Monthly Archives: August 2010

The View from 30,000 Feet

I don’t fly very well.  For many years I racked up thousands of frequent flyer miles jetting all over the U.S. and many places in Asia.  I even flew first class a lot back in the go-go 1980s when Wall Street was a sexy place to work.  I once made the mistake of reading Michael Crichton’s “Airframe” (about an airplane disaster) on a 747 bound for Tokyo.  Just as the plane was nearing take off speed, I heard a loud “pop” on the left side of the plane.  One of the engines had blown out.  The pilot immediately slammed on the brakes, and instead of ascending gracefully into the blue, we stopped awkwardly on the JFK tarmac.  Shortly we were surrounded by fire and rescue vehicles.

Ever since then, take offs have become white-knuckle times for me.

So this month when I needed to fly out West to take my son to college, I had to face again another take off.  I have discovered that if I count to myself, slowly and silently, I have very little angst as the plane leaves the ground.  I have also discovered that most large jets reach take off speed about 27 to 33 seconds after they begin to accelerate.  Also, the audible tone designating that it’s OK to use approved portable electronic devices occurs 167 to 210 seconds after the start of the flight.  I can’t help it; I’m a numbers guy…

Once airborne, my nerves settle down quickly and I truly enjoy looking at our fine country from cruising altitude.  Up there the world seems very different.  I am always impressed how big and unpopulated the nation is – something I rarely feel driving on highway 66.  I see farms, towns and forests of all sizes and shapes.  I see lots of open spaces.  The change in perspective is dramatic; and it allows me to see things differently.

Working day to day in the capital markets is sort of like driving on the highway.  It’s easy to get bogged down by the immediate, here-and-now stuff – by the noise, the traffic and the frustration that comes with this daily grind.  And lately, the market seems to be dominated by the latest economic data point, “expert” opinion about this or that, or some new technical fear (the Hindenburg Omen, for example).  But that’s not how long-term investors should view the market.  They really should be looking at the market from 30,000 feet – at the big picture; at things as they really are.

But how can we do this?

Every once and a while, an excellent piece of research crosses my desk that can provide this perspective. The latest one, titled “A Study of Real Real Returns” comes from our good friends at Thornburg Investment Management (  In this report they look at 20- and 30-year returns for all of the major asset classes accounting for the real-life impacts of expenses, taxes and inflation on total returns.  Why these long periods of time?  With advancing longevity, it’s reasonable to assume that investors will not only accumulate saving for 30 years or more while working, but they may also need income from those savings for 30 years after retirement.

So what asset classes did the best in this study?  Stocks and municipal bonds.

Stocks, the capital markets pariah of the moment, have proven to be the best performing asset class over long periods of time.  Critics of stocks point to their performance over the last 10 years to “prove” that stocks will underperform in the “new normal.”  I would note that stocks have underperformed (bonds, cash, whatever, etc.) only twice in the last 100 years: the 1930s and the 2000s.  For the decade of the 1930s, the S&P 500 was down 0.3%.  For the ten years ending December 31, 2009, the market fell 9.1%.  Note that both of these periods begin at a peak of equity prices, valuations and bullish sentiment.  I suppose any numbers series will compare unfavorably when compared to the peak of that series.  Lost on the current audience is that stocks performed well for the six decades in between these two bad ones, with 3 of these decades posting gains of at least 400% for the S&P 500.

Municipal bonds do well due to their ability to avoid taxes.

So despite the current loathing of stocks, the smart folks at Thornburg conclude their report with these wise words, “[our]… study confirms that the highest returns come from the more traditional asset classes – common stocks and municipal bonds.  Asset classes that have traditionally been associated with inflation protection have not generated significant positive real real returns over long periods of time.”

“Over the 20 years that Thornburg has conducted this study, the results have been consistent.  There is no reason to think that they will change significantly going forward.  The two primary unknowns, inflation and tax rates, will remain… A simple asset allocation among the highest real real turn asset classes, accompanied by a reasonable withdrawal rate and spending policy, may provide investors with the best chance of sustaining their portfolios and preserving wealth going forward.”

That’s what I’ve been trying to say…

An Unusual Suspect

SozeCertain movies really speak to me.  I like ones with complicated plots, witty dialogue and a surprise ending.  Spike Lee’s 2006 movie, “Inside Man,” is a wonderful example of this.  But perhaps the best example is Bryan Singer’s 1995 movie, “The Usual Suspects.”  This quirky little firm actually won 2 Oscars, but a huge part of its appeal and charm is Kevin Spacey’s tour de force performance as Verbal Kint.  The movie’s complicated plot is nicely summed up by the folks at IMDB: 

“A boat has been destroyed, criminals are dead, and the key to this mystery lies with the only survivor and his twisted, convoluted story beginning with five career crooks in a seemingly random police lineup.”   

At one point during his interrogation, Verbal is asked about Keyser Soze.  He answers, “Who is Keyser Soze? He is supposed to be Turkish. Some say his father was German. Nobody believed he was real. Nobody ever saw him or knew anybody that ever worked directly for him, but to hear Kobayashi [the lawyer] tell it, anybody could have worked for Soze. You never knew. That was his power. The greatest trick the Devil ever pulled was convincing the world he didn’t exist. And like that, poof. He’s gone.” 

Later he adds, “…And like that he was gone. Underground. Nobody has ever seen him since. He becomes a myth, a spook story that criminals tell their kids at night. ‘Rat on your Pop, and Keyser Soze will get you.’ And no one ever really believes.”  So, from this point in the movie, the audience becomes fascinated, even obsessed, with who in the movie might be this criminal specter, Keyser Soze.  Who is this mysterious superman and what can he do?

During our investment policy meeting last week, as we were discussing the prospects for deflation, I said something like “Deflation is the Keyser Soze of the capital markets.”  Why did I say this?  Deflation is something to be greatly feared.  It is rarely seen, but its impact is pernicious and evil.  It really is the boogey-man for economists and central bankers. 

In simple terms, deflation is when the price of things goes down.  More precisely, it occurs when price measures such as CPI or PPI post year-over-year declines.  But one might wonder if lower prices are not a good thing.  After all, who doesn’t like buying things on sale?  The problem with system-wide deflation is that it encourages savings and discourages consumption.  Why is that a problem?  Consider this example:

Let’s say you were interested in buying a $30,000 automobile.  You picked out the one you wanted and were about to buy it.  Then you heard that you could buy the same car for $28,000 at a different lot.  Then right after that, another dealer was offering the same car for $26,000.  At this point maybe you buy the car.  On the other hand, you may choose to wait (thus favoring savings over consumption) to see if the price could move even lower.  If this price behavior becomes rampant, spending falls and the economy stalls. 

Deflation also discourages investment, because there is no reason to risk capital on future profits when the expectation of profits may be negative and the expectation of future prices is lower.

Deflation is scary to economists and policy makers because it is hard to fix.  The normal tools available to central banks are not well equipped to deal with deflation.  It’s like trying to fix a leaky pipe with chop sticks.  In a normal recession, a central bank can lower short-term interest rates to entice banks to lend and borrowers to borrow.  In times of deflation this does not work.  Central bankers understand that it’s much easier to stop deflation from happening than trying to cure it once it emerges. 

The fact that deflation rarely occurs is another reason, I think, there is much confusion about what it is and what it does.  The few examples I could think of were: 1) the Great Depression, 2) Japan from the early 1990s, 3) Hong Kong in 1997, and 4) Ireland last year.  During the Great Depression we found out that the economy was not going to fix itself without fairly aggressive policy intervention.  In Japan, policy makers are still struggling to put that economy on a self-sustaining growth path. 

We have seen deflation-like behavior in one part of our economy already – the housing market.  Prices have come down, borrowing costs have come down, housing affordability is near record levels, and yet, consumers are not buying.  Could it be that the prospect of even lower prices and/or borrowing costs are encouraging postponement of new home purchases?

I am not an economist, and I really don’t have a good handle about the prospects for deflation in the U.S.  The credible economists I listen to tend to think we can avoid it.  Yet, it is something on my “worry list” and something I want to keep a close eye on.  Some things that go “bump” in the night are as scary as we can imagine…

It’s the Little Things That Matter

The Little ThingsThis week someone posted a few pages from my high school yearbook (Go Broncs!) that featured a page on new clubs as of that year.  On that page I saw a picture of the new Science Fiction Club, which included a picture of me!  I will admit it, I like Science Fiction.  In my younger days I spent hours consuming the works of Isaac Asimov, H.G. Wells, Harlan Ellison, Philip Dick, Ray Bradbury, Kurt Vonnegut and others.  Summer days would often find me in the local theaters catching a double feature of Sci-Fi B-movies.  I don’t think I really disliked any of those flicks – as long as they had alien monsters, rocket ships and ray guns, I was a big fan.

One of my favorites from the old days was “War of the Worlds,” a 1953 Byron Haskin film based on H.G. Wells’ novel starring Gene Barry and Ann Robinson.  The story is fairly simple – “meteors” start falling to earth creating large craters which inevitably attract the local folks.  Unfortunately for these curious townsfolk, the “meteors” are actually Martian space craft filled with Martians bent on planetary conquest.  Earthlings are no match for the Martian death rays, and even the best military power on earth (they actually try to nuke them!) has zero impact on the invaders and their futuristic technology.

*Spoiler Alert* Don’t read the next paragraph if you ever want to see the movie and its surprise ending.

So, obviously the Martians don’t win, but with all our weapons ineffective, how is this done?  Microbes.  The Martians are all killed off by invisible germs, which turn out (luckily and conveniently) to be deadly to them.  Whew!

I thought of this movie and its miraculous ending this week when I read about the oil spill in the Gulf of Mexico.  It appears that the big patches of oil that used to be on the surface are mostly gone!  What happened?  Scientists think that oil-eating microbes may be the reason.  It turns out (luckily and conveniently) that certain germs living in the ocean love to eat oil.  Who knew?  All of the human technology applied to the problem (the skimming, the burning, etc.) certainly helped, but a large part of the solution appears to have come from Mother Nature herself.

So now we know that microbes can kill Martians and eat oil; what does this have to do with the stock market?  In discussions about the stock market, a lot of people tend to focus on the “Big Things.”  What are these?   Things like the economy, retail sales, exports, government budget deficits, new regulations, healthcare reform, etc.  They are obviously important and we would all like to know exactly how the big things affect the market.  By the way, the stock market itself is really a big thing.  The trouble with “Big Things” is they tend to be very hard to predict and their impact on the stock market is even less certain.  Yet, many people love to argue about them as they are all that matter.

So what are the “Small Things” pertaining to the stock market?  There are several, but I wish to focus on just one – earnings.  When one company reports its quarterly earnings, it may seem like a small thing.  After all, what are just one firm’s profits in the grand scheme of things?  Well, it could mean a great deal.  For example both UPS and Caterpillar reported very strong earnings in the second quarter. The shipping business and order trends for large equipment are very strong.  Rail freight demand and pricing are near record levels.  Exxon Mobil had revenues of $100 billion in the latest quarter.  All of these small things are supportive of economic strength somewhere out there.

How does this square with the fact with that the majority of people in the U.S. still think the nation is in recession?  Perhaps the media, other commentators and even policy makers are too focused on the “Big Things?”  If investors could connect the dots on the small things, and worry less about the “Big Things,” maybe they could see that the overall situation is nowhere near as bad as some of the commentary we see daily would suggest.

Consider the following under-reported positives:  Ninety percent of those who want to work are working.  Forty percent of homes in the U.S. have no mortgage.  Personal incomes are growing.  Government fiscal stimulus is continuing.  Inventory accumulation is just getting started.  Huge pent-up demand exists in the auto, housing and other big and important industries.  Export demand from Asia continues to be very strong. Monetary policy remains very accommodative.  I consider this list quite impressive and is likely to outweigh the negatives currently being touted.

I am no Pollyanna.  I am not always positive or bullish.  I simply see things a bit differently from the rest of the crowd.  I am not always right; not always confident of my views. But right now, I feel that sentiment has grown way too negative given the mix of positives and negatives I see right now.