All Blue Sheets

50% off! Why aren’t we happy?-Quite a few clients called us after reading their October account statements to ask, “Should I be scared, or does Financial Advantage have this under control?” A 50% nosedive in the S&P 500 index of large company stock prices is bound to unnerve any investor who is paying attention! This bear market has been even more punishing than the now-famous “bursting of the tech bubble” between January 2000 and October 2002, but it has happened in just one year! It’s more than a little disquieting; what’s going on?

In this issue of the Blue Sheets we will introduce our sixth long-term investment theme:INFLATION. We believe that structural inflationary influences are increasing, particularly on the monetary front, virtually ignored by the investment community so far. If our observations are sound, rising inflation constitutes a fundamental, long-term shift in eco-political realities that presents new investment opportunities to exploit as well as new risks to be minimized. To wrap up, we’ll describe what we think is a rather clear economic outlook and its implications for risk and opportunity in the marketplace for investments.

In Ben we trust?

To grasp what’s really behind the wild swings in the financial markets the past few months, we need only ponder our headline insight from Hyman Minsky, an American economist who focused his work on understanding the characteristics of asset bubbles and the financial crises that inevitably follow them; for in fact this is the very circumstance in which we now find ourselves.

Lunch at La Grenouille

When we last heard from BB, Rosy and Murph, they had agreed to lunch together at New York City landmark La Grenouille on 52nd between Park and Fifth. And so they did, on a warmish Thursday in May. Murph had agreed not only to present his strategy for a retirement portfolio designed to prosper in Tom Friedman’s “Flat World”, but also to pick up the not-insignificant tab in gratitude for his friends’ influence on this strategy.

Summary of Part 1

As regular readers will recall, our Summer 2006 Blue Sheets recorded a meeting that veteran Wall Street money manager George Murphy held in his offices in lower Manhattan with two old friends of very different investment persuasions. Murph had invited his astute buddies to help him discern a safe path through the jungle of opportunities and risks in a tumultuous new era of global commerce.

Murph’s big meeting

As he wheeled back from his big, cluttered desk, George Murphy looked a gruff sort of character with unkempt, bushy gray hair topping a six foot frame lavished with twenty surplus pounds. A fixture in Wall Street’s private dining rooms for over 50 years, Murph still manages conservative money from spacious but anachronistic offices on the 23d floor of the venerable Equitable Building in lower Manhattan. Over the years he has hosted dignitaries here, interviewed the reigning cognoscenti and grilled into discomfort a wide assortment of Warren Buffett wannabees.

Come and listen to a story ’bout a man named Jed
A poor mountaineer, barely kept his family fed,
Then one day he was shootin’ at some food,
And up through the ground came a bubblin’ crude!
Oil, that is; black gold, Texas tea.

-From The Ballad of Jed Clampett

Those of us old enough to have savored the cultural delights of network TV between 1962 and 1971, will doubtless remember the Beverly Hillbillies. Perhaps you can still sing along with the Ballad of Jed Clampett (above), which recounts the saga of those lovable mountain folk who parlayed an accidental oil fortune into a posh Beverly Hills address where they never quite fit in with their uppity neighbors. The decade-long TV series ran out of gas, ironically, just as Texas oil production peaked and began a long, slow decline, passing the mantle of power to OPEC, the Clampetts of the Arabian Desert.

In 1930, 24-year old Max Schmeling became the first German heavyweight boxing champion of the world by beating American Jack Sharkey before a huge crowd in New York City. In 1936 at age 31, and now a former champ, Schmeling was brought back to the States as a sort of sacrificial lamb to fight the undefeated 22 year old Joe Louis. Max was a 10-1 underdog. In an interview with sportscasters before the fight, he was asked why he thought he had any sort of chance against America’s rising star. The always soft-spoken and humble Schmeling replied simply, “I see somesing.”

What the former champ had seen when he studied Louis’ fight films was that the American dropped his shoulder every time he threw his famous left jab, leaving his head unprotected for a split second. Exploiting this vulnerability over and over with his powerful right, it took Schmeling until the twelfth round to finally knock out the younger fighter in what many consider the greatest upset in boxing history. All because he “saw somesing.”

One of the five global economic themes around which we have designed our investment strategy is Debt Leverage. This summer’s issue of the Blue Sheets explores the home equity loan phenomenon that has supported US consumer spending and asks the question, “How much longer can this go on?” We think the answer has profound implications for interest rates, inflation and the attractiveness of stocks and bonds.

For the better part of two decades, these Blue Sheets have been our forum for commenting on developments in the global economy and in the securities markets which supply essential capital to businesses and governments. In the course of all that observing and commenting, we have learned a thing or two about the roguish independence of markets and the often tenuous relationship between economic realities and securities prices.

Over the years, experience has humbled us with her repeated instruction in the futility of short-term forecasting. At the same time, though, she has taught us the power of understanding long-term forces in both the economy and the stock & bond markets. While we do occasionally venture an opinion, say, that interest rates may be bottoming or that a business cycle seems long in the tooth, our serious decisions about the makeup of client portfolios emerge from our studied convictions about a few powerful long-term forces.

Aided by a dip in oil prices and a reasonably smooth conclusion to the presidential election, the stock market (S&P 500) zipped 8% to the upside in just four weeks, bailing out a heretofore uninspiring year for stocks. This surge from late October almost immediately rekindled enthusiasm among investors previously worried about deficits, rising interest rates, global terrorism, the falling dollar, high valuations, slow jobs growth, consumer debt burdens… well, you probably know the litany by heart. But all it took was a couple of “up days” and all of a sudden the sky is blue and the future is sunny!? What happened to the problems and the risks? I was feeling
confused.

A Unique Time

Most of the money we manage for our clients is earmarked for retirement, either present or future. For this reason, we are especially concerned about capital preservation; about minimizing losses; about doing everything in our power to earn positive returns even during times when stock prices are falling, as they were in 2000, 2001 and 2002. During those gloomy years of the “bear market”, we were able to identify several asset classes that represented good value… small cap stocks, mutual funds that adhere to a deep-value discipline and, of course, long-term bonds that rose in price as interest rates declined. Emphasizing these asset classes allowed us to
preserve capital and earn a fair return for our clients despite a nearly 40% drop in large cap stock indexes over those three years.

At a store near you

Shopping this past Christmas was a more international experience than we had expected. From two very fashionable, ultra American department stores we brought home one evening a quilt, a set of sheets, three wooden toys, two sets of hand painted stemware and a stained-glass candle holder. Everything but the candle holder was from China; and the candle holder was from Japan. From a manufacturing point of view the score for this short shopping spree was China 7, Japan 1, USA zip, zero, nada.

The following edition of the Blue Sheets was written the weekend before the tragic attacks of September 11.  Since that time, our Investment Committee has been analyzing the potential implications of the week’s events on financial markets and the economy.  We are reviewing every detail of our investment policy.

In the meantime, none of our research so far in any way contradicts or is in conflict with the strategies and observations contained in the Blue Sheets of September 8.

After more than a year of wrenching declines in popular stocks, Wall Street’s proffered wisdom is that a “market bottom” is forming and before long the good times will be rolling again.  These assurances are very tempting, indeed.  But an objective examination of the data suggests that the extraordinary stock market of the last decade was a temporary emotional phenomenon that caused distortions in both the capital markets and the economy that may take a long time to correct.  There will still be great investment opportunities, but they won’t be the same ones that worked last time.

When we wrote “Bubbles, Roses and Ducks” back in January of this year, NASDAQ was making its run to 5,200.  Today, much chastened, the popular index lies quivering at half that level.  One of my investment heroes, Sir John Templeton, has long maintained that a true investor delights in falling securities prices because he or she is a buyer; everyone likes to buy when things are on sale.  It seems appropriate to write our concluding issue of the year 2000 by addressing the question, “Are stocks on sale? Is it time to buy?”

The air is muggy in Baltimore, and the nearest breeze is probably 100 miles away.  The Orioles are well out of contention (again!) and volume on the New York Stock Exchange has shriveled to 600,000.  It’s the doldrums before the long Labor Day weekend when we find ourselves saying, “My gosh, where did the summer go?”  It’s the perfect time to catch up on our reading.

In the January 200 issue of these Blue Sheets (“Bubbles, Roses and Ducks”) we analyzed the split personality of the current stock market.  As you recall, we delved into the psychology of the speculative bubble to understand the unheard-of valuations then prevalent among new technology offerings.  We also examined how, amidst the speculative furor, shareholders were pulling their money out of “value funds”, forcing them to sell stocks which were already on the bargain table, making them even cheaper.

Sometimes, at the close of a year, it is difficult to decide what aspect of the markets to write about.  The final year of the twentieth century was not such a year!  In 1999, more than 100 mutual funds (out of 7,000) registered returns in excess of 100%!  The initial public offering (IPO) market was boiling all year long, with scores of first-time offerings more than doubling on their first day of trading.