"the Letter"

Investment Strategy: "the Letter"

By Jeffrey Saut | 29 July 2008

Last week I received the following letter:

"I know you’ve been hearing from Barrie about concerns he has for the future of the economy; I’m equally concerned and wondered how my portfolio is positioned for what I see coming. Here’s what I’m worried about: In what seems like a very short period the U.S. has gone from the world’s largest creditor nation to the largest debtor nation. The country continues to spend vast amounts of borrowed money on consumption but very little on infrastructure or productive investments. Employment numbers don’t distinguish between service jobs and manufacturing jobs; that is, manufacturing jobs are disappearing overseas and being replaced by lower paying service jobs. As a country we seem to produce very little than can be exported. The GDP, which is often touted by our government as an indicator of how well our economy is doing, seems to me misleading as it doesn’t make a distinction between productive spending and consumptive spending. For example, spending on building new factories would be desirable while spending to clean up after Katrina or Exxon Valdez would be undesirable, but as I understand it all three would figure equally into increasing the GDP. I’ve read that the consumption makes up over 70% of our current GDP. If this is true then the GDP is more a measure of how fast this country is going broke than how fast it is gaining wealth. I also don’t think the consumer price index is really a representative measure of how the economy is doing. We’re told that core inflation is low, but this doesn’t include food / energy or I think housing prices, all of which are going up. If these were figured in the inflation number would be far higher than reported. In summary, I think the picture mainstream economists like to paint is of a healthy economy chugging along. But behind the facade I see reckless consumer and government spending camouflaged as economic growth. I hope I’m wrong, but I’m both very pessimistic about the future while also mindful that huge opportunities exist and could be exploited. I see high inflation and perhaps a collapse of the economy if too many dollars return to this country at one time. I think the worst places to be would be in U.S. dollars or currencies of other countries that are largely consumers, whereas producing countries like China and India would be safer places to be. In the short term I would think that U.S. companies that have a large export business would be good bets; as the dollar declines they would sell more overseas. I also think commodities such as energy and precious metals would be good bets as well as those companies that are in the business of new energy (solar / wind) or mass transit. The demand for energy and precious metals is not likely to decline and the demand for alternative energy sources and mass transit can only grow. I also worry about big box store stocks like Wal-Mart (WMT/$56.83) that exist on low margins and high sales; in the past people were willing to drive further to get to these and save a few bucks, but with the cost of gas this strategy makes less sense and we may see a revival of the neighborhood store. Sometime in the next few weeks could we discuss where my portfolio is positioned and the risk / benefit ratio of where we could be."

I reprise this letter today because it speaks to many of the concerns investors are currently voicing. To the first point that our country is now the largest debtor nation in the world, I have no response other than to say it’s true. The nation appears to be "eating its young" as we saddle our children with ever increasing debt that is likely sinking the footings for a generational "war." Yet, the problem lies in a lack of leadership with our politicians; I mean where are the 'statesmen'?!

As Charlie Reese wrote in his excellent article "545 People Responsible for America’s Woes," "Politicians are the only people in the world who create problems and then campaign against them. Have you ever wondered, if both the Democrats and the Republicans are against deficits, why we have deficits? Have you ever wondered, if all the politicians are against inflation and high taxes, why we have inflation and high taxes?" Indeed, where are the statesmen?! Lee Iacocca actually does Charlie Reese one better when he writes:

"Am I the only guy in this country who's fed up with what's happening? Where the hell is our outrage? We should be screaming bloody murder. We've got a gang of clueless bozos steering our ship of state right over a cliff, we've got corporate gangsters stealing us blind, and we can't even clean up after a hurricane much less build a hybrid car. But instead of getting mad, everyone sits around and nods their heads when the politicians say, 'Stay the course.' Stay the course!?! You have got to be kidding. This is America— not the damned 'Titanic'. I'll give you a sound bite: 'Throw all the bums out!' You might think I'm getting senile, that I've gone off my rocker, and maybe I have. But someone has to speak up."

Speaking to our letter writer’s manufacturing jobs point, an amazing thing is beginning to happen. The cheap dollar, combined with soaring transportation costs, is causing U.S. companies to bring manufacturing jobs back inside our boarders. While said movement is in the nascent stage, it should build into what our letter writer terms "productive spending" on new factories, etc. As for inflation, anyone that lives in the real world knows the government’s figures are a joke.

We have argued for some time that the "core" inflation numbers (ex-food/energy) should be totally ignored in lieu of the "headline" inflation numbers. While even the "headline" numbers understate the inflation picture, they clearly are more in sync with what’s happening in the real world. And that, ladies and gentlemen, is why we continue to avoid fixed income in favor of stocks.

Consider this, since 1968 the "headline" inflation number has averaged 4.6%. That means the cost of many of the things we buy doubles every 15 years. If a couple decides to retire at age 60, statistically one of them will live to be 90 years old. The implication is that over those 30 years they will lose 75% of their purchasing power to inflation. Plainly, fixed income will not be able to maintain your purchasing power, which is why we continue to favor stocks, preferably stocks with a dividend yield.

Late last week, however, stocks fell out of favor again as profit-taking reigned after the previous week’s huge rally. Also clouding the environment were shockingly weak economic figures from Europe, worse than expected U.S. home sales, and a prediction by PIMCO’s Bill Gross that U.S. bank losses will be at least one trillion dollars. We have warned investors that the U.S. dollar to euro exchange rate was having deleterious effects on Europe, so last week’s news should have come as no surprise.

As for homes sales and Bill Gross’ prediction, the statement– that the financial disaster won’t improve until housing prices stabilize— is now legion. Lost in the noise, however, is that while existing home sales have indeed collapsed, median prices have actually been moving "up" for the past four months ($215,100 in June versus $195,600 in February)! Whether this marks "the turn" for the economy is questionable, for while we don’t think the news will get a whole lot worse, we also have a difficult time believing it will get materially better either.

Meanwhile, the long-standing "trade" of shorting the financials and going long materials/energy has unwound rather dramatically over the past few weeks. To be sure, various financial indices rallied more than 30% in just six trading sessions, while crude oil is off 16% and natural gas has crashed 30%. We think the ferocity of the sector rotation is overdone in the near-term, which is why we recommended selling some of the financial indices we tranched into for trading purposes a few weeks ago. The quid pro quo is that last week we also recommended buying energy stocks for a short-term trade. Our vehicle of choice was the ETF ProShares Ultra Oil & Gas (DIG/$86.49).

The call for this week: According to Richard Russell, "Yesterday (7/24/08) Lowry's Selling Pressure Index rose to within one point of its July 15 all-time high. That tells me that big money has been selling into all rallies, and that's just plain bearish. Selling Pressure should be declining rapidly when the market rallies. That's not what is happening."

Still, as long as the S&P 500 (SPX/1257.76) remains above 1240, we are constructive on stocks. [[Guess you can forget that! : normxxx]]

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Normxxx    
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