The Thanksgiving Holiday begins tomorrow, a time to express our gratitude for our family, friends, colleagues and the fullness of our lives. Financial markets, unfortunately, have little to be thankful for during the past few weeks. Just a few days ago, the Congressional “super committee” announced that they had failed to reach an agreement on how to reduce the federal deficit. This was precisely the outcome BSW expected – both in terms of the committee’s failure and the equity market’s reaction. I hate to root for bad news, but there is some satisfaction in the “I told you so” aspect of our portfolio’s defensive posture – and markets wild swings during the past two months.
October 2011, one of the best stock market rallies in history. I wanted to cheer, but I just could not believe the hype. Again, I hate to root for bad news. I am an indefatigable optimist. From my perspective, optimism is the only realism – the only world view that squares with the facts and the historical record. As an investor, though, one must simply be rational. And a rational analysis of the situation in October was that the market was rallying on form over substance. The debt crisis in the developed world (Europe, Japan, and the United States) is a complex, entrenched, and structural problem that cannot be whisked away with hyperbole and accounting gimmicks. Investors came to realize this once again in November and markets collapsed.
The various debt crises around the world are difficult to fully comprehend, mainly due to numbers that are so unfamiliar in size and scale that we just can’t relate. Who can visualize a “trillion” of anything? That’s why analogies and images help. If there is one image that illustrates how untenable our present situation is, it is this one: http://www.huffingtonpost.com/2011/07/26/us-debt-visualized-graphic_n_906239.html or, better yet, check out the video here: http://www.youtube.com/watch?v=WBxWdD9YKdY&feature=youtu.be. Every conscientious American should spend some time digesting these representations – which could be replicated with similar effect for Europe and Japan.
The European situation is even more intractable because it is fundamentally a cultural clash. Southern/Latin Europe (led by France) is clashing with Northern/Teutonic Europe (led by Germany) about nothing less than how one should live. The Southern Europeans want a “flexible” system that allows for a steady devaluation of the currency to wash away debts and government largesse. The Northern Europeans want France and the PIIGS to live by northern rules: Keep your currency sound, budgets balanced, and let unsustainable entities (companies, agencies, etc.) fail. It is oil and water. For a great distillation of the situation, listen to uber-writer Michael Lewis’ recent interview on NPR here: http://www.npr.org/2011/11/17/142437694/lack-of-trust-underlies-greeces-societal-problems. As such, the European crisis repeats the same pattern over and over again. Bad news sinks markets until European leaders offer up the latest subterfuge “fix.” Markets leap with joy until investors dig into the details and discover, once again, that the Emperor’s “fix” has no clothes – all form and talk, no substance and action. Then the bad news revs up again and markets fall. Repeat.
Again, an analogy is useful. Imagine the developed world as a patient who has grown dangerously obese (indebted) through years and years of overeating (excessive credit) and junk food (wasteful spending). After suffering an acute illness that required life-saving measures (bailouts, emergency fiscal/monetary policy), their physician warns them that they need to change their ways or suffer a worse fate later. He recommends rigorous exercise and dietary changes (saving, budget cuts, and tough choices on spending). The patient heeds the physician’s advice, but finds the going tough and is constantly lured, and disappointed, by unproven “magic pills” (quantitative easing, stimulus spending, etc.). Eventually, though, the patient is forced to accept the inevitable: that recovery will require hard work and discipline over a long period of time.
This analogy is not meant to be grim. Again, I am staunchly optimistic. The debt crises began with consumers, who passed their borrowing folly back to their bank lenders, who in turn passed their lending folly to governments around the world. Governments are struggling, both at home and abroad (five European governments have fallen from power thus far in 2011) because they are the end of the line. But the events of the past week simply hasten the day that financial and political leaders realize that there never were any magic bullets. We simply have to put our shoulders to the wheel and begin the arduous task of “right-sizing” our balance sheets. Many corporations have already done so and are lean and profitable. Consumers have also begun this effort and are about one-third of the way complete. If and when governments can muster the courage, will, and fortitude to do the same, I am confident that several emerging undercurrents (microfinance, the Arab spring, cheap renewable energy, dirt-cheap computing power, genomics, etc.) will set the stage for a sustained period of prosperity similar to 1945 to 1965, which followed the last true global crisis of World War II. Although we have yet to turn this economic corner (and, hence, BSW remains defensively positioned), there is a distant, but visible, light at the end of the tunnel upon which prudent investors (like BSW) remain focused and confident.
We hope this summary provides you with better insight into your portfolio and BSW’s outlook. If you have any questions regarding out positioning or would like to discuss your portfolio in greater detail, please don’t hesitate to contact BSW. From all of us at BSW, have a happy Thanksgiving.
-David Wolf, Chief Investment Officer