Quarterly Investment Commentary
January 2010
A Question of Value
Question: would you rather have 20 nickels or
one dollar bill?
Well, that all depends on how well you think the
Federal Reserve is doing its job.
A post-1946 nickel weighs five grams and is ¾
copper and ¼ nickel. Copper and nickel are
metals that have a value of their own.
Like most commodities, copper and
nickel are traded in U.S. dollar terms
internationally, so prices are very
much affected by a weak U.S. dollar.
Dollar weakness is in turn affected by
Fed policy.
Current monetary actions have been extremely
loose, contributing to a weak dollar abroad. At
the same time, commodity prices have been
surging. In fact, the current metal value of a
nickel is greater than a nickel—about 5.2¢. So, if
you said you would
rather have the nickels,
you would be siding with
the broader investment
community.
Though it is meant for
amusement here, the
subject highlights the
unintended effects of Fed policy which is taking
on a weightier resonance in the media as we
march into 2010. Some writers have conjectured
that the whole of 2010 will be characterized by
how successful the Fed is at unwinding its
balance sheet. Will runaway inflation ensue?
Will the U.S. roll back into a recession? What
should investors expect for the year ahead?
It is worth inserting here that we do not
explicitly advocate endorsing economic
forecasts largely because the future is
unknowable. Additionally, experience suggests
that once an analyst manufactures a prediction,
she loses her objectivity. It is difficult to filter
out her bias and give contrary facts equal weight
going forward, which lessens her sensitivity to
changes in the markets. We work hard to
preserve our objectivity. Therefore, instead of
relying on forecasts, we strive to interpret the
signals that the markets and the economy are
sending. Then we weight the
probabilities of various outcomes
accordingly within our clients’
portfolios. It means we will do an about
face at times as economic conditions
change. At other times it may mean we
do nothing because nothing
fundamental has changed.
Last quarter we showed a chart of price-to-
normalized earnings multiples for stocks and
their relationship to the consumer price index
(CPI). We pointed out that the stock market
seemed to believe that
inflation and deflation
were not real threats as
evidenced by its p/e of
14.9x. That market
confidence has not
diminished over the last
quarter. The market p/e
has risen to 15.6x while
the year-over-year CPI has increased from -1.3%
in September to +2.9% in November. That is
quite a jump in consumer prices with no
apparent deterioration in investor confidence.
Our long-time readers will know that we expect
to see more of the same in the near future.
Probably the most significant argument against
the inflation view is the current high
unemployment level. The argument goes that
with unemployment so high—currently 10%--
there is too much slack in the economy for
demand to drive prices higher.
This view finds its roots in the popular Phillips
Curve model which is most often simplified to
assert that there is a tradeoff between
unemployment and inflation. However, as fund
manager John Hussman aptly contends, “this is
a misinterpretation of A.W. Phillips (1958)
analysis. While the famed “Phillips Curve” was
described as a relationship between (nominal)
“money” wages and unemployment, the British
data Phillips used was from a period when
Britain was on the gold standard, and the
general price level was extremely stable. Thus,
any wage inflation observed by Phillips was
actually real wage inflation. The Phillips Curve
is simply a standard economic argument about
relative scarcity. It says that when the labor
markets are tight, nominal wages rise faster
than the rate of general inflation (i.e. real wages
rise), and when unemployment is high, nominal
wages rise slower than the rate of general
inflation (i.e. real wages fall). As we observed in
the 1970's, high unemployment can exist in
concert with high rates of inflation. All that
happens, in that case, is that wages tend to rise
slower than prices. Assuming labor productivity
is growing as well, real wages don't keep pace
with productivity growth. In any event,
unemployment emphatically does not prevent
the inflationary consequences of reckless
creation of government liabilities.”
Another problem with the ‘no inflation’
argument is that unemployment is a lagging
indicator. The chart below plots the change in
consumer prices with the unemployment levels
that follow 11 quarters later. (Note: we use CPI
as a surrogate for an inflation metric here,
though technically, money supply is a more
accurate measure.) Clearly, unemployment
follows CPI; it does not lead. In fact, the chart
suggests that CPI might be a better indicator of
what will happen to unemployment than vice
versa. CPI appears to be calling for
unemployment to drop in the coming quarters.
Likely they will meet somewhere in the middle
as unemployment drops and CPI increases.
If unemployment refuses to decline and stays
stubbornly high, the effect on stock prices would
be dubious. In times past, higher levels of
unemployment have been consistent with lower
p/e multiples on stocks (see the chart below).
That is to say, above 8% unemployment, p/e’s
have dropped to 11x and below historically. As of
late, that relationship has not held up. At 10%
unemployment, p/e’s are still above 15x.
Though we have our suspicions, no one knows
whether inflation or unemployment will blink.
We turn our attention to yields for more
evidence. Longer term Treasuries have been on
the rise. The 30-year Treasury yield rose 188
basis points (or 1.88%) last year as prices
declined, resulting in a total return of -25%—its
worst return ever. The yield on 10-year
Treasuries climbed a whopping 159 basis points
in 2009 from 2.25% to 3.84%, providing
investors seeking a safe haven with a
disappointing -10%. return. What’s more, many
predict that bond market pain is not over.
Morgan Stanley is projecting yields to climb
further to 5.50% in 2010.
Too, inflation expectations have increased over
250 basis points since the beginning of 2009. If
Morgan Stanley is correct and 10-year yields go
to 5.50%, the breakeven inflation rate would be
somewhere around 4.00%--the highest we have
seen.
It is important to note here that a marked
increase in bond yields would not be enough by
itself to dissuade us from stocks. The chart
below shows the historical relationship of
Treasuries to p/e multiples of the S&P 500. As
one would expect, at very low yields and
especially at very high yields, stock returns
suffer as multiples head south of 11x earnings.
However, in the middle yield ranges of, say 4%
to 6%, stocks have always maintained earnings
multiples of 14x and higher. So, even if yields go
to 5.5%, there is no evidence suggesting stock
returns should suffer.
It is also important to note that we believe what
happens will largely be dictated by government
policy. Let us be clear. We are not saying that
the government has control of where we go; only
that their actions will be central to how the
markets play out in 2010.
When central banks manipulate interest rates,
there may be unintended consequences. The
Fed has been holding interest rates artificially
low for some time now, believing they can
eventually increase short rates and unwind their
expanded balance sheet in a slow and orderly
manner. We believe the recent rise in long-term
interest rates and therefore, the steepening of
the yield curve, is a warning that the Fed could
be coerced into moving more aggressively than
they would prefer.
Other signs that investors are growing
increasingly leery of central bank policy can be
seen in changes in credit default swap (CDS)
rates since mid-October (see the chart on the
next page). The chart shows that the cost to
insure an investor against a U.S. government
debt default has doubled in the last three
months, insinuating that U.S. debt is riskier
than the likes of Australia, France, and
Germany.
What starts off as a mild trend often ends
violently a la a Minsky moment. One only has to
observe the most recent financial crisis to see
Hyman Minsky’s financial instability hypothesis
in action. Early last decade, Greenspan and
company manufactured a low interest rate
environment that bonded with the U.S.
government’s home ownership push to
germinate the seeds that would eventually lead
to the collapses we saw in 2008.
Fed Chairman Ben Bernanke has recently gone
on record refuting the connection between the
Fed’s loose monetary policy and the housing
bubble. In a speech delivered in Atlanta, he
absolved then Chairman Greenspan—and by
extension himself (he was a Fed Governor at the
time)—of any policy missteps. He used complex
math and cited the Taylor rule as justification
for holding rates low. He further postulates that
the real cause of the crisis was the proliferation
of accommodative lending products such as
adjustable rate mortgages (ARMs) and interest-
only (IO) mortgages.
Without going into the detail of what the Taylor
rule is, it is instructive to note that the Stanford
University economist who invented the rule,
John Taylor, has gone on record as saying that
the Fed misapplied his formula. Furthermore,
the primary reason the aforementioned
mortgage products looked attractive to
homebuyers was because of the low interest
rates.
What is equally concerning as the policy
mistakes of the 2000s is the lack of willingness
to admit they were ever wrong. Then again, only
after 30 years and the death of every former Fed
member did the central bank admit that loose
monetary policy caused the inflation of the is under control even when it is not. Otherwise,
1970s. In three decades we should have the they do not get to retain their post. In essence,
truth. they are betting on the notion that the certain
immediate loss of public confidence (not to
Government policy fashioned this current mention, their own re-appointment) is a greater
economic problem. It is doubtful that the same moral hazard than the uncertain deferred
economic policies will pull us out. The American demise of the economy. Third, denial. Because
public has been learning the hard way that of their proximity to the echo chamber, the
leverage can provide the illusion of wealth, but smart feedback they are getting on all sides
the trip down from that credit bubble high is really does suggest that more of the same is
painful. A sagacious king once wrote, “The rich really the best course of recovery.
rule over the poor, and the borrower is servant
to the lender.” Savings is the source of real Whatever the motive, the outcome is still the
wealth. America’s overlords thought they might same. The Federal Reserve is engaging in
perhaps be able to suspend that maxim while expansionary monetary policy while the federal
the economy moved beyond the ill-effects of the government continues its profligate deficit
internet bubble crash in the early-2000s. All spending.
they did was create a larger problem later.
These facts are
enough to persuade
us to maintain our
short position in
longer dated
Treasuries and our
long position in
inflation protection
as we see no reason
that yields will not
continue to rise.

As for domestic
stocks, they are
slightly overvalued
and there is a virtual
floor (courtesy the
Fed’s commitment to
“do whatever it
takes”) underneath
current prices. There
Why then doesn’t the government appear to be is an equal amount of upside and downside, but
worried about the consequences of their we have been (and will continue) trimming
actions? I offer several possible reasons. First, equity positions as stock prices continue to
hubris. They actually believe that the same advance. We would look to materially reduce
experimental financial engineering that fueled stock exposure if prices advance another 15% or
the last round of excesses can be initiated from more.
within the government’s laboratory with an
exemption from real world rules. Second, Even so, we favor larger cap stocks with
incentives. Even if they know their actions will international exposure over mid and small
not succeed, they do not consider themselves to capitalization companies that are dependent on
be in the position to tell the truth. People in the tired U.S. consumer.
power manage the mass’ perception, which
generally means communicating that everything
There is definitely a case to be made for a
“double dip” in stocks. Indeed, we have
chronicled here before how a -30% or greater
drop in stock prices is conceivable. We do not
feel that kind of a pullback is probable at this
time, even given the government’s present
course. If events do play out differently and
stocks fall precipitously, we believe it will be
temporary in nature and we would be equity
buyers if prices drop far enough. One must keep
in mind that stocks should only be viewed as
long-term investments.
The greater likelihood in our minds is that the
dollar continues to drop vis-à-vis developing
currencies. It is possible that stocks could
continue to go up even in the face of a devaluing
currency. As such, we are maintaining our
bullish view on commodities.
As hard as we are on the government’s policies,
the fact is that crises are inevitable.
Acknowledging that does not make them less
painful. Reality is, however, that crisis creates
opportunity—for the buyer. But you have to be a
buyer. We do not advise trying to predict market
tops and bottoms. We believe an all-weather
approach that participates in the good times and
does not get wiped out in the bad times yields
very satisfactory results over time.
The destructive behavior we witness most often
is the timing penalty. Investments go up and
people wish they had owned it before so they
buy at the high. Then when prices fall they get
discouraged and bail out. One of our missions as
a firm is to give our clients a longer-term
perspective in order to prevent that common
kind of injurious investor behavior.
Conclusion
One reason we get fired up about encroaching
socialism is because we believe freedom is our
country’s greatest asset. Freedom drives
innovation and allows capital to flow and change
directions when needed. Freedom does not
guarantee that we will never have recessions,
Voisard Asset Management Group • 146 Monroe Center NW, Suite 820, Grand Rapids, Michigan 49503
800.343.9041 • dvoisard@voisardgroup.com • bmcclard@voisardgroup.com
but it does ensure our country’s economic
progression. Our nation is incredibly buoyant.
We are mobile and entrepreneurial. It is
important to not underestimate that resilience.
Investors need not be discouraged by price
downturns, but encouraged. That is counter-
intuitive. During times of turmoil it is easy to
want to wait on the sidelines until things get
better. But that attitude is already reflected in
prices. I know of no investors who consistently
and successfully pick market tops and bottoms.
There is an adage that says that the only people
who have bought at the highs and lows are liars.
That does not mean that many do not still try.
Some in their frustration with traditional
technical timing tools have turned to alternative
metrics. I recently heard of one gentleman who
uses astrology to predict stock market
movements. Another relies on the migratory
pattern of the African elephant to divine market
direction. No kidding.
The lesson is that investors will always face
difficulties, fears, and opacity in their decisions.
There will always be very good reasons not to
invest. The present time certainly has its fair
share of them. America has not had to deal with
the shift of power from the west to the east
before. It is understandably a challenging time.
The reality has not changed. The only way to
create wealth is to invest and stay invested.
Your Investment Team,
Douglas E. Voisard, CFP®
Brian McClard, CFA