October 20, 2003
Dow Jones Average: 9,722
S&P 500 Index: 1,039
Running Up the National Tab
Over the past five years the United States has accounted for 60
percent of worldwide economic growth even though it represents only
five percent of the world’s population. American consumers absorb
goods and services equivalent to all U.S. production and a net 500
billion dollars worth of overseas production every year. With so much
of the world dependent upon a high level of U.S. consumption, economic
policy has been designed to keep Americans in a buying mode. Our government
has provided a triple dose of economic stimulus consisting of tax
cuts, interest rate reduction, and more government spending. Foreign
governments, particularly China and Japan, have endeavored to keep
their currencies weak relative to the U.S. dollar so Americans can
more easily afford their exports. So far the strategies have worked.
Most Americans continue to spend as much or more than they earn, borrowing
money against the value of their homes, while foreigners save money
and invest it in U.S. stocks, treasury bonds, and mortgage securities.
There is no doubt that debt levels are high and rising in the U.S.
Statistics indicate that Americans hold a record amount of debt, mostly
in home mortgages, relative to their incomes. The Federal government
is accumulating new debt at a rapid pace as it attempts to cover increased
military spending with revenues reduced by the tax cuts. The largest
states in the U.S. are also borrowing to cover serious budget shortfalls..
The U.S. is increasingly in a debtor position, dependent upon the
willingness of foreign investors to reinvest their export earned dollars
at the current low U.S. interest rates. All of this borrowing and
spending has sustained the world economy over the past seven years,
but is not likely to be sustainable economic practice over a longer
time period. The debt imbalances mentioned above may seem like a prescription
for trouble, but so far they have not led to an economic dislocation.
One could argue that Americans spending and foreigners lending has
created a virtuous cycle of economic activity. Americans buy domestically
produced and foreign goods at a pace that requires some financing.
The loans are provided in part by foreigners reinvesting their capital
in U.S. bonds and mortgages. A problem arises only if interest on
the debt becomes too burdensome, crowding out other necessary spending.
Americans could be viewed as a party of people at a restaurant, ordering
a rather lavish dinner replete
with many bottles of the most expensive wine. The owners of the restaurant,
in the same position as foreign owners of U.S. debt, would be pleased
with the big tab being incurred, unless they thought it would not
be paid in full with a currency of reasonably
stable value.
For the past several years the U.S. dollar has been declining in
value relative to the currencies of Europe, Japan, Canada, Australia,
and other developed countries. The real return for a foreign investor
buying U.S. bonds is the interest income from the bond, less U.S.
inflation, plus or minus the change in the U.S. dollar’s value
relative to the investor’s national currency. As the U.S dollar
declines in value, foreign investors lose money on the hundreds of
billions of dollars they have invested in U.S. bonds. Economists fear
that at some point foreigners will be reluctant to invest in U.S.
bonds at the current low yields, sending interest rates in the U.S.
higher. An upward shift in rates would be bad for the U.S economy,
the bond market, and the stock market. Given the recent, noticeable
rise in U.S interest rates, the trend toward higher rates may have
already started.
Current Strategy
The shares of weak companies have performed better
than shares of more profitable companies during the stock market rally
of the past six months. The market action is an echo of the 1999-2000
bubble, when money losing companies and companies with no real products
outperformed more established corporations. The theory behind the
recent disparity is that weaker companies have more to gain from an
economic recovery. Because the economic recovery is in its incipient
stage, no one knows how strong it will be or even whether it will
last long. While such unknowns are a reason for caution in our opinion,
many investors seem more than willing to imagine a recovery
that turns money losing and marginally profitable companies into profit
generating machines. We do not see a recovery built on the solid foundation
of savings and pent-up demand, but rather one based on levels of borrowing
that will be hard to maintain.
There are few obvious buys in the stock market at this time. Stocks
are fully priced for an earnings recovery that may or may not materialize.
Companies that are not dependent on the economy, such as the medical,
food, and energy stocks, are languishing in price, but are not declining
to compelling purchase levels. For accounts
that have limited exposure to stocks, we are building some partial
positions in leading companies such as Johnson & Johnson, Nokia,
and others with similar financial and product strength. We continue
to look for smaller companies that may be rolling out a new product
or showing marked improvement in their balance sheet. We were quite
active on the bond side in the latest quarter. As interest rates spiked
upward from the lows of June we started buying shorter term notes
and longer term inflation protected securities. The inflation protected
government bonds have been one of the strongest asset classes over
the past few years, and became cheaper only briefly in late July and
early August. Investors have been reluctant to part with their treasury
inflation protected securities (TIPS), because current economic policy
has raised fears of
increased inflation. We believe that a strategy of shorter term paper
and inflation adjusting securities is the best way to protect one’s
capital, and remain positioned to buy higher yield bonds should rates
rise further.
