From the Archive: Small-C May 2009 Letter

The portfolio returned 5.3% for the month, bringing our year-to date return to 16.1%.There was little change in our positioning, as laid out previously.  The strength in the equity market, however, begs a few questions:

Why are we short equities?  This we had the opportunity to participate in an excellent exercise which forced us to think hard about the case for which direction to pick in equities.  Our main conclusion was that that many convincing arguments can be held up for either side.  Our personal view draws from the following:

• Unemployment is still rising and will continue to do so.  Entire sectors as yet untouched by layoffs must inevitably contract, and reduce the productive capacity well into next year.  However, we must recognize that unemployment has no predictive power to equity returns
• Barack Obama and his administration are increasing government interference in private life at a furious pace.  We want to like Obama.  His foreign policy holds out great promise, but in terms of expanding government he already looks worse than George Bush - which is saying a lot.  We have to admit, though, that equity markets reliably outperform during Democratic administrations.
• The Other January Effect, which we have written about before.  However, new study has shown that the dominant strategy is to be in cash after a down January, not short the market.
• Demographics.  There are some 80mn baby boomers on the verge of retirement.  We are led to believe they had a great deal of their retirement savings invested in stock.  They have been badly hurt by the last year’s equity declines.  They want to exit the equity market, either to protect what they still have left, or to have cash to spend in retirement.  The buyer for their equities is the less-numerous, cash-strapped younger generation.
  
• We just don’t see the value in owning equity.  There are endless arguments to be made around a correct valuation; the only thing we have to guide us is a feeling that equity just doesn’t offer the right ratio of pleasure to pain in the owning of it.  Sure, interest rates are low, but there are plenty of vehicles to earn an acceptable, contractually defined yield.  Sure, we could miss out on a 20% gain, but we don’t feel we desperately need that 20% gain when set against the very real possibility of losing 20%.  Incidentally, we think the world is moving into a sustainable "dividend yields greater than bond yields" environment of the type that existed prior to 1960.

Why are we long China?  We often hear analysts express a view that China is / will be an economic powerhouse because it lacks the constraints of a democratic political system.  When the communist party decides to, for example, build out highways or increase consumption of domestic cigarettes, it sends out a diktat and its will is done.  China has elevated 500 million people out of poverty in a generation - what can’t it do?  We think there is a naïve, pernicious idealism behind that view.  More Chinese may have risen out of poverty in the last generation than any other nation, but standards of living are well behind those in the Western world.  When Chairman Mao conceived his Great Leap Forward, the result of this government-ordered investment program was uncounted millions of deaths by starvation.  Most Westerners of our generation have no experience of even the slightest worry that there might not be food for a day and can not come close to imagining the horror of entire cities starving.  We’ll take our democratic process, thank you, which is precisely why we like China.  We believe that China does indeed have 50 years of strong growth ahead of it, that the gains of the last decade have been due precisely to a opening of the Chinese political system, and that increasing information, growing freedom, and economic success will tie up in a virtuous cycle.

Why are we long inflation?  We believe Adam Smith, who in 1776 wrote "for in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coin". And we believe Milton Friedman who in 1956 reminded us "Inflation is always and everywhere a monetary phenomenon".Major western governments have begun to print money, supposedly to "stimulate the economy", by increasing government expenditure programs using newly issued debt.  And if no one wants that debt, what do they do?  Well, becoming a fantastic Ouroboros, the government itself buys it.   What they are doing, and they surely realize this but can not state it explicitly, is using inflation to 1) reduce the real value of debts (and therefore redistribute wealth from lenders to borrowers) and 2) expropriate the hard-earned savings of the thrifty and older, to support the young and irresponsible.  Inflation is a more subtle way of doing this than explicit expropriation or rising taxation - though governments are doing that as well - a move which will serve to redistribute power to the politicians and bureaucrats, not, as stated, to redistribute wealth to those disadvantaged by the current downturn.  Does that sound outrageous?  It should.  If you played by the rules for last decade and were successful, your winnings are being stolen.

What are our investment goals?  What is our benchmark?  We have never set in writing either of these rather important concepts.  Our investment goal is to increase capital at a rate significantly greater than inflation over the long term.  How long?  The figure we have in our head is 60 years.  Being realistic, that implies we hope not to access this capital within our lifetime.  Our long-term benchmark is 0% or the S&P 500 return, whichever is greater.  We hope to preserve capital, but consider ourselves risk-tolerant - a 20% loss in year would not make us greatly uncomfortable.

A corollary to the "P-side Theory of GDP": Among market commentators, it is popular to say that the drop in wealth, across house prices, stocks, pensions, what have you, that we have experienced over the last year will lead people to adjust to more frugal standards of living, and because of that economic growth will be impaired for years to come.  Jeremy Grantham makes a representative summary:  "No longer as rich as we thought - under-saved, under-pensioned, and realizing it - we will enter a less indulgent world, if a more realistic one, in which life is to be lived more frugally."  Hmmm.  We don’t quite buy the argument.  Nowhere does he mention that we will work harder as well.  Imagine that over the last several years, people were in some measure living off of wealth they believed was stored in various assets.  We don’t dispute that - the popularity of home equity loans indicates they probably were.  Now, that source of consumption has disappeared.  True as well.  We dispute the conclusion that inevitably this leads to reduced consumption and therefore GDP.  Certainly, over some horizon, people will be more careful with money.  But aren’t they also spurred to produce income, where before they consumed assets?  We think this change in asset values brings the producer back online, and GDP can indeed start to grow again.  Isn’t that all a bit contradictory to our whole bearish stance?  Somewhat, we admit, but part of our argument is valuation as well, which we believe will remain lowered for long after economic grow restarts.