October 11, 2010

“Many people would sooner die than think; In fact, they do so.”
–Bertrand Russell

This letter will be a bit unusual. What we attempt to do here is to give you a glimpse into our thinking and our approach to these strange capital markets and their behavior…

First, why is this market strange? If you went to sleep on January 4th, 2010 and just woke up, you would have noticed that the S&P 500 is up “only” 4.5% (as of the time this is being written). If, however, you would have added up all of the daily oscillations of the S&P 500 since the beginning of the year until now, you would have come up with an astonishing 161%! This means that the market's mentality shifts very frequently — almost daily.

To put it simply: Nobody understands what's going on, and, what is worse, what's next? The truism “Markets hate uncertainty” is as true as ever. What we attempt to do is to separate the myths from reality, which should give us (and, we hope, you) a better understanding of our approach to the portfolios.

Most of you might enjoy the latest reports: the markets have been generous to your accounts in 2009 and so far in 2010, and we have recovered most of the losses the accounts suffered in 2008; you will also notice a very significant improvement in the furthermost right column of the report, which shows the combined results of your accounts since inception. It is time for you and for us to give a very serious thought to positioning the accounts for the next 3-4 quarters. That is why we decided to concentrate on our “inside lab” in this letter, and elucidate our approach to the markets and the economy (of course, the former does not necessarily have a strong correlation to the latter). We selected ten myths associated with the economy and the markets, and provided you with the arguments which, in our opinion, show why these statements are indeed myths.

Myth #1: The policies of the Obama Administration are helping us emerge from the crisis…

“A stupid man's report of what a clever man says can never be accurate,
because he unconsciously translates what he hears
into something he can understand.”
–Bertrand Russell

You hear a lot of discussions regarding the stimulus package. Did it create new jobs? Did it help the economy? Should we have TARP #2?

Economists and scientists often appeal to the history of the Great Depression. Of course, the current crisis is not comparable with what happened in 1929-1932. Then, the GDP was going down by more than 10% per year; at the worst moments, manufacturing was cut in half, and the unemployment rate was about 25%. We have not reached a crisis of such magnitude (yet). However, today's crisis is very similar to the Great Depression in political aspects. At the height of the crisis, a new President came to power. What did he do? He criticized financial markets and its participants, promised to reform the financial system, introduced new regulations, and increased the role of the government in the economy. Sounds familiar? The myth is that Roosevelt not only failed to accelerate the exit from depression, he slowed it down. The law that Roosevelt introduced (National Industrial Recovery Act, NIRA) as a matter of fact cancelled antimonopoly laws and gave trade unions the monopoly to hire workers. This law was so ridiculous that the Supreme Court voided it in 1935 as non-constitutional. Roosevelt developed a new one — NLRA = National Labor Relations Act) in the same year, 1935. The intent was good: to support the prices and manufacturing, and stop the decrease of salaries. There are many economists (see the research done by the UCLA Professor of Economics Lee Ohanian and University of Pennsylvania Professor of Economics Harold Cole "How Government Prolonged the Depression, Wall Street Journal, Feb.2, 2009) who believe that these policies have significantly slowed the exit from the recession.

The most interesting question today is: how likely is our president to repeat Roosevelt's mistakes? The answer does not look good so far…

Myth #2: The unemployment picture should improve together with the economy.

“I think we ought always to entertain our opinions with some measure of doubt.
I shouldn't wish people dogmatically to believe any philosophy, not even mine.”
–Bertrand Russell

The Noble Prize in economics has just been awarded to three economists (two U.S. economists, and one British). What are their accomplishments?

Professor Peter Diamond shared the Nobel Prize with Dale Mortensen and Christopher Pissarides for research into the difficulties of matching supply and demand, particularly in the labor market.

“This year's three laureates have formulated a theoretical framework for search markets“ such as ones where buyers look for sellers and applicants look for jobs, the Royal Swedish Academy of Sciences, which selects the winner, said today in Stockholm.

We, as a society, are just witnessing the truth of their theories.

Myth #3: Health Reform will decrease the cost of the medical care.

“It has been said that man is a rational animal.
All my life I have been searching for evidence which could support this.”
–Bertrand Russell

If you think that adding 19 million people (give or take) to the medical insurance rosters will decrease the cost of medical insurance, you are wrong. Who is going to pay for that? While we do not have the answer to the question on how to accomplish the noble task of providing health insurance to everybody, we are witnessing the never-ending sequence of increases in medical care insurance. Anthem Blue Cross of California dramatically raised rates — by as much as 39% (!) in 2010. The facts are here.

Myth #4: Emerging Markets have run their course.

“Do not fear to be eccentric in opinion,
for every opinion now accepted was once eccentric.”
–Bertrand Russell

What the emerging market economies have today is a two-fold situation: on the one hand, their lands are stocked with natural resources, their national finances are very strong, and a rising middle class is spurring breakneck growth in their businesses. What they do not have is an adequate infrastructure. According to the International Energy Agency, 400 million people in India do not have electricity, Brazil does not have a developed system of ports, and the transportation in China remains very inadequate. Emerging market economies and governments are committing over $6 trillion to address this problem, and for the investors, the infrastructure boom offers a very rich opportunity.

Myth # 5: Gold buying is a bubble.

“I would never die for my beliefs because I might be wrong.”
–Bertrand Russell

The lack of any agreement on currencies during IMF and World Bank meetings added further support to gold, says Bill O'Neill, one of the principals with LOGIC Advisors. “One of the reasons people have been buying gold is due to the fact it is serving as the ultimate alternative currency. Every time you see that lack of agreement and indication there is nothing imminent…that's a positive for the gold market.” Overall, the metal remains underpinned by the same factors driving it for the last 1½ years — sovereign debt issues, uncertainty about currencies and central-bank buying, he says. “I don't think there is any change in the basics that have allowed gold to move higher.” Still, O'Neill cautions, there is some risk to speculators only because of the heavy net long position that has already been built up, which means potential for selling in the form of profit-taking should some traders opt to exit. “If the market was to get into a change in psychology…and if we were to see a situation where some liquidation started, that could be pretty aggressive.”

Myth # 6: The budget deficit is not dangerous for the economy or for each of us.

“Science may set limits to knowledge,
but should not set limits to imagination.”
–Bertrand Russell

The emission of dollars will lead to inflation, and is as a matter of fact, just a hidden tax on everybody holding U.S. dollars. Inflation is not only a hidden way to dip into your pockets; it leads to macroeconomic instabilty, and therefore, to the reduction of planning horizons and a deterioration of investment climate. Financing of the budget deficits by issuing government obligations is probably a more civilized way than the direct taxation of individuals and businesses. But if such financing is prolonged, then the real interest rates will increase rapidly, and the private investors will be squeezed out of the markets. History has shown that NO COUNTRY CAN SUCCEED JUST BY PRINTING MORE AND MORE MONEY AND THUS DEBASING ITS CURRENCY. One only hopes that this government fully understands the consequences of the very dangerous political games it is playing with OUR money…

Myth # 7: Financial markets do not need to be regulated.

“Our great democracies still tend to think
that a stupid man is more likely to be honest than a clever man.”
–Bertrand Russell

Capital markets are the key elements of the market economy. Moreover, they are indeed the face of a free market economy. However, the modern capital markets are impossible to imagine without regulations. “Greed is good!” — and will always find its way. Unless the regulations are in place, the capital markets will continue to produce bubbles. The government however has to be extremely careful and diligent in producing such regulations. We are not confident at all that the latest financial regulations serve their purposes….

Myth # 8: The economist can produce forecasts for several years into the future.

“A hallucination is a fact, not an error;
what is erroneous is a judgment based upon it.”
–Bertrand Russell

We all know that economists are constantly revising their forecasts — for GDP, for inflation, for deflation, for the beginning of the recession, for the end of the recession, for the price of oil, etc. To see how wrong the economists (even, supposedly, the best of the best) are, it is enough to compare their forecasts and the real numbers published in the annual report "World Economic Outlook." By carefully comparing the forecasts with the real data, it is easy to make a simple conclusion — the forecasts have two qualities: “being constant” and “being non-constant.” “Being constant” means that the forecasts very strongly resemble the results of the previous year, but as the new economic data start to come out, the forecasts change and become “non-constant.”

Economists cannot be sure about tomorrow's data, and therefore they build their forecasts on the extrapolation from the existing data. Both the forecasts of economists and the forecasts of meteorologists do not carry any financial liability. Nothing wrong with being wrong again.

The most useful macroeconomic models developed recently are analyzing microeconomic trends. Such models really can predict the structural changes and their size. The famous saying by Professor Francis Diebold, one of the most well-known macroeconomic forecasters: “The news about the death of macroeconomic models is not exaggerated.”

Myth # 9: GNP growth always improves the quality of life for the country's citizens.

“The main things which seem to me important on their own account,
and not merely as means to other things, are knowledge, art, instinctive happiness, and relations of friendship or affection.”
–Bertrand Russell

Below is a quote from Bobby Kennedy on what the Gross National Product means and, more importantly, what it does not mean.

GNP produced inside of the government sector is not related to the quality of life at all. By definition, the product produced by a private enterprise is the cost of its production. How do you determine the cost of what the government produces?

It only provides certain services for the society, and therefore can only be measured in the amount of its payroll. Bigger = better. As long as the role of the government in GNP is relatively small, the distortion in GNP is relatively small, and remains the same yesterday, today and tomorrow. What we are witnessing now is a complete distortion of the U.S. economic picture (please note that we are stating facts, not political opinions). Great Britain has a higher GNP per capita than France, but only a few would argue that the lifestyle in France is significantly better - with its sun, sea, wines, and cuisine. It is not surprising that more Brits live in France than Frenchmen in Britain.

A continuing expansion of the government programs DOES NOT improve the lifestyle.

Conclusion: What are we doing?

Once again, we are taking a very careful approach to the securities we select in Vega Equity* portfolios. We do not expect a significant correction in the market in the near future, but remain reasonably cautious — you will see a larger selection of dividend paying stocks in the portfolio, hedging positions (yes — gold!); we continue to maintain a relatively large exposure to the commodity-related stocks, and some positions have been hedged with covered calls.

In Vega Safety portfolio we remain on the shorter end of the curve. We do understand that it is very frustrating to see low single-digit coupons on the bonds — but this is what the current market environment offers, and there are no miracles there. We will probably be residing in a low interest rate environment for some time.

Call with any questions you might have, and we would be happy to readjust your accounts to reflect your (and our) points of views.

Vega Capital Group Team.