The Ethical Investor: August 2010

I want to write an investment newsletter, but I don’t like the pay-and-email model. I want it to be transparent, and like everything I write, I want the information and analysis to reach as many people as possible. So here it is. I wrote this first edition last Monday, but it took a week to get some feedback and rejigger the format. If any of it is out-of-date, now you know why. I most regret that I didn’t post it in time for you to take advantage of this. — AWO

It’s a stupid time to start an investment newsletter.

Economists are worried about a “double-dip” recession, public and private debt are at record levels, the world has just escaped two financial crises in three years, and the Chairman of the Fed says the future is “unusually uncertain.” With record-breaking temperatures outside, a smart person would work on their tan until the economy returns to normal.

Trouble is, I don’t know what “normal” looks like.  

See, what makes Bernanke’s quote so potent isn’t the “uncertain.” Our lives are always uncertain, never more so than when we bet on a future state of the world. Which means there’s never a good time to pretend that you know what people should do with their money.

It’s the “unusually” that makes you knit your brow. Only, I don’t think there’s anything unusual about today’s economy.

Allow me a brief analogy. In 1973, psychologists Amos Tversky and Daniel Kahneman gathered several groups of people and read aloud a different list of names to each group. On each list, there was a different number of male and female names — some of them famous, some not. After the reading, each person was asked to estimate whether there were more male or female names on the list they had just heard.

Whenever there were more famous male names than famous female names, the groups guessed that there were more male names — and vice versa. Of course, they were often wrong. There were more female names, but they weren’t famous. The only names that registered strongly in their memory were the famous ones, making it seem like there were more male names.

Tversky and Kahneman referred to their subjects’ erroneous judgment as the “availability heuristic.” (A “heuristic” is a mental rule of thumb.) It’s the reason that people tend to overestimate the number of deaths by car accident and underestimate deaths by medical error. Or why fewer people get on an airplane the month after one crashes.

We have short memories and strong emotions. Whatever is recent or more commonly reported seems more likely.

I’m not implying that fear of another recession or financial crisis is delusional. On the contrary, we should always be on guard for another recession or financial crisis. But we aren’t always as attentive as we should be, are we? It’s only because we’ve recently lived through trying storms that we’re on the lookout for rough seas ahead.

My point, more bluntly, is that this uncertainty is not a fluke. Financial instability is built into modern capitalism. There’s nothing unusual about it.

I don’t know how carefully Bernanke chose his words, but uncertainty has an important history in economic thought. It’s different than risk, which applies to a possibility to which you can assign a probability. When a prediction is too complex or you have too little information about it, that’s uncertainty, an unquantifiable possibility.

Uncertainty is all around us, just not in our economics textbooks. You have to go back to the 1920s and read two of my intellectual heroes, Frank Knight and John Maynard Keynes, to understand that uncertainty plagues every investment. The only people who think investing was easier before the crisis are the ones who didn’t understand how unstable the system was…and probably still don’t.

The legendary tech exec Andy Grove lives by the motto, “Only the paranoid survive.” All investors should too.

So here I am. Because now is as good a time as any. Besides, the planet is only going to get hotter. There will be plenty of sun left for tanning after we’re done surveying the financial landscape.

What Will Make the Economy Grow?

After the European debt crisis stabilized, July was a very good month for the market, up 7.5%:


The Dow is about even since the beginning of the year, but the new GDP numbers have everyone anxious about another dip. According to the latest revision, the recession was even worse than we thought:


We found out that GDP grew 2.4% in the 2nd quarter of 2010, which didn’t sound that bad at first since we thought 1st quarter growth was 2.7%. Check again. The new estimates say GDP grew 3.7% in the 1st quarter.

Good news: We have more GDP than we thought. Bad news: Growth is slowing more sharply than we expected.

What we just experienced was a classic inventory cycle. At the beginning of the recession, firms slowed production and sold off inventory. As inventories began to run low, firms started producing again. They have now restocked.

Inventory growth added to GDP growth in the past few quarters, but we shouldn’t expect that boost going forward. GDP growth will now be much closer to the growth of sales, or “final demand,” and it ain’t pretty:


The weak recovery doesn’t surprise me — or most economists, for that matter. The last three recessions have all been “U-shaped,” with high unemployment lasting long after the recession has ended. The short explanation is that the job market looks very different than it did, say, thirty years ago. Workers have far less power, and shareholders have a lot more. The result, as Robert Reich puts it, is “a great decoupling of company profits from jobs.”

Good news: Stock market valuation is based on profits, and “profits have recovered 87 percent of what they lost in the recession.” Bad news: Because of high unemployment and slow wage growth, consumers have less money to spend. Before the recession, they could borrow to keep consumption high, but they hit a ceiling in 2008. Until jobs and wages recover, profits will be limited by what consumers can afford.

There are two ways around this constraint. The first option is for the government to fill the gap. Unfortunately, the impact of the American Recovery and Reinvestment Act of 2009 (ARRA) will start to decline as we head toward 2011. And we shouldn’t count on ARRA to make up for lack of private consumption when it was barely enough to counter budget cuts by state and local governments. In the fiscal year that started a month ago, state governments have to beg for another $90 billion.

Many investors fear that Congress will move in the opposite direction by allowing the Bush tax cuts to expire. Don’t count on it. Politicians are well aware that the most reliable way to get re-elected is to throw money at their constituents right before the election.

The Democrats’ plan — to allow the tax cuts on individuals above $200,000 and families above $250,000 to expire, and to cut taxes further on middle- and low-income brackets — has some investors worried that small businesses will suffer. The reality is that the tax hike would hit less than 2% of small businesses. Redistributing some money downward would actually stimulate the economy because lower-income households are more likely to spend it.

The second antidote to low domestic consumption is for firms to find more consumers. In other words, export.

For this strategy to work, the dollar must depreciate. For far too long, the demand for dollars in Asia and the Middle East, combined with our excessive borrowing, has kept the dollar “strong” — making exports expensive. American firms need foreign consumers. They need a weaker dollar.

Europeans need a weaker currency more desperately than we do. It’s their only hope of growing fast enough to pay off their debt. During their recent crisis, the euro depreciated significantly, which certainly contributed to the appreciation in the first half of the graph below. As trade economist Menzie Chinn reminds us, however, “The euro is a relatively small component of the US trade weighted exchange rate.” Sovereign debt crises aside, the dollar will continue its descent:


My bet: Short the U.S. dollar.

Ethical considerations: The strong dollar hasn’t benefited most Americans. It has been a boon to multinational banks. The influx of foreign lending contributed to the Great Financial Crisis. The national economy will be more stable and equitable with a weaker dollar and smaller trade deficit. And it’ll speed up production at a time when millions of unemployed need firms to hire more.

Who Will Make the Economy Grow?

According to a 2006 government report, the top exporting industries are transportation equipment and chemicals.

In the first category, Ford Motor Company is the only member of the Big Three that trades on the stock exchange. S&P improved Ford’s credit rating to B+ earlier last week. I’m reminded of Michael Milken, who made his fortune identifying “fallen angels,” blue chip companies that had gone through a temporary rough patch. The rating agencies tended to judge creditworthiness by past performance, not future potential. Take a look at the Great Financial Crisis, and ask yourself whether they’ve learned their lesson since the 1980s. Bottom line: B+ is too low.

My bet: Long Ford Motor Company.

Ethical considerations: The auto companies have earned my disdain over the years by lobbying against energy efficiency standards and for taxpayer bailouts, but Ford is the only one that didn’t eat out of the TARP trough. The quality of their vehicles and their investment in renewable energy have both improved in the past few years. Economists refer to the Heckscher-Ohlin-Samuelson theory, which says that it’s best for everyone if countries allow firms to specialize in their comparative advantage. If American firms lose that advantage to foreign firms, American workers can specialize in something else. But they can’t, can they? The theory assumes that factors of production can take any form. Workers can shift from car manufacturing to computer repair in no time. The theory is flawed. Workers deserve some protection from forces out of their control. Of course, creative destruction is necessary for economic growth, but with the quality ratings Ford’s cars have been getting lately, I don’t think it’s time to take the hatchet to Detroit.

In the second category, Jon Huntsman, Sr., is betting big on his company, and he’s staking the financial health of a cause very close to his heart, the Huntsman Cancer Foundation, on the share price of Huntsman Corporation too. This is as trustworthy a businessman as you’ll find. With his son as U.S. Ambassador to China, Huntsman is well-placed to understand and profit from the export market.

My bet: Long Huntsman Corporation.

Ethical considerations: Huntsman’s ethics are unimpeachable. Better him than, say, the Dow Chemical Company, whose environmental record is improving but still suspect.

What’s Standing in the Way?

Two complications should inspire humility about those long positions. First, the stock market is overvalued by historical standards. The most common measurement is the inflation-adjusted price-to-earnings ratio, where earnings are averaged over the last 10 years:


As much as we ridicule the “New Economy” claims made during the bubble, it really does look like we’ve reached a new plateau in the past 15 years. I’m not willing to concede that it’s permanent, but I will hypothesize that it won’t disappear until Reich’s “great decoupling” reverses gears. The numerator, stock prices, is investors’ valuation of future earnings. If investors have reason to believe that companies can maintain faster earnings growth than they have in the past, the P/E ratio should increase. In an era when shareholders have more power than workers, this may not be an irrational judgment.

Another possibility is that the stock market will seesaw sideways for the next couple years while earnings rise, until the P/E ratio is back to its historical average. It’s impossible to know which path is more likely. Notice that the curve spends very little time near the average. It deviates for whole decades before returning to trend. Observers in 1940 would have expected a strong bull market; instead it underperformed until the mid-1950s. The P/E ratio also reached today’s inflated level back in 1961, but anyone who shorted the market then would have lost out on the biggest bull market since the 1920s. This is the uncertainty that Knight and Keynes were talking about.

Bottom line: Keep a healthy portion of your portfolio in other investments.

The second complication is housing prices, which remain more than 50% above their historical average:


Since the end of the homebuyer tax credit, MBA purchase applications have resumed their descent, almost a sure sign that home prices will come down further:


For every dollar lost in housing wealth, consumption falls by 5 to 7 cents. With Fannie and Freddie buying mortgages, the decline should be gradual, but it’ll still take a bite out of GDP.

Bottom line: Betting on the recovery isn’t necessarily an immediate winner. Don’t be surprised if you have to weather a few false starts in the next six months.

What Else Is Overvalued?

Speaking of historical averages, gold is out of control. There is no rational reason for its value to have increased almost 300% in the last five years. You might say it was a “flight to safety” by investors looking to get out of the stock market, but the bubble began before the Great Financial Crisis. Mostly, gold has a lot of old wives’ tales behind it. It is not a good hedge against inflation, it is not a good hedge against rising commodity prices, and it is not a good hedge against a falling dollar. The big boys know it’s a bubble, and they’re riding the wave. You don’t want to be caught without a seat when this music stops:


Timing the end of a bubble is high risk stuff. Who knows when people will come to their senses? The flight to safety may not have triggered the bubble, but it did accelerate it. As bond spreads come down, look for investors to move back to riskier investments.

My bet: Short gold.

Ethical considerations: This bubble isn’t benefiting anyone except speculators. Get that money out of gold and into productive investment!

What About the Rest of the Commodities?

Gold aside, commodities are the place to be. Like gold, there are a lot of myths about commodity futures. No, they’re not riskier than stocks. In fact, they’re slightly less risky:


No, they’re not less profitable than stocks. They’ve delivered almost the exact same return:


No, technological progress doesn’t keep their prices from rising. And no, they don’t only go up when there are speculators or a falling dollar or high inflation.

Despite a huge slide during the Great Financial Crisis, they continue to deliver superior returns:

RICI VAMI_Jul 2010

That’s the Rogers International Commodities Index, my favorite because it’s the most diversified and its founder has the best pedigree. If you want to invest in it, you can use an ETN, but make sure you know exactly what you’re getting into. ETNs carry their own risks. (See here, here, and here.)

Commodities are the place to be because, no matter what happens to the U.S. economy, the world is going to need a lot more commodities. Land is getting scarce, and developing countries like China need raw materials en masse. Peak oil is real, and climate change is going to make the weather more volatile and severe.

Some investors are worried that China has been stockpiling commodities and is about to slow its growth, but if so, it’ll only be temporary. China has the best approximation we’ve seen in a long time to what the great economist Arthur Lewis called “unlimited supplies of labour.” They need to keep production moving at a strong pace, lest the rural migrants riot in the streets. Water shortages will make it hard to irrigate enough fields to feed all those mouths.

My bet: Long commodity futures.

Ethical considerations: High prices will encourage the industrialized nations to conserve and maybe even give entrepreneurs the incentive to invent a cost-saving technology, but they also make it more expensive for poor people to eat. Research indicates that rising food prices threaten to throw millions into poverty in the developing world. Fortunately, if you use an ETN, you won’t contribute to this rise. An ETN is a debt security where the issuing bank promises to pay you a return based on the index’s performance upon maturity. It doesn’t buy any actual commodity futures, and neither do you.


Next month, I’ll explore other asset classes.

Question everything I say. Do your own research. Keep your portfolio diversified. And always consider the ethical ramifications of your investments.

There’s plenty to be uncertain about, but look on the bright side: In the long run, the economy always goes up.


Graph sources: Google Finance, Menzie Chinn, Dean Baker, Doug Short, Calculated Risk, Gary B. Gorton and K. Geert Rouwenhorst, Beeland Interests.



All material presented herein is believed to be reliable but I cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. Anthony W. Orlando may or may not have investments in any funds, programs or companies cited above.


Communications from Anthony W. Orlando are intended solely for informational purposes. I believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided “AS IS” without any warranty of any kind. Past results are not indicative of future results.