March 13, 2012

What’s a Few Trillion Among Friends?

The Investment View from Prescott, Arizona

By Will Hepburn

Last week I picked up a $100 trillion dollar bill – Zimbabwean dollars – to hang on my wall as a conversation piece.  It is worth less than $5 U.S. because the government of Zimbabwe just kept printing and printing until they could hardly give the things away.

This got me thinking about the way our Federal Reserve Bank is printing money– actually that term is getting to be pretty “last century” as the kids would say.  Create money is a better term because most money these days is made up of electronic payments not paper and ink.

Anyway, the Fed has created so many new dollars that most of us are numbed by the numbers, so let me put it into perspective for you with an example from Art Cashin.

If you want to have a million dollars, just set aside $500 each week for 40 years and you will be a millionaire.  And you could then pull out $500 each week to live on for another 40 years, and that is with no interest.

To get a billion dollars, just put away $500,000 each week for 40 years.  Gulp.  Maybe you can see where this is going, because to get a trillion dollars, would require $500 million every week for 40 years.

Even with this simple example, the numbers quickly become hard to grasp, but with our government throwing T-T-T-trillions around like they are petty cash, I am getting alarmed.

So, with all this printing of money, why has inflation not roared back to life like in the 1970s?

The text book definition of inflation is too many dollars trying to buy too few goods, so the price of the goods gets bid higher and higher as people try to put all the extra dollars to work. 

Certainly the “too many dollars” part is happening, but this is a two part phenomenon.  All those dollars must also get spent to run up the price of the goods.  When shoppers see prices beginning to rise they begin to buy more quickly to get in before prices rise further.  This creates a “velocity” to money and is the beginning of an inflationary spiral.

But spending is what is not happening at least for the moment.  All that new money has been getting sucked into a black hole of debt service – into our banks, mortgage payments, and now into Europe.  Until consumers stop feeling the heat from their debt burden, they are not likely to spend a lot.

This is why inflation is not a huge problem at the moment.  But we are surrounded by the rocket fuel of oodles of money being printed, so what happens if the spark of inflation sets it off?

Inflation, when it happens, takes off rapidly.  How rapidly can it happen and how can it affect our daily lives?  Let’s look at Germany in the 1920s to see.

To understand the wild numbers involved in German inflation, maybe it’s best to start with something basic…like a loaf of bread.  In the middle of 1914, just before the war, a one pound loaf of bread cost 13 cents.  Two years later it was 19 cents.  Two years more and it sold for 22 cents. By 1919 it was 26 cents, double its cost 5 years earlier.  A thirteen cent increase does not sound like much, but it takes 14% inflation to make costs double in 5 years.

The US experienced similar inflation in the 19-teens – four straight years over 15% – but we quit spending and our inflation dropped as we entered the 1920s.  Not so in Germany.

In 1920, a loaf of bread soared to $1.20, and by 1921 it hit $1.35.  By the middle of 1922 it was $3.50.  At the start of 1923 it rocketed to $700 a loaf.  Five months later a loaf went for $1200.  By September it was $2 million.  A month later it was $670 million (wide spread rioting broke out).  The next month it hit $3 billion.  By mid month it was $100 billion.

This is what happens when a government prints money with abandon.  Are we abandoning the value of our currency like Zimbabwe?

Not yet, but this is one of the things I worry about.

Workers of The World Untie!

From the Desk of Bryan Jarman, CFA

No, that is not a typo.

I had the unique opportunity of living in the Soviet Union during the last 45 days of its existence back in 1991.  Then, for over a year I watched the transformation as they struggled to make the change from communism to capitalism. 

I stood in lines to buy bread.  I stood in separate lines to buy milk.  I “shopped” in stores where there were only a few morsels of food (unrefrigerated kielbasa – sausage) way back in a corner where it could be watched over.

Handing over my rubles to purchase what was available, I watched the attendant determine my change with an abacus, the precursor to the modern day calculator.

In front of the Republican Stadium in downtown, Kiev, Ukraine, hundreds of individuals would gather, standing shoulder to shoulder as they held out or stood over a few imported goods they wanted to sell.  This was the birthplace of the post-Soviet entrepreneur – all weather, outdoor markets like our flea markets without cars or booths.

These workers had been promised cradle to grave care by a communist government that ended up tying its people down.  The Soviets took Russia, a wealthy and culturally diverse nation and imposed a system that caused its economy and its culture to sink to the level of its lowest contributor, because the system took away any incentive for its people to want to get ahead.

The government that was going to give them everything ended up taking everything away from those workers.

The Kiev market vendors endured long days in often harsh weather, standing and jostling for space just to try to sell a few meager goods because they knew it would improve their lot more surely than the government promises.  They knew that their reliance on government just tied them down.  They wanted out, opted for self-reliance and are better for it today.

It is time for the workers of the world to untie!!  Stop looking to the government for solutions.

A Slice of Life

I’m in Phoenix as this newsletter is being delivered to you, doing a little business and watching a Diamondbacks game.  I tried out for the Diamondbacks “Golden Glovers” the old guys (and gals) who sit on the sidelines shagging foul balls.  The physical part was no problem for me, having played ball for 50 years, but since I am still working they couldn’t hire me.  Yes, hire!  They will actually pay you to sit on a major league ball field and be part of the action.  Is this a great country or what?

And if you are on your way to Sun City, check out the new 303 Loop that runs from I-17 over to Grand Avenue before turning south to I-10.  The northern section is like your own private 4-lane highway over to Grand Avenue and Sun City.  What a cruise!

How’s The Market Doing?

The market is making good headlines, but when I look at the actual numbers, the markets seem stalled.  As of this writing on March 11th, the Dow Jones Industrial Average** has made no progress and is actually below its level of my last newsletter writing, two weeks ago.  So much for the run at 13,000 the TV commentators spend so much time talking about.

The number of stocks driving the market up continues to get smaller.  In short this is a toppy market – one that has great potential to decline.

The bond market usually signals economic strength with rising interest rates, but right now rates are staying low, indicating that the economy is not strengthening, but staying weak.  This means that interest rates, the price of money that businesses need to expand, will be staying low for a while longer because of low demand for borrowed money.  That is bad news for savers.

Gold stumbled over the past two weeks – not bad enough for me to want to get out, but certainly not encouraging for a guy who likes to buy investments in up-trends.

Mental Floss

Q:  What is the one sport in which neither the spectators nor the participants know the score or the leader until the contest ends?

A:  Boxing

What’s Going On In Your Portfolio?

With the market looking toppy, we increased the size of our hedge this past week, so if the market declines we have a better chance of just perking merrily along.  We hold stocks of pharmaceuticals and biotech companies, automakers, real estate and retailers, all strong market sectors.

Our Shock Absorber* hedging strategy is dampening the volatility as we designed it to do, allowing us to stay more fully invested despite storm clouds forming over the stock market.

Flexible Income* accounts remain invested in the same mix of corporate and municipal bonds we have held for several months and continues with steady, if unspectacular performance.  If it ain’t broke I don’t want to try to fix it.

Our Spotlight Strategy

Shock Absorber Growth – A New Way to Reduce Risk

For many years, the hallmark of our work at Hepburn Capital has been reducing the risk of being invested.

Techniques that I developed and used over the years included my “1% rule” where I strive to make sure that no single investment ever lost a client 1% of their portfolio. 

“Stop-loss” rules to sell investments that declined beyond normal fluctuations kept our money safe for many years.

And then the markets changed and the ups and downs became sharper and more closely spaced – “volatile” in industry lingo.  My stop-loss rules shook us out of many investments that later went on to be big winners.

So we have adopted a strategy that will allow us to stay invested longer, trying to capture those gains that eluded us last year, and will actually reduce the overall risk of being invested.

The technique involves pairing investments that move opposite to each other – one usually goes up when others go down, greatly cushioning the overall value of the portfolio. We adjust the amount on the two sides to match the market, but the cushioning effect is what we are after with this tactic.

By scientifically selecting the investments that we pair together, stress-testing shows that we can participate in much of the stock market’s gains on good days while keeping declines small on bad days.  With minor adjustments to the mix of investments, this strategy would have allowed us to stay invested during the 2008 market melt-down with only small losses, and still make good money in up markets as well.

The new strategy smoothes out the ups and downs of the market so well that we have begun to call it the shock absorber strategy.

If you want lower-risk growth, our Shock Absorber Growth strategy is for you.

*    The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed.   Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account.  Not all trades are profitable.  It should not be assumed that current or future holdings will be profitable.   A list of all trades in these accounts for the past 12 months will be provided upon written request.

**  The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market.  Investors cannot invest directly in the S&P 500 Index.

Traditional Income
Flexible Income
Adaptive Balance
Adaptive Growth
Shock Absorber Growth

This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy.  Please discuss any legal or tax matters with your advisors in those areas.  Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.