Q1 2011 Meridian Quarterly
The Ebullient Market: Toward 1,500 & 15,000
One thing is clear, the stock market is on a tear. Perhaps things will have changed by the time you receive this letter, but right now the bulls are in full control. I’ve nicknamed this bull market the “ebullient” market due to the enthusiasm and energy this market has generated. In an economy marked by massive numbers of people on food stamps and an unemployment rate that has fallen only due to the huge number of people dropping out of the work force, one must wonder what is supporting near record earnings and historically high stock market valuations.
It is my opinion that this market is bubbling over. Of course that has been my opinion now for quite some time, but as I have learned with past extreme valuation markets – valuations can stay higher longer than anyone expects. I remember when the NASDAQ was barreling past 2000 and quickly hit 3000 – I thought surely theses stocks are set for a fall; instead that index quickly hit 4000. I remember quoting Keynes to brokers in the Merrill Lynch office saying “Don’t confuse brains with a bull market” and “The market can stay irrational longer than you can stay solvent”. Yet, the NASDAQ continued its pace and hit a high of 5048.62. With each new high I shook my head and took the criticism from my peers as a pollyanna.
I was nearly fired from Morgan Stanley for not being a team player and selling the “MSDW Global Technology Fund” that management was pushing in mid-2000 (a fund that no longer exists). As the NASDAQ began its descent and eventual crash to the 1139.90 level I felt vindicated, of course I had already left and started my own company and was beginning to see signs of a housing bubble. In June of 2004 I was quoted in Bloomberg saying “I think there’s a bubble. It’s similar to the NASDAQ several years ago.” I was on track, but certainly early. What I didn’t call was the 2008 stock market crash, even thought the signs were clearly there (overvaluation and record profit margins).
My point is not that I am some seer, its obvious that I am not. But nearly every metric I use to value the market is showing warning signs that things are overheating. This doesn’t mean the markets are about to crash, but it does portend for lower returns over the coming decade. What I don’t rule out is a market that continues to go up despite lousy fundamentals. Do not be surprised if the S & P 500 hits 1,500 or the Dow Jones Industrial Average hits 15,000. I just don’t believe these levels are sustainable and believe the downside risk is greater than the upside potential return.
There is one exception to this. Large cap stocks that are high-quality (meaning good cash flow, good balance sheets and solid fundamentals) do not appear to be significantly over-valued, they may actually present a reasonable opportunity to earn a return of 9 – 11% over the next 7 – 10 years. Having said this they are are also subject to large fluctuations in value.
If the market continues its blistering pace our portfolio’s will continue to lag. I believe it is wise to seek to preserve capital when valuations become out of hand. It is my belief that our returns will be higher over the cycle by lowering our allocations to stocks when they become valued as they are now.
The US Is Not Greece
This is a common theme on my blog and in my last quarterly commentary, but because there is so much confusion and because the U.S. debt and deficit have become front page news on a daily basis I feel the need to cover it again.
In short, pretty much everything you are hearing regarding our national debt and annual deficits is flawed. Yes, we are running very high deficits and yes, the spending is out of control and much of it is junk spending, however the United States is not at risk of defaulting on its dollar-denominated obligation. The common refrain among both Republican and Democratic politicians alike is that the United States is akin to Greece, meaning we are on a path to ruin where we will no longer be able to honor our debts. This line of thinking exposes a deep flaw in these politicians and commentators understanding of the inner workings of our monetary system.
The simple fact is that the only way that the U.S. doesn’t honor its commitments is if they choose not to. All of our debt is denominated in dollars. The United States is the monopoly issuer of dollars in a non-convertible, flexible exchange rate system which means that we can always pay our bills. We can never be insolvent. This doesn’t mean that we won’t have inflation or dollar devaluation as a potential affect, but we are NOT revenue constrained. We can always pay our bills.
Greece on the other hand owes its debts in Euro’s, a currency in which it does not own or control the printing press. The Greeks must produce and sell something to someone with Euro’s in order to get them to pay their debt, if they can’t they face a spiral…which they are currently facing.
Does the United States have economic and fiscal problems, YES. Are we at risk of becoming insolvent, only if politicians act stupidly (I’m sure that makes you feel much better…), otherwise NO.
The great irony is that economic commentators, gold bugs and politicians are constantly railing on the Federal Reserve (of whom I am no fan) for “printing money out of thin air” which is an untrue statement. The Federal Reserve has the ability to change the nature of U.S. debt obligations, but they are not adding net new assets into the system – that is done by Congress when they deficit spend.
Most people believe that our spending is constrained by the amount of taxes the government can collect plus the amount the government can borrow. This is not true. In fact, the government can spend irregardless of either. It is only because of old laws and rules that the government issue’s debt whenever there is excess spending over tax receipts.
I encourage you to read my blog and the blog Pragmatic Capitalist at www.pragcap.com for a better understanding of our monetary system. I have a feeling the rhetoric is about to hit a fever pitch and the fools doing the pitching have no idea what they are talking about.
Corn, Oil & Gold
I’ve been on a documentary kick this quarter, watching five of them. What I learned has changed my perceptions of a lot of things, in particular food and oil. More specifically, our entire economy exists based on access to cheap oil and cheap corn. Without either, major disruptions would ensue which could have dramatic impacts on our economy and stock market.
The documentaries I watched are:
Waiting for Superman
Each of these documentaries offered something that was alarming, yet eye opening. I won’t go into each one, but to say that Food, Inc. completely changed the way I think and eat is an understatement. Inside Job just confirmed what I already knew and Crude Awakening jolted me to the massive risks that exists without a cheap and abundant supply of energy.
The question that kept haunting me was whether the stock market had enough of a cushion or Margin of Safety in it should a supply shock hit Oil or Corn, my answer is that it doesn’t. As we watch the steady day to day increase in Oil, we see the affects it has on everything else. The Federal Reserve is serving as a great villain (and trust me, they are one), but our economic policies that favor and are dependent on cheap corn and oil are the two major long term threats our economy faces. In addition, under-regulation of our out of control financial industry.
In conclusion, I remain cautious with your portfolios, but am constantly looking for opportunities that make sense. Please call or e-mail me with questions, concerns and if you want to get together to talk.
Scott Dauenhauer CFP, MSFP, AIF