Saturday, September 17, 2005

Desert of the Real Newsletter-October 2005

Welcome to the Desert of the Real—
Real Investment Returns in a Dry Season
October 2005(copyright) Robert C. Feightner

Welcome to the Desert of the Real.[1] DON'T FORGET TO READ THE FOOTNOTES! This issue of the newsletter is the sixth in an ongoing series. It is free of charge and directed to anyone who wants better investment results.

Who Said Life was Fair, Right?

The Author made this comment in the last newsletter regarding the difficult choice that average-wealth individuals have in obtaining good investment expertise. You can become an independent investor such as the Author and his cohort, or you can find a good financial representative. Neither is easy, but they are doable. Contact me if you would like some guidance on this issue. But there are no shortcuts. I recall (and paraphrase) a statement a football coach once made: “A lot of players want to know the tricks of the trade. I tell them that they need to first learn the trade.”

Why are Stocks so High and Long-Term Interest Rates so Low?

A topic that confounds, or conundrumizes[2] financial experts and economists is why are long-term rates low and why are stock P/Es so high? It has stumped some of the finest minds, so why not let a weak mind such as the Author’s take it on?

In the August issue of this newsletter, the Author quoted Douglas Greenig of RBS Greenwich Capital in Greenwich, CT on the topic of low long-term interest rates.[3] In “Outlook for Rates and the Curve,” Greenig states that a combination of several factors has kept long-term rates low:

“As I have noted in previous commentaries, the key ingredients in the special sauce are: the positive supply shock from globalization, technology-led productivity gains, rapid expansion in money and liquidity for a decade, and the knock-on effects of increased wealth and income inequality worldwide. (Original emphasis).”

The Author discussed each of these topics in turn. There has indeed been greater supply, slower wage gains and disinflationary pressures in the world economy. A couple of years ago American financial writers were even booting around the deflation (“D”) word.

So what could the last factor, the “effects of increased wealth and income inequality worldwide”, have upon this situation to help us deconundrumize the conundrum?

For help, I will call upon an expert I cited in the September 2005 Newsletter, Jeremy Grantham. [4] Grantham, in analyzing the current state of affairs, states, “A sustained excess of savings would be completely compatible with lower returns on all fixed incomes. It would also be compatible with a lower return to stock holdings, which would require a higher than average P/E precisely as we have today.”

But here is where things break down. Grantham states that an excess of capital and lower returns on stocks and bonds would also REQUIRE lower returns on capital investments, or lower profit margins. However, as Grantham notes: “

Corporate profits margins, however, are not just above average, they are at record levels. (For the record, they are also excellent in Europe and much improved in Japan.) This is completely incompatible with theory of excess savings turning into excess investments and forcing down returns.[5]

Is America the Land of the Free, or Merely the Cheap?

Data Grantham assembled shows that while profit and wages increased in tandem in Europe, Japan and the UK since 1970, profits and wages have diverged in the US, giving US workers a much lower share of profits[6]. This European out-performance also occurred from 1960-1970, when more socialized economies existed in both Europe and, to a lesser extent, in the US[7]. Finally, Grantham notes:

The U.K has become amazingly Americanized, but not at least in this way, as the two series-income and profits have risen in sync for them, and both rose faster that the U.S. profits by a little and wages (by a lot).

Could stagnant wages in the US be buoying corporate profits and thwarting the means reversion mechanisms of capitalism? And why would stagnant wages buoy corporate profits here in the US when more market-rational wages are apparently not depressing corporate profits in Europe and elsewhere?[8]

A Poor Explanation is better than None…

The Author has a few thoughts on this matter. He acknowledges the wage divergence, but could there be some other reasons for buoyed margins other than wage divergence?

Technology Advances. Technology makes producers more productive, and sometimes supplants labor. Could American technology gains in the examined period have held labor costs at bay? However, for this to happen, it seems that technology savings in the US must have had to far-outstripped Europe and Japan in this period of time. Seems unlikely.
An Historical Aberration? As stated earlier, the 1980s saw massive moves toward deregulation of industry and more monetarist policies in the U.K, Europe and to a lesser degree, the US. But let’s consider the ambient states of the UK, Europe and the US when the 1980s started. The U.K. was saddled with numerous unproductive state-owned industries that were draining the Exchequer. The US was far less regulated in 1980 and perhaps Europe and the UK had greater efficiency gains to make while the US was just way ahead on the deregulation efficiency curve and there were fewer efficiencies to harvest.
It is Always Easy and “Politically Correct (or Incorrect?)” to Just Blame the Chinese. The Author could do that but will not. The Author is a committed internationalist and free-trade advocate. Every nation has the right to compete equally, fairly, and in a nonmilitary manner, in the world economy. If China and the EU are the dominant economic powers in the world in 2050, good for them. The Author makes numerous international investments and will continue to do so, putting his investment capital to work where it will obtain the highest return.[9] That being said, the Author will not invest in tobacco companies or companies that derive a majority of their revenue from weapons production.

So where does this leave the analysis? None of the proffered answers appears sufficient to explain why American workers are receiving a smaller, and declining in absolute terms, cut of the profits. And as US workers compete in an ever- larger world, prospects for bigger paychecks are even less likely. This is an important economic issue that requires further analysis.

“I Want What’s Coming to Me,” said Antonio “Scarface” Montana

If wage growth is lagging profit growth, then Americans must buy equities to capture some of that profit growth. But with historically high P/Es, stocks are no bargain. One strategy to employ is to buy stocks that pay large dividends. And with most dividends taxed at the lower 15% tax rate, a worker’s returns would get better tax treatment than his labor. As most of us know, we now live in a country that taxes returns on capital lower than returns on labor. The equal taxation levels between capital and labor that Ronald Reagan enacted in 1986 have been re-tilted and tipped in favor of capital[10]. So workers need to participate in the capital markets to have any chance of regaining lost economic ground.

“Sha, la, la, Live for Today”, sang The Youngbloods in the 1960s

And the Baby Boomers, and by genetic extension, their kids, listened. Good song, bad idea. The U. S savings rate is about 1%, down from about 11% in 1980. And what little “wealth” the American economy can manufacture for the average worker, housing appreciation, is being tapped like kegs of beer at a frat party.

With a savings rate of 1%, what is the chance of the average American becoming a real participant in the capital market? Oh, and in case you are thinking, ‘Golly gee, Mr. Author, isn’t that savings rate figure skewed because Americans invest in their 401(k) s,’ the Author says ‘perhaps, but not by much’. The Author has not seen a full explanation of how the 1% figure was calculated. But investing in a 401(k) is only tax deferral, not tax avoidance or tax reduction. The 401(k) proceeds will be taxed as ordinary income, a rate that for most Americans will be higher than 15%.

You’d Better Change Your Profligate Ways, Baby

There is not really much to say on this point. Americans must make a determined effort to save and invest. The reasons are legion, while the excuses are infinite. Just remember what old Grand pappy Allis Chalmers said: “Pay yourself first.” In case you never had a Grand pappy say that to you, take it from Old Author Rob: “Pay yourself first!” Sock away at least 10% of your income away. More if you can. YOYOMF.

Next month, the author will talk about the advantages of the ROTH IRA. The author will also address the Federal Estate and Gift Tax.

Is the Summer of Stock Market Love Over?

Yep. The short-term technical indicators that the Author follows have turned negative. Some of the long-term indicators are tanking. Despite this, he still has very large unrealized capital gains in the few holdings that remain. Most of his picks have stopped out with good gains and about half of his portfolio is now in cash. He will look for buying opportunities and watch if the mid-term and longer-term indicators turn negative. If so, the Author will move to a negative market strategy. The elements of a negative market strategy would include:
1. Lots of Cash.
2. Buying Puts on equities or index ETFs.
3. Inverse Index Mutual Funds. These are mutual funds that move in the opposite direction of the market. They are available on the S&P 500, the NASDAQ and the DJIA. Some even move at two-times the market, so you can leverage your capital more effectively in the event of a market decline.

Right now, the Author advises taking profits, tightening up stop loss orders, writing Cover Calls on stocks that have nice gains, consider buying Calls on stocks instead of taking long positions, and taking only partial positions in stocks with strong momentum and good technical indicia. When things turn negative, the Author will let you know. September, and a Stock Market Winter, are coming.

Welcome to the Desert of the Real!

IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.

About the Author: The Author is a former corporate healthcare attorney, computer software company executive and stockbroker for a major wire house. He currently lives in Albuquerque, New Mexico. He trades for a living, works as a computer security consultant, and writes this newsletter to assist others in their investing activities and to keep abreast of important issues in the equity and financial markets. He may be reached by email at camelrat (at) Remember to insert the @.

[1] The title of this Newsletter, “Welcome to the Desert of the Real”, comes from the 1998 film “The Matrix”. The world in the Matrix is a Simulacrum, a computer–generated illusion. It only “looks” and “feels” like the late 20th century. Instead, human beings are enslaved in tanks of fluid, wired to the Matrix. Also, readers steeped in post-structuralist philosophy may recognize the title as a paraphrase of a quote in Jean Baudrilliard’s 1981 book, “Simulacra and Simulacrum”.

On the subject of films, the Guild Cinema is an art house movie theatre in Albuquerque. The Guild had a recent series of “Cult Classic Films of the 1970s”. The series included a classic thriller, “The Taking of Pelham One, Two, Three”, a John Houston directed gem, “Fat City”, and an uneven but intriguing film directed by Jack Nicholson, “Drive, He Said.”

The 1970s is a decade that is easy to dismiss or deride. But for cinema, it had some watershed events. “Jaws” was the precursor of the Summer Blockbuster film. “The Poseidon Adventure” and “The Towering Inferno” were templates for the Disaster flick, ala “The Day After Tomorrow”.
The 1970s also signaled the decline (in number made, not necessarily the quality) of the Western with the excellent final performance from John Wayne in “The Shootist”. A new iteration of the Gangster film came with the cinema uber-classics “The Godfather”, I and II.

Adult films moved from stag night at the Elks club to semi-mainstream acceptance. “Deep Throat”, “Behind the Green Door”, and “Debbie Does Dallas” were water-cooler topics in their day and a source of Johnny Carson monologue jokes. Linda Lovelace’s unique skills provided the code name for the Watergate whistleblower that recently went public. Now adult films are available at most video stores and on cable television. Not a value judgment, just the facts.

Two seminal Vietnam films closed out the war and began the national reflection upon the Vietnam War. “The Deer Hunter” brought the war back home and personal. “Apocalypse Now” took us into the heart of darkness that lurks in the shadowy frontier between “us” and “them”. But the complete vision of “Apocalypse Now” had to wait until 2001 with the release of “Apocalypse Now-Redux”. The Author believes that the omissions of the additional “Redux” sequences from the 1979 cut of “Apocalypse Now” cheated viewers of Coppola’s complete trenchant vision. In “Redux”, when the grizzled French solders emerge from the fog, the audience, and America, are drawn into that fog. Rent or buy “Apocalypse Now-Redux” and take the full ride up the river and into the howling heart of darkness. The Horror.

And finally, on a lighter note, the 1970s gave us the funniest sports film ever, “Slap Shot”. Hockey players everywhere can recite the lines of dialogue from memory-just ask the Author. And while “Slap Shot” is forever enshrined as a comedy cult classic, it is also a clever and well-written farce about the marketing of sex and violence in mainstream American entertainment.
[2] If the extant situation is a conundrum, then those who seek to understand the conundrum must conundrumize themselves to be effective students of the conundrum and to be able to deconudrumize the conundrum. This is some writing and some neologisms that only a post-structuralist could love. Or are they now called neoconstructivists?
[3] [3] Mr. Greenig’s thoughts appear in Volume 1 - Issue 41 June 27, 2005 of John Mauldin’s newsletter “Outside the Box”. Mr. Mauldin is a hedge-fund expert and financial writer, among many things. Mauldin’s website is
[5] Grantham, ”All Quiet on the (Market) Front”, p. 2. This issue needs some further discussion. Grantham is apparently saying that excess capital will not be used as efficiently as capital that was employed in an economic environment where capital was scarcer and businesses were inclined to be more careful in their use of it. (Bad Money following Good Money, or a variation on the “House Money” effect.) Here is an example. Joe Smith struck it rich in the recreational vehicle industry. His business grew to a size where it could expand no further. Rather than hire an investment professional to invest his excess capital, he got it in his head to open a chain of restaurants featuring Old Joe’s Biscuits and Gravy. Old Joe knows nothing about the restaurant business. His biscuits are dry and his gravy lumpy. He can barely keep the business running. Margins are low because his capital is less efficiently deployed than it would be in alternative uses.
[6] In the August 16th 2005 edition of John Mauldin’s Newsletter, Mauldin includes an article by economist Dr. A. Gary Shilling, “The Consumer-Dependant Economy.” Shilling includes data that demonstrate that the share of income going to the top 20% of earners is increasing, while the lower 80% are finding their shares of income slipping. (As we know, the poor consume and the wealthy buy assets, creating greater demand for assets and lowering returns on such assets.) Shilling also says that pressure on wages will continue. This article also discusses consumer spending in America that is outstripping income, the Housing Bubble, the abysmally low savings rate in America, and the poor retirement prospects for many Americans.
[7] The local PBS affiliate here in Albuquerque broadcast two excellent shows on Saturday morning, August 13th. They were titled “World Economy”. They chronicled the influence of the Keynesian, controlled economies, of the middle decades of the 20th century and the move to de-regulation and more market and more monetarist policies of the 1980s forward. There was great discussion from then-contemporary politicians in the US, UK and Europe and interviews with Milton Friedman, Friedrich Hayek and others. These were events that happened within the lifetime of the Author and have affected his fate much more than the besotted breakup of the Sex Pistols, the traumatic cancellation of the television comedy series “Bosom Buddies”, or the fortuitous advent of fuel-injected motorcycle engines. Catch these “World Economy” shows if you can. There may be more in the series.
[8] The wage figures used by Grantham also include employee benefits costs.
[9] It is worth being said that English investors profited handsomely by financing the railroad boom and industrial expansion in America during the 19th century. If the Author can profit from international development, he will take that opportunity. The Author would also like to state that he gives the bulk of his charitable contributions to international causes, environmental causes, and animal welfare groups. Charity does begin at home, but the author seeks to help those who can least help themselves, and suffer most from intentional, and unintentional, human activity. As Christmas approaches, he will plug some of these groups.
[10] Republican President Teddy Roosevelt warned against taxing labor returns at a higher rate than capital returns. Jeremy Grantham also notes that,”the share of profit going to labor is now almost at its lowest point since 1929. Until about 20 years ago, economic thinking had it that income/profit maldistribution was a contributing factor to the Great Depression. Let’s hope the economists then were wrong!” Grantham, ”All Quiet on the (Market) Front”, p. 2.


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