proportion.
5. Sovereign debt problems in Europe.
Greece is going to eventually default, in my humble opinion - or at least restructure its debt, which I'd consider to be the same thing. Unfortunately, it's seems too hard to make the math work. Portugal, too, faces some long days ahead of it.
But when it comes to Europe, the entire civilized world is currently incentivized to delay those days of reckoning as long as possible. Doing so will make that eventual Greece default easier for a recovering European banking system to absorb, and it will also make the real risk here - contagion, or the risk of default spreading to other Euro countries - that much lower, too.
So timing is important here. From strictly a risk-based perspective, it's encouraging that policymakers in Europe appear to recognize the importance of that timing, even if they're unable to publically advocate for what is really an informal “kicking the can down the road” policy. Europe appears hell-bent on avoiding an outright default in either Greece or Portugal in the near-term and containing the eventual default fallout in the long-term.
Also, when it comes to Greece in particular, a sense of scale is often lost in the all the teeth-gnashing. The economy of Greece is about the same size as the economy of Dallas. So while that eventual default will be unpleasant, it will be far from apocalyptic in and of itself.
It's an ugly situation with no easy way out and, candidly, some disturbing moral implications. But the least-worst option also seems to be the one that will most likely be realized in Europe.
6. The U.S. economy.
I'll focus this section on the three areas where I've received the most questions.
A - The U.S. fiscal crisis.
This discussion could go in many different ways, and, alas, most involve politics. But here is one important fact you should know about the real risks of the current fiscal status of the U.S. of A.:
The bond market is not concerned.
And that speaks more to me than a thousand pundits.
The yield on US ten-year bonds actually fell below 3% this week - a development in striking contrast to the hysteria out there on this issue. The implication there is also that the biggest danger the economy faces is still a prolonged period of semi-stagnant growth - not excessive growth with high inflation. More on that in a minute, too.
So as one analyst said in reference to our fiscal state, the problem is not necessarily where we are today - it is where we are headed.
From an apolitical perspective, there are several seemingly rational choices than can be made to dramatically reduce the deficit over the next ten years. For instance, by ending spending on the Afghanistan and Iraq wars and letting the recently extended “Bush tax cuts” expire, we would reduce by half the $20 trillion in debt that we would otherwise owe by 2019. And I think the odds are quite high that each of those things will happen - which means the fiscal debate should really be focused on entitlements. Otherwise, the U.S. runs a very real risk of becoming a giant pension fund that happens to sleep 300 million people.
The good news, then, is that political grandstanding aside, we appear to have both some low-hanging fruit and a few years to address our fiscal woes - the current debt ceiling issue notwithstanding. I'd just as soon we get our fiscal house in order today, mind you, but I suspect the reality is that the politicians will want to make this debate the focus of the 2012 elections.
And that brings up the bad news; whether or not we have the political will to actually fix our fiscal problems is still an open question, unfortunately. It's also unclear to me if Americans truly understand and/or are ready for the sacrifices that will be needed to get our house in order. I do know, however, that if we don't address our fiscal situation, the market will, and not in a way that will be particularly pleasant. But I don't think it will come to that. Ultimately, in my opinion, patriotism will trump politics and we will get it done.
If we do successfully tackle our fiscal problems, then it would seem there is a reasonable chance that a long-term bull market could ensue. Seriously. But I concede that's seems like a big “if” from where things stand right now.
B - Inflation.
Core inflation is currently very low. The rise in food and commodity prices earlier this year was evidence of recovering demand and/or increasing speculation, not an early sign of widespread inflation. That doesn't make it any more enjoyable to fill up the tank on the way to Outback, but you can still get filet mignon and three lobster tails for $14.99 once you get there. No kidding. I cannot stop telling people about this.
The risk of future high inflation, however, appears uncomfortably high, and that should concern us all greatly. “Concern” as in “starting thinking about” as opposed to “build a bomb shelter,” I mean. For thirty years, the Federal Reserve has put the control of inflation at the very top of its list of priorities. So it should be a good reminder of how close to the abyss we were several years ago that the Fed has been willing to throw it's prime directive right out the window and risk high inflation later in order to get the economy moving now.
The issues of inflation, quantitative easing, and/or printing money are worthy of a much longer discussion than I can easily capture here, however. So I'd suggest that perhaps we can discuss them more on the July conference call.
For now, I'd just like you to know that while inflation is likely one day going to be something we have to deal with, right now, that risk is nowhere on the horizon. So we will swerve around that cone when we get closer to it. And to be clear - inflation won't be a boogeyman that suddenly jumps out of the closet one night and starts maniacally blasting an airhorn. We'll know when to be concerned - and that will likely be before the economists tell us we should be.
I also happen to believe the best protection an equity investor can have from inflation is to own companies with competitive advantages, so they can pass price increases on to their customers. Moats matter. But, again, this is probably worthy of a more detailed discussion at a later time.
C - Interest rates.
It appears interest rates will stay low until well into 2012. And I have nothing more to add on that point.
The Biggest Actual Risk
I believe the biggest near-term risk to our economic growth and by extension the stock market is housing - or more specifically, any further unanticipated steep drops in home prices. The foreclosure crisis is not over, unfortunately.
I view our housing woes as essentially an inventory problem. At current sales rates, the country has a little over 8 months' supply of unsold homes. While that is much better than the 12.5 months' supply we had a year ago, it's still well above the long-term average of 5.5 months' supply. So it should be no surprise that it will take some time to continue to work through all that inventory - and that prices will likely continue to inch downward for a while longer still.
So, expect continued lousy housing headlines for a while. That said, I'd be surprised if prices dropped more than another 5%. If they did, for whatever reason, then the probably of another recession would rise to an uncomfortable level. I believe the odds of this happening are still low, mind you, but it is another reason to keep your head on a swivel these days.
As an aside, I also think the next six to nine months could be an amazing time to buy property - with a mortgage, specifically. But I suppose that's another subject.
Ignore All This Noise in Particular
Finally, some risks that I think are particularly overblown.
1 - The end of QE2.
There is angst in some quarters of the market about what will happen once the Fed winds down its current quantitative easing program on June 30th. I believe these concerns are overblown, however, and the end of QE2 will be the dog that doesn't bark.
In short, I think the end of QE2 is already priced in the market. There is no surprise to any of this, and while projecting a drop in the stock market based on what happened at the end of QE1 may be emotionally satisfying, it is analytically ridiculous. I'd also submit the credit markets are not reacting at all. I suspect that's because the Fed isn't going to suddenly walk away once the program ends. It's going to proceed cautiously, reinvesting interest payments and principal from maturing bonds - and given the size of the Fed's balance sheet, that will look and feel accommodative for some time.
So I am not concerned about the end of QE2 and/or any meaningful impact that might have on Tarpon. And while I agree it's not entirely clear where new high-volume bond buyers will come from, I think it's a mistake to extrapolate that uncertainty into a black hole of demand on July 1st. Primary dealers are, after all, sitting on hundreds of billions of extra cash due to all this quantitative easing, and I suspect that will in some way, shape or form help the market transition smoothly, too.
More to the point, even if I am completely wrong, and the market did drop due to the cessation of the program, I think an improving economy will make that decline brief and shallow. So, again, I think this particular “risk” is being way overblown.
2 - The US not raising the debt ceiling this summer and/or a default on U.S. debt.
This debate is the boy that cried wolf. Again. If the U.S. defaults, it will be the most widely predictable crisis in the history of the modern world. And those never seem to actually pan out. The risks we need to fear are the ones we don't see coming.
I'll be the first to concede that should this happen, the consequences would be catastrophic. But that is also the reason it's not going to happen. More specifically, I put the probability of this happening at 1%.
Now I'll be the first to say it's a mistake to presume an excess of rational thought on the part of our elected officials. So I suspect negotiations about all this will, like the federal budget talks held this winter, go right up into the eleventh hour. To the extent that delay contributes to more market volatility, well, we'll grind it out and keep our eyes open for any opportunities that might show up.
But there is next to no real risk that the U.S. will default on its debt this summer. There is simply too much at stake, and policymakers will hammer something out because, to be blunt, there is no other option.
Tying It All Together
Judging from the headlines and recent market sell-off, I think it's fair to say that most equity investors are perceiving the risks above to be higher than warranted. Politics, fatigue and psychology each play a huge role in explaining those misconceptions. And I think that represents a real opportunity for us to profit.
As a result, I believe that the returns we will earn in the second half of 2011 will reflect that we have profitably borne those risks well. The portfolio is not going to march straight up, of course, but in the long-term, I continue to believe we are going to do quite well.
Please let me know if you have any additional questions. And stay tuned for more information on that call in July.
Thanks for hanging in there with me.