Summer is here.  We hope you found some time for friends and loved ones over the long weekend.  We hope you also found time to pause and be thankful.  We were blessed here in southern California with a break in the clouds which offered a brief reprieve from the early June gloom as well as the recent turbulence of the market.  It has been many years since I've been out on a surfboard, but the past couple months have reminded me of choppy surf without a decent swell.

At the end of March, I outlined my disbelief in the popular view that the US economy would overcome all obstacles, achieve a V-shaped recovery, and continue to push stock prices toward ever higher levels.  As I stated then, “those optimistic outcomes require investors to ignore the 900lb gorilla...that got us into this mess; trillions of dollars of public and private debt.”  In the last few weeks, the financial markets have refocused on the European component of that debt, as well as other global problems.  Judging by the recent double digit decline in the stock prices, my scepticism is now more widely shared.  My expectations concerning 2010 year-end price levels remains unchanged from my Annual Forecast as well as my last writing. I continue to expect prices of both homes and stocks to end the year near the levels they ended 2009.

Just a few weeks ago with the market hitting new two-year highs, my forecast of stocks ending the year unchanged typecast me as a pessimist.  Now that stocks have suffered double digit declines, and are well below where they ended 2009, that same forecast looks optimistic!  Despite our caution, we maintained some long term exposure to the stock market even at the highs, just in case our forecast was wrong.  The correction of the last two weeks gave us the opportunity to increase our exposure at much lower prices.  It would not be shocking for stocks to extend their decline another 10% (S&P 950-1000) so we aren’t close to fully invested yet.  Our Diversified Portfolio should now track approximately 50-60% of the change in S&P 500 (currently S&P 1089). Unlike the major market indices, all our managed portfolios remain at least marginally profitable in 2010.

Hopefully the market will continue its decline giving us the opportunity to get more aggressively invested at even lower prices.  If on the other hand we are close to the bottom, our Diversified Portfolio is way ahead of the market for the year and will capture over half of any future recovery from current levels.  The market will have to post at least double digit gains to catch up with us.

The recent market correction was triggered by fears that the current Euro crisis would result in a repeat of last year's economic and market collapse.  I believe the chances of this occurring are extremely remote.  Last year, financial institutions were heavily dependent upon the repurchase (repo) market for short-term funding.  When the subprime mortgage disaster triggered the collapse of Lehman Brothers, the repo market evaporated.  Financial institutions instantly lost their primary source of funding.  That forced them to cut off short-term funding to commercial and industrial companies, which in turn caused the entire economy to seize up.

The world today is completely different.  Surviving commercial and industrial companies have virtually eliminated their dependence on short-term borrowings.  They have prudently refinanced a record amount of debt that was coming due in the next few years into long term loans.  This puts the balance sheets of non-financial corporations in the best financial shape they have been in at least 100 years.  Consequently, a financial institution disaster like we had last year would seriously slow the economy but could no longer trigger a crisis of such major scale.

Financial institutions no longer rely on the repo market for short term funding either.  The Fed is supplying short term money to banks at near-zero cost while banks (with the help of government guarantees) have dramatically increased their capital.  Prior to Fed intervention, mortgage defaults reduced bank capital while reduced mortgage payments meant the interest these banks were receiving was less than the interest they were paying on deposits (including repos).  With the Fed supplying deposits at or near a zero rate of interest, the lack of interest income merely reduces profits, but does not cause a loss (pretty cool if you happen to be a bank – not so cool if you’re a taxpayer).  Some day, borrowers failing to repay their mortgages will cost the banks huge amounts of money.  For now, banks can restructure many of those mortgages such that they don’t have to book the loss before the final payoff date of the mortgage (which may be years or even decades away).  As long as the overnight funds rate remains close to zero, it is virtually impossible for a new round of defaults to create a banking crisis like we had last year. 

In the absence of such a crisis, commercial and industrial corporations are positioned to remain profitable, even when (not if) economic growth slows.  Because companies will remain profitable, stock prices may decline further, but it is extremely unlikely that they will collapse.

A few weeks ago, when the stock market was hitting two year highs, gold prices and gold related mutual funds were even hotter.  The unrealistic fear of a repeat of last year's crisis fueled the so-called “flight to safety” into both gold and TBonds.  It seems to me that someone in this trade has to be wrong.  TBonds perform best when inflation falls sharply, while gold performs best when inflation rises sharply.  Assuming these were my only two options, I would side with the Gold Bugs, but I wasn’t prepared to own gold near the record high prices a couple of weeks ago.

Recent client queries wondering why I wasn’t in gold were strangely reminiscent of client calls I received in 1999 about why I didn’t own internet stocks.  We have held positions in gold related mutual funds during most of the past decade, as gold prices tripled.  We have briefly held gold related positions this year including a position that we opened and closed since the drafting of this letter last week.  Those investments were important contributors to our superior long term returns.  Consistent with our process for all investments, our decision to buy gold is based fundamentally on relative value.  When compared with other asset classes, if gold related investments display a favorable risk/reward ratio, we will go long.

The unfortunate fallacy that is fed so repeatedly about gold is that we should buy it for safety.  Period.  Investments in gold supposedly provide stability; gold protects purchasing power as a hedge against inflation, gold acts as a store of value in a crisis, etc.  However, owning gold is not always a prudent way to protect your portfolio.  Gold owners hold an asset that produces no internal rate of return.  Bonds pay coupon. Companies produce revenue (ideally) that owners share (dividends and/or appreciation).  Owning gold entitles you only to price fluxuations based on external factors.  Contrary to the claims of precious metals advocates, buying gold has historically proven to be extremely speculative.  These advocates often ignore the real results of gold investing.  Like any other asset class, buying gold when it is expensive can lead to dismal returns while buying gold when it is cheap relative to other investment options is prudent.

Even during the past decade, when gold scored spectacular gains, gold prices were much more volatile than the S&P 500!  Conversely, those who bought gold related investments in '79 and '80 to protect against the inflation threat discovered that gold provided less inflation protection than either stocks or bonds for decades.  Even in the correction of the past few weeks, when gold prices fell less than the S&P 500; the best decision would have been to buy US Dollars to protect yourself from falling gold (and stock) prices.  Gold usually performs well during sudden short term unexpected economic crises or inflationary spikes.  Stocks have historically provided better protection against inflation over the long term. 

Bearing this caveat in mind, gold may or may not be a wise investment choice.  I do believe inflation is likely to eventually return.  A likely response to this is an eventual rise in gold prices.  It would not even surprise me if a speculative bubble inflates gold to $1500 or even $2000 per ounce.  Therefore, I am willing to buy gold related investments whenever the price declines sufficiently.  At the present time I have a simple rule of thumb: I prefer to own gold whenever its price is at least 10% below the S&P 500 index (like earlier this year),  I prefer stocks whenever the S&P 500 index is at least 10% below the price of gold (like last week).

Because the price of gold is so volatile, the best reason to own gold is because of its profit potential when you get it cheap.  When you overpay, no asset class provides safety.  Gold mining stocks are even more volatile than Gold or the S&P 500.  Therefore, gold mining stocks provide more opportunities.  The correction last week brought mining stock prices (like other stock prices) back down to fair value.  We opened a position in gold miners on Tuesday and closed the position on Thursday with a 7% profit.  While we did not buy expecting to be out in two days, volatility proved to be our friend.

The bottom line is that investors who put money in stocks at current prices levels (S&P 1087) should achieve very acceptable long term rates of return.  It will require a speculative bubble like we had in the late 1970s to cause gold prices to do better than that.  It will also require the timing savvy to exit the position before this bubble violently deflates.  For those who have the cash and the guts to buy stocks if they take another leg down, the long term investment returns should be outstanding.  I reiterate, “for now our 2010 forecast remains unchanged.  When the dust settles US stocks are likely to end the year very near where they began”. 

Clyde Kendzierski
Chief Investment Officer

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