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THE
FINANCIAL ECONOMY VERSUS THE PRODUCERS OF GOODS AND SERVICES “There is not the slightest analogy between playing games and the conduct of business within a market society. The card player wins money by outsmarting his antagonist. The businessman makes money by supplying customers with goods they want to acquire. There may exist an analogy between the strategy of a card player and that of a bluffer. There is no need to investigate this problem. He who interprets the conduct of business as trickery is on the wrong path.” ~ Ludvig Von Mises [1] My goal is to seek intrinsic value for clients. Within this goal I can sleep at night knowing the value investor seeks to channel hard earned client assets into areas which may need additional investment capital. We will eventually need more capital investment in the real economy as the financial economy continues to outpace our (United States) former source of wealth. We know from fact the tax laws in the United States today provide a stimulus to many forms of debt (writing off mortgage income from debt – the word mort in coming from the French word “death’). Earnings or earned income taxes, income from savings and investment taxes (capital gains) and ultimately estate taxes which may bear a significant burden on entities which retain the bulk of their capital in land or other less liquid investments. This is not an attempt to question the ethics of our tax laws or the intentions of the central banking system known as the Federal Reserve. This editorial is for the prudent investor considering today’s facts and when developing a strategy to minimize direct taxes and indirect confiscation of the purchasing power of their assets (inflationary policies implemented by central banks) into their investment thesis. In the past the United States economy was run on savings and investment. Today, we see an economy largely running on debt and consumption. This is not disputed by Federal Reserve Officials or other entities who post their economic reports to the public. The reality is this phenomenon isn’t accepted by all investors. One look at the sector weightings in the S&P 500 from 1980 versus 2005 (latest data to date from May 2005) begins to provide an idea at the overwhelming change in United States common stock allocations from 25 years ago [2]:
This is not to imply there are not other productive areas within the United States economy. A further review of the S&P 500 reveals 4 sectors with less than 3% allocation each (Industrials, Transportation, Commercial Services and Telecommunications). Utilities barely escaped this analysis with 3.01% despite this sector being one of the best performers in the past year (second to energy and no doubt due to the strong rally in bonds resulting in decreased yields on US Treasury paper). There are always industries where we consider potential investment should we see intrinsic value for our clients, however further analysis often reveals other risks associated with what Benjamin Graham noted as the “margin of safety” [3]. My clients in the world of technology and health care may point out areas where they may see value in future investment capital, however the focus of this editorial is the dynamics between sectors which may be affected from today’s levels of credit and money supply (inflation) resulting from the cause: easy monetary policies and artificially low interest rates. In addition, we know the earnings of many companies listed in other sectors (GE – Industrial) are greatly due to financial transactions such as leasing. A first look at today’s commodity index (Commodity Research Bureau – CRB) reveals a new movement upwards to potentially retest the historic high of 323.33 this past March 2005. Experienced readers on Financial Sense Online (FSO) know the CRB has traded in a range around 210 to 310 during the past 25 years when priced in dollars (known today as Federal Reserve Notes) but when adjusted for the “official” inflation numbers we see the real rate of increase in nominal terms is nowhere near the previous high in the early 1980’ or middle 1990s. Commodity Prices Adjusted for Inflation (Source: Di Tomasso Group/CRB Index)
While this chart has been pointed out in other editorials, I’d like to make some general summaries:
Will rising asset prices continue in tangible things we consume daily? It appears our planners have been very successful at channeling credit and money supply into financial assets such as many types of stocks and bonds. A well documented effort by “the central banks” to “conventionally conduct monetary policy by manipulating the short-term nominal interest rate” [4] no doubt greatly stimulated assets purchased with debt (real estate) but has resulted in the loss of purchasing power in the US Dollar via other fiat currencies and real tangible assets. Our forecast is a continued rise in asset prices when priced in dollars and a decrease in many asset classes when priced in gold or silver (especially within sectors greatly dependent upon debt). Many people within the United States understand the fact we need water, energy, food and many strategic commodities to continue our way of life. This is becoming clearer on the radar screen given today’s comments from US Secretary of Energy Sam Bodman on a Chinese State Run Oil and Gas Company’s proposed counteroffer to Chevron Texaco’s bid for Unocal: US
sees 'complex' review of any CNOOC, Unocal deal Dr. Marc Faber’s “Gloom, Boom & Doom Report” for May 15, 2005 recently commented on speculation from some experts that “China is pursuing a strategy of ‘string of pearls’, which is designed to build strategic relationships along the sea lanes from the Middle east to the South China Sea in ways that suggest ‘defensive and offensive positioning’ to protect China’s growing energy requirements.” I had listened to Marc’s dynamic speech at the San Francisco Gold Show in 2004. He commented not only on Asia’s growing requirements for commodities but also their potential strategy of exporting goods to the US while importing goods from select Asian nations to hopefully build a more diversified consumer base. It doesn’t take a rocket scientist to understand the growing demand for precious metals by foreign central banks as a hedge against the massive amount of US Dollar denominated Treasury holdings that could greatly increase the existing supply deficit today. History “Rhymes” A recent book by Eric Clements was sent to me this past week (I have a home in Jerome, Arizona) that provided some insight to the radical change in perception of wealth creation in the Southwestern United States. The Grand Canyon State was once known for its mining (copper), cotton (Pima) and cattle industries. Today, there seems to be no shortage in credit stimulating demand for residential housing developments in the Arizona as well as much of the Sonoran Desert.
One interesting note, Jerome, Arizona was named after Eugene Murray Jerome, a New York investor and the cousin of Sir Winston Churchill's mother, Jennie Jerome. Sir Winston Churchill said it best… “A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty.” Investment Opportunity Looking at arguably America’s greatest investor, we see from actions (not words) the fact that Warren Buffett understands our current fiat currency situation (inflation and potential loss of confidence in paper assets – credit risk) from his father. He may been taught some Keynesian economics at Columbia U but the his father, Hon Howard Buffett obviously well understood Austrian economics in a speech to congress 57 years ago today [8]: “But it was not always this way. Before 1933 the people themselves had an effective way to demand economy. Before 1933, whenever the people became disturbed over Federal spending, they could go to the banks, redeem their paper currency in gold, and wait for common sense to return to Washington.” ~Howard Buffett The last three deals for Berkshire Hathaway involved energy, natural gas and pipelines. In addition to the silver purchase in 1997 (37% of the worlds above ground stockpile) he’s been moving to foreign currencies via FX bonds [6]. I would speculate the management at Berkshire not only understand the structural demands for energy (peak oil thesis), but also knows petrochemical commodities are rising in price because of the dollars loss of purchasing power (inflation) due to excess money supply and credit. We see an opportunity in many asset based companies. Preserving capital is paramount and the individual investor may enjoy success in a similar strategy by investing in undervalued or under allocated sectors, which may greatly benefit from the coming debasement in our currency to meet the overwhelming liabilities to our currency. The “Strategy of Monetary Policy” Former Federal Reserve Vice Chairman Alan S. Blinder stipulated the Federal Reserve Act tells the central banks to pursue “maximum employment” and “stable prices.” [9] This is obviously in great contrast to an entity today, which seeks to prevent deflation at all costs even at the risk of severely depreciating the relative value of the US Dollar. Yesterday Crude Oil traded over $60 per barrel and we’re witnessing rising prices not only in commodities but also the goods and services we consume daily. The unfortunate irony is evident to those who study monetary policies and history. “Anyone who thinks there will be deflation does not understand twenty-first-century central banking. There may well be a deflationary collapse later, but before that happens the government will print money until the world runs out of trees.” ~ Jim Rogers [10] “If central banks effectively insulate private institutions from the largest potential losses, however incurred, increased laxity could threaten a major drain on taxpayers, excess creation of money by the central bank, or both. In the end, we would be faced with a severe misallocation of real capital.” ~ Remarks by Chairman Alan Greenspan, Before the Council on Foreign Relations, Washington, D.C. 2002 “As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods.” ~ Alan Greenspan, Gold and Economic Freedom, 1966 Inflation
- * in·fla·tion: ( 1. The act of inflating or the state of being inflated. 2. An abnormal increase in the available currency…
…and credit beyond the proportion of available goods, resulting in a sharp and continuing rise in price levels.
Today’s Market The Dow Jones Industrial Average was down 11.74 points at 10.587.93, off an intraday high of 10,646.24. The benchmark index has now fallen for three straight sessions. The Nasdaq Composite Index rose 0.96 point to 2,092.03 after briefly touching a four-month high in early trading. The S&P 500 Index increased 0.27 point to 1,213.88. Stories from the press site benchmark yields “plummeting” and documented oil prices falling 1.6%. Markets in the United States began the day on a “promising note” as investors embraced the positive value implications of low bond yields (a good thing for an economy running on debt) which “plunged” even in the absence of “scheduled market-moving” economic reports. Again we’re seeing concerns about slowing global growth, spurred by record high energy costs as well as the speculation about “policy makers” voting for a rate reduction. European shares closed at three-year highs on Wednesday with British retailers and banks buoyed by hopes of an interest rate cut. Germany's indices reportedly “surged” after breaking through a key technical level. In late breaking news… CNOOC, China's biggest offshore oil company, launched a formal bid late Wednesday for Unocal Corp., offering $18.5 billion for the California oil and gas producer. Have a good evening, Chris Sumner [1]
Von Mises, Human Action, fourth edition, copyright 1996 by Bettina B.
Greaves VI.
Uncertainty, 6.
Betting, Gambling, and Playing Games
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Clements
made some interesting observations about past western United States
resource towns, documenting the attempts by the Federal Government to
“artificially inflate the price of gold” in the 1930s (efforts to
depreciate dollars in circulation after seizing private holdings of
gold) as well as the deflationary consequences of excess credit on the
properties in many areas. [5] While I must confess I have yet to
finish this book, I note the author seems to have an excellent idea of
what money was and is today. Specifically, he comments on how many
institutions in the industrialized East benefited greatly from the
financing and ownership of many tangible asset based companies (mines
as well as energy, food and water) and rights in the west. In summary,
Bernard DeVoto was quoted suggesting western mineral development
“has not made the west wealthy” but rather the stockholders in the
eastern banking entities.
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– [11]
