Volume 1 14 Risk Uncertainty in 2010 Dec 21 2009

8/14/2019 Volume 1 14 Risk Uncertainty in 2010 Dec 21 2009

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BOECKHINVESTMENTSINC.,17501002SHERBROOKESTREETWEST,MONTREAL,QUEBEC.H3A3L6TEL.5149040551,[email protected]

VOLUME 1.14

DECEMBER21,2009

There have been five overriding themes for

our investment letters during the past year.

Below we list and review them.

1) Expanding liquidity drives financial

markets, particularly when it occurs in the

face of a sub-par but recovering economy

and weak price inflation. This is the sweet

spot in the cycle we so often talk about, and

it is the best of all times for stock and

corporate bond prices when perception of

risk abates.

2) The Great Reflation underway since

late 2008 has done its first job - aborted

what surely would have been a full scale

depression at least on the scale of the 1930s.

That was Act I.

3) No one should believe that the huge

reflation underway will make the economy

and financial system whole again. The

private sector debt excesses were far greater

by 2008 than they were in 1929. A good part

of the reflation effort is to transform private

debt into public debt, and this will surely

create another, different debt monster. As

the year draws to a close, credit rating

agencies are starting to downgrade

sovereign debt and credit default swaps

(CDSs) and are showing increased concern

that some major developed countries are

going to have problems servicing their debt

(e.g. Japan, U.S., etc.).

The markets are starting to tell us that

Governments with brittle, over-extended

fiscal positions will soon have to put in

place credible fiscal consolidation -- tax

increases, expenditure cuts, decline in

services, etc. This means more deflation,

more uncertainty.

RISK & UNCERTAINTY IN 2010:

Hopefully Some Return Too


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THEBOECKHINVESTMENTLETTER WWW.BOECKHINVESTMENTLETTER.COM 2

4) Zero interest rates in the U.S. together

with Federal Reserve asset purchases, much of

it low quality, has done its job of inflating asset

prices which improves balance sheets. Better

financial markets greatly help capital raising

ability, further strengthening balance sheets.

As a result, they are much improved. The

question is over sustainability. Fears of

renewed asset bubbles have surfaced,

complicating Fed and other central bank

decision making. Do they risk tightening too

soon or too late? Does a middle ground exist?

Zero interest rates are an extreme anomaly and

cannot last unless the U.S. economy remains

permanently depressed and in deflation like

Japan has been for 20 years. This seems

unlikely but cannot be ruled out.

5) The great flaw in the international

monetary system has allowed the U.S. - the

key reserve currency country in the world - to

run up a $4 trillion tab with foreign central

banks and has created excess liquidity and

asset bubbles in countries buying those dollars.

It has also contributed mightily to the

destruction of savings and investment in the

U.S., and has created massive disequilibria in

the global economy and financial system.

Economics 101 tells us clearly that all

disequilibria eventually get corrected. The

interesting questions are how and when? That

will be the story for Act II of the drama and it

hasnt been written yet.

As the year 2009 draws to a close, there

is clearly an aura of unreality. We barely

survived a near-death experience nine months

ago. However, the pain and the fear for most

people were brief. It was not like the 10-year

depression in the 1930s that changed attitudes

for two generations. The recent experience

probably won't change many peoples' attitudes

at all, and may even have a perverse, moral

hazard effect. If the U.S. and other

governments are always going to bail out the

banks and other over-indebted, overleveraged,

reckless players, and stick the costs onto the

sober and prudent, why not join the former? As

Mark Whitehouse put it in a recent article,


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"Let's default and go to Disneyland - the

American dream - default and then rent."

The music is playing again, people are

up on the dance floor and the bankers

(somewhat diminished in numbers) are getting

rich once more and raising tens of billions of

dollars in equity on the much-improved stock

market to pay off their TARP loans so they can

pay out mega bonuses. Meanwhile, the banks

are sitting on hundreds of billions of dollars of

bad loans with more to come (default lags can

be long).

The question for investors is - do you

get up on the dance floor like everyone else

and pretend that the crash was a bad dream?

Or, do you pay attention to the unresolved

problems, do a little dancing, but be ready to

grab a chair when the music stops?

A key point we have been making all

year and will continue to do, is that the stock

market in March 2009 met most of the criteria

for a durable bottom. These were: good

valuations, massive fear, very expansionary

monetary policy and government through

intervention, bailouts, and stimulus etc. to do

whatever it takes to put air back in the burst

balloon. Simply put, the government took the

downside out of the economy and risk assets.

The odds were very high that the

market environment would be good for some

time and it has stayed that way. However, the

so-called fundamentals are very artificial - the

stimulus, the subsidies (first-time home buyers,

cash for clunkers, moratorium on foreclosures,

etc.), the zero interest rates - none of that can

last.

A second key point we have been

emphasizing is that no one knows what the

underlying economic conditions are really like,

and more important, what they will look like in

6-12 months. No one knows how sensitive the

still over leveraged economy is to a rise in

interest rates. No one knows how long nervous

foreign central banks will keep buying dollars.

No one knows whether the recovery in asset

prices might morph into a full-blown asset

bubble. Or the reverse. No one knows when


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sharply rising government debt: GDP ratios

will hit the wall, as in the case of Greece.

No one knows how much debt is too

much. The private sector debt super cycle went

through a process of steadily rising over 25

years to reach 170% of GDP. All along the

way, the same questions were being asked -

how much is too much? The answer was: a lot

more than most people thought. But when you

get to the end, they dont ring a bell to give

you a warning. Think of the elastic band

analogy. You keep stretching it; it weakens

gradually until a certain point. Along comes

a shock and it snaps. That happened in 2008

with the private debt structure. It will happen

with the government debt if a credible plan is

not put in place to bring it under control, but no

one has any idea of when. It probably won't be

for quite a while, but no one will give you a

written guarantee.

A third key point we strongly believe is

that there is no long term any more for

investors. It is totally inappropriate in this

environment to think in terms of point

estimates -- how high the stock market might

go and how long it will keep rising. Estimates

of numbers and time are useless and, in this

highly uncertain world, no one should believe

such forecasts.

The issue is risk and uncertainty. The

dilemma for investors as they face near-zero

returns on safe, liquid, short-term assets is that

if they want some return, they are necessarily

driven to accept a level of risk that is

uncomfortable and unknown. While this is

always true, the difference going into 2010 is

that a lot of things could go very wrong on

very short notice. For most of the post-war

period, that was not the case.

Investment Conclusions

Our take on the investment environment as the

year draws to a close is as follows:

1) We are not yet in a full-fledged asset

bubble, although as we pointed out last month,

gold and other commodities may be a lot closer

to one. The recent correction in those markets

is helpful and the injection of a little risk may


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curb speculative juices for a while. Risk assets

in most developed markets are still well below

old highs. The exception is real estate outside

the U.S. Quite a few markets are getting too

hot for comfort.

2) The Fed and other central banks will

continue to talk of exit plans, but they are as

concerned as we are that underlying economic

conditions have been driven by artificial

factors and are not nearly as strong as recent

data suggests. Remember, the two most

powerful influences driving Fed policy are

first, unemployment, and second, elections.

There is 10% unemployment and a much

worse picture counting discouraged workers

and structural unemployment. With a key

election next year, the Fed will not be

tightening any time soon.

3) Foreign central banks will continue to

hold their nose and buy enough dollars to

prevent a collapse. Dollar erosion over time,

with periodic rallies is a better bet. Moreover,

dollar short positions are huge, so dont count

out sharp counter-trend moves.

4) The world will remain very

deflationary for some years and Government

bond yields are very low as a result. The risk is

on the side of an increase, but it will likely be a

gradual trend.

5) There will be enough economic

strength for awhile to support corporate credit.

Spreads against Treasuries should be flat to

down. That will continue to provide

opportunities to enhance returns.

6) The stock market environment will

remain good for the time being. Profits have

recovered substantially, liquidity is plentiful,

and interest rates are so low that investors will

continue to be driven to riskier assets - stocks,

corporate bonds, commodities, emerging

markets and probably gold, although that looks

like a very speculative market.

7) Markets of countries, ex. the U.S., with

strong currencies, sound finances, stable

politics and with commodities making up a

large percentage of the GDP, should continue

to do very well. Examples are Canada,

Australia, Brazil, Columbia and Norway.


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There are more. High-growth developing

countries like China and India will also do

well, but as valuations get stretched, volatility

will increase a lot. Good entry points are

essential.

A final note - remember the U.S.

reflation is an experiment never before

performed in peacetime except in post-1989

Japan. The lesson there is not very consoling.

Japan never got past Act I - the avoidance of a

depression. Act II, as we pointed out, is all

about restoring equilibrium and returning to

sustainable, non-inflationary growth. Japan has

had less than 1% real growth for 20 years even

with zero interest rates. Lack of growth has

pushed the debt to GDP ratio close to 200%.

Forget an easy solution; there does not seem to

be any solution and ultimately there will be a

yen collapse and a sharp rise in interest rates

that will cause havoc with government debt.

However, the U.S. is not Japan; there

are many differences which we will explore in

another letter. The point is that the U.S. is

experimenting with the unknown. Act II of the

Great Reflation lies ahead. Therefore,

investors, as we have emphasized before, must

look for milestones to assess whether

underlying conditions are changing. The most

important to watch are:

1. The dollar

2. Treasury bond yields

3. Corporate credit spreads

4. Credit defaults swaps on sovereign debt

We have added the last one to our

previous list because credit rating agencies are

getting nervous and are still licking their

wounds after their catastrophic performance

prior to the crash of 2008. There are, of course,

a variety of other milestones to watch which

we will be monitoring. For the time being, we

don't see any significant signs that the

liquidity-driven improvement in asset markets

won't continue into 2010. But remember, this is

a risky, uncertain world; you should carry

more liquidity than normal, be more risk

averse if you are not in a position to recoup


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losses easily and if you have taken a big hit to

your net worth as a result of the crash.

Tony & Rob BoeckhDecember 21, [email protected]

*All chart data from IHS/Global Insights, andmay not be reproduced without writtenconsent.


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Stocks


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The


Commodities


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The


Currencies


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The


Interest Rates


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The


CORPORATE SPREADS AND VIX

Volume 1 14 Risk Uncertainty in 2010 Dec 21 2009

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Transcript of Volume 1 14 Risk Uncertainty in 2010 Dec 21 2009