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Hoisington


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The more data that I see about the economy, the more I believe that they are right with deflation. I was not in that camp early this year, but things have certainly changed. If GDP growth had remained strong, we could have out grown some problems, but at recent rates it is just too slow.

 

However, I will not put a dime into long term treasuries. I see too much risk with guys like Bernanke who could activate QE2, 3 and 4 at the same time and create massive currency debasement. If the treasury vigilantes see such action, they may become quite frightened and dump their bonds. Then we could go to a stagflation scenario.

 

Either way, I can't see the economy do much better until a few things occur. It certainly won't be manufacturing alone pulling us out of this one as so many want to us believe. Do you recall how tiny manufacturing is for the U.S.? It has largely moved to a service economy and there the picture has remained bleak.

 

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alertmeipp: How will the government make sure there is inflation? Jawboning? I believe monetary policy is broken I'm not a believer in QE. Even if it's bigger than Japan's, I don't believe it works in balance sheet recessions. As for fiscal policy, the mid-term elections will rule that out (I think).

 

Cardboard: I am/have been in the deflation camp b/c we did not take our Austrian medicine, in regard to asset write-downs at banks. I don't buy the common argument that we're "earning" our way out... makes no sense from an economic growth perspective. Yes, the banks are "earning" their way out (over 10 years), but we, as an economy, are not... just look at the shape consumers are in. How is income growth?

 

 

 

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It certainly looks to me that we are beginning to slip into what appears to be a multi-year deflation. My guess is the government is largely powerless to stop it, although they likely can make things worse with inappropriate policy decisions. The fact that we have not seen something like this in 80 years means most people do not get it (they only get and view as possible stuff they have experienced, and the more recent the better). The fact that Japan has been living it the past 20 years should provide valuable insights and more than a few lessons. I do not expect our current situation to mirror Japan but it perhaps will rhyme. At the end of the day, no one really knows. However, the risks appear to me to be rising to the extent that a possible deflationary period should be entering into rational investors thought process.

 

If Ben Graham understood better the risks that were brewing in the late 1920's what would he have recommended an intelligent investor to do? Would he have said 'do not try and predict what the economy might do'? The first rule is capital preservation. If we have a situation where the probability of a deflationary depression is the highest it has been in 80 years (perhaps still only 20% chance of actually happening) my guess is he would recommend extreme caution. The reward is not worth the risk.

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It certainly looks to me that we are beginning to slip into what appears to be a multi-year deflation. My guess is the government is largely powerless to stop it, although they likely can make things worse with inappropriate policy decisions. The fact that we have not seen something like this in 80 years means most people do not get it (they only get and view as possible stuff they have experienced, and the more recent the better). The fact that Japan has been living it the past 20 years should provide valuable insights and more than a few lessons. I do not expect our current situation to mirror Japan but it perhaps will rhyme. At the end of the day, no one really knows. However, the risks appear to me to be rising to the extent that a possible deflationary period should be entering into rational investors thought process.

 

If Ben Graham understood better the risks that were brewing in the late 1920's what would he have recommended an intelligent investor to do? Would he have said 'do not try and predict what the economy might do'? The first rule is capital preservation. If we have a situation where the probability of a deflationary depression is the highest it has been in 80 years (perhaps still only 20% chance of actually happening) my guess is he would recommend extreme caution. The reward is not worth the risk.

 

I'm willing to entertain this as well as a reasonable scenario and in fact I bought some Russell 2000 puts a week ago so that I can worry less while I contemplate what to do.  I figure the stock market will more heavily discount the risk if everybody else begins to worry too -- hence the puts.

 

But I have lingering questions.  Right now Australia and UK for example are seeing approximately 3% inflation.  Would Ben Graham stay totally out of equities or would he venture into foreign markets?  If you are afraid of deflation, then go where there is relatively higher inflation.

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Carvel46,

 

"Cardboard: I am/have been in the deflation camp b/c we did not take our Austrian medicine, in regard to asset write-downs at banks. I don't buy the common argument that we're "earning" our way out... makes no sense from an economic growth perspective. Yes, the banks are "earning" their way out (over 10 years), but we, as an economy, are not... just look at the shape consumers are in. How is income growth?"

 

I am with you now. When GDP was looking like 4% growth and I saw savings rates go up, I thought that we could get out. At least that we could cut the damage by a lot. I thought that consumers had learn their lesson, would cut on debt and that we could develop a more sustainable economy. What I realize now is that the only ones who learned anything are the ones who lost everything. So many other ones are still living on the edge it is not funny. Consumer debt to income is still at 120% vs 75% historically if I recall the numbers correctly. Again, if I am not mistaken, Canadians are now at 144%. Same reality in most countries.

 

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Regarding Ben Graham, if you want to know what he would do, just read the Intelligent Investors. Once you have done that, you will realize that so called high quality, cheap stocks of today, are not so cheap. His perspective on asset allocation or bonds vs equities is also excellent.

 

One thing to remember about Graham is that he did not avoid the debacle of the Great Depression. He recovered, but his losses were substantial. His writings which were done afterwards show how scared he was by the event.

 

Stocks were so overvalued when I read that first in 1998 that I was shocked. I could not imagine seeing bargains like he was looking for ever again. By late 08/early 09 they were everywhere. And today, we have companies missing earnings and still flying high with ridiculous P/E's: NFLX, AMZN and others. No one will convince me that enthusiasm is not present.

 

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alertmeipp: How will the government make sure there is inflation? Jawboning? I believe monetary policy is broken I'm not a believer in QE. Even if it's bigger than Japan's, I don't believe it works in balance sheet recessions. As for fiscal policy, the mid-term elections will rule that out (I think).

 

Cardboard: I am/have been in the deflation camp b/c we did not take our Austrian medicine, in regard to asset write-downs at banks. I don't buy the common argument that we're "earning" our way out... makes no sense from an economic growth perspective. Yes, the banks are "earning" their way out (over 10 years), but we, as an economy, are not... just look at the shape consumers are in. How is income growth?

 

 

 

 

The moves in the past were not large enough.  How about a $1 million tax credit (refundable) to every citizen?  You still think we would have deflation?  The idea that deflation can't be stopped is laughable.

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Watsa,

 

If dealing with Deflation were so "simple" then why hasn't Japan done anything like that for the last number of years?

 

SmallCap

 

The problem is Japan is already a nation of savers.  Most of them would have just put the money back in the national post office / bank.  In the US, you can bet that most people would spend it, at least after clearing out their debt.

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watsa_is_a_randian_hero:

 

I agree. Yes, I believe deflation can be stopped with fiscal stimulus... as your tax credit example alludes to. The problem is that U.S. culture does not take kindly to fiscal pump priming (even when it's pro-growth like gov-funded, early stage R&D). And, QE, in our current context, simply seems to encourage speculation--pushing investor out on the risk curve. Although, eventually investors have to ask what multiple they are willing to pay in a slow growth economy with frequent recessions.

 

I'm curious how do you think about inflation/deflation in regard to picking specific investments? Higher MOS? Income?

 

 

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Watsa,

 

If dealing with Deflation were so "simple" then why hasn't Japan done anything like that for the last number of years?

 

SmallCap

 

Japan never took drastic enough steps.  US ultimately may not either, because of fear of overshooting, and the anger of destroying the wealth of upper class. 

 

All I'm saying is deflation is problem that is "simple" to fix...albeit with consequences.  Again, I submit that giving every citizen a $1 million tax credit would solve the deflation "problem."

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watsa_is_a_randian_hero:

 

I agree. Yes, I believe deflation can be stopped with fiscal stimulus... as your tax credit example alludes to. The problem is that U.S. culture does not take kindly to fiscal pump priming (even when it's pro-growth like gov-funded, early stage R&D). And, QE, in our current context, simply seems to encourage speculation--pushing investor out on the risk curve. Although, eventually investors have to ask what multiple they are willing to pay in a slow growth economy with frequent recessions.

 

I'm curious how do you think about inflation/deflation in regard to picking specific investments? Higher MOS? Income?

 

 

 

I agree that a large tax credit is unlikely.  However, keeping taxes rates the same, boosting government spending, and buying back government bonds (QE) has the about the same effect, does it not?  They both create deficits financed by printing new money.  

 

In terms of your specific investments question, I'm long financials (return on capital businesses, not reliant on nominal GDP growth for stock returns), long levered energy & basic materials (should pay off in event of inflation), long variable rate preferred stocks (should also pay off in event of inflation).  Also have about 30% of portfolio in LEAPS that will pay off about 20-30% returns as long as the market doesn't fall more than about 20% over the couple years.  Also have about 10% of portfolio in merger arb plays that are less correlated to short-term market movements.  Short gold (I think this falls whether we have inflation or deflation, barring hyperinflation.  The same weaknesses people point out in fiat money exist in gold.  Gold is top performing asset class over last 10 years.  Also, read buffett on aliens & gold), short weaker/pricier consumer discretionary (I think consumer remains weak regardless of monetary outlook) such as garmin, netflix, chipotle, whole foods, green mountain, underarmour. Short some other stuff as well.  

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watsa_is_a_randian_hero: Yes, it has the same effect... but depends on the size. Can the effect be quantified? Otherwise, this is just a theoretical discussion... unfortunately, the discussion is against a backdrop of huge amounts of lost shadow banking.

 

Maybe the U.S. did take more drastic steps than Japan... I'm unclear on this. We do have a more flexible economy, younger with population growth. But it doesn't seem like we took our medicine, I suspect because we did not have the safety net that Sweden had in 1992. Not sure Japan's excuse? Maybe it's also cultural? It often seems to come back to culture...

 

Nice job implementing your portfolio.

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