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Current Comments

March 26, 2012

The US Economic recovery continues to move ahead. Employment is slowly increasing, and the unemployment rate declining.

And U.S. Leading Economic Indicators continue to increase, auguring positively for the future. U.S. consumers have more deleveraging to do, but some of them are spending already, even though it might be better if their debt levels headed lower. The consumer will not be the driving force in this recovery, but they are beginning to make a contribution.


Housing still has several million (about 7 million) of mortgages that are in foreclosure or seem headed that direction, which will be an overhang over the housing market. Housing starts remain below the total of longer-term rate of household formation and demolitions and removals of housing stock. Hence, we are slowly absorbing the excess, and some think we are getting closer to the bottom in housing starts. I continue to think that the government is working hard to prop up housing values, as a way to prop up the banks. We won't have a recovery if the banks are collapsing, and that is contrary to current federal policy.


Early publicity focused on subprime loans and the borrowers. More recent disclosures have disclosed much fraud and malfeasance in the banking and mortgage sector, by the lenders and creditors. Many of these cases would normally be criminal, and prosecution is minimal. The recent $25 billion agreement is, in my view, a free pass and a large gift for the banks, mortgage lenders, and creditors. In many cases the liability would be much larger. There were over 1,000 federal prosecutions over the S&L events in 1989-1990s; there are close to zero this time around.

The Energy Sector

The energy sector is one area of the economy experiencing dramatic change. Horizontal drilling and associated technology is bringing about large increases in production, especially of natural gas, and this will continue, both here and in Canada. The energy crisis as we knew it, is over. Natural gas prices are barely above $2/ mmbtu, down from over $8/ mmbtu a couple of years ago. The rapid growth has created some imbalances, largely because of pipeline constraints. Some crude oil in Canada is selling for as low as $65/bbl, because of the lack of pipeline transportation to move it south or elsewhere. Meanwhile, crude is selling for over $100/bbl in the Gulf of Mexico. U. S. natural gas production has increased about 30% since 2005, and oil production, which had peaked in 1970, has recently turned up – probably ending its long-term decline for now. .

Natural gas might sell for $14-16/mm btu in Japan, and $7-10/mm btu in Europe. U.S. natural gas prices are likely to benefit as America's (and Canada's) planned LNG (liquefied natural gas) terminals become operational, and gas is shipped abroad, lowering foreign natural gas prices and raising ours.

Taken together, it all suggests that crude oil prices (and gasoline) are higher than they need to be. Some commentators ascribe this to the possibility that Israel will attack Iran, and the U.S. will then be required to support Israel in the subsequent conflict. Intrade currently puts this probability at about 42%. But without the next war, I would expect our energy prices to decline somewhat.


U.S. Manufacturing

Cheaper US energy prices are giving a boost to manufacturing. Firms are opening facilities that were previously closed, and thinking about building more. Energy is a big part of total cost in some industries, such as steel and fertilizer. This takes a while to happen, but it seems to be proceeding. The growth and rebirth of U.S. manufacturing will be another contributor to rising employment.


So there is some pent-up demand for housing, particularly at lower, market-clearing prices, some for autos, and probably a few other things as well. Many of the ingredients are there for a continued expansion.


Basque in Bakersfield

My wife and I were recently driving near Bakersfield. In the spirit of Robert Frost, we came to a fork in the road and we decided to take it. We ended up searching for a Basque restaurant. I lived in Bakersfield for a few years when I was young lad, and had eaten at some of the Basque restaurants there as a child. They served good food. There are at least four Basque restaurants in Bakersfield – the Woolgrowers, Narducci's, Noriega's, and Benji's. Three of them are located within a two block area (which is awkward to find, in a quasi-industrial district; Benji's is near the freeway). But if you find yourself lost in Bakersfield, they may be worth a visit. Basque food is healthy and wholesome.


The Year Ahead

U.S. equity markets have already climbed most of the way toward earlier targets. Some suggested 1450 on the S&P 500 , for example. Most valuations remain reasonable, but they are no longer extremely cheap. Emerging markets are a better value, and they have rebounded somewhat, but they may be affected by a slowing China. I think the next turn for much of Europe might be up. The larger risks are 1) U.S. politics, and 2) an Israeli strike on Iran.

Thank you again for your confidence.


Gary N. Clark, CFA


September 22, 2011

The Theatre of the Debt Ceiling was the large event this summer. My view is that it would have been better to have more fiscal stimulus initially, in the form of additional direct spending. Tax decreases are less effective when there is less demand for final output, as was the case in 2009. Granted, the attendant increase in federal debt is not good for longer-term economic growth, and the U.S. margin for error is smaller than it used to be. More importantly, the eventual settlement lowered the likely economic growth rate for the next year. The path to recovery is narrower, as there is less maneuver room for fiscal stimulus. The federal debt is approaching unwieldy levels, where it seriously encroaches on the option to implement more fiscal stimulus, even in appropriate. Debt service becomes a more material issue as the debt grows, and when interest rates increase. Much of debt service is similar to a transfer payment, moving funds from one group to another. But the other group may be a bank, or Chinese or Russian, or Dutch.

Many stock and commodity prices abruptly declined after the “agreement” was reached in August. Many analysts are sure those prices were speaking to us, but not everyone is sure what they are saying. I think they are clearly saying that the likely growth rate in the quarters ahead is now less than before, perhaps 0-1.5%.


Leading Economic Indicators (LEI) continue to augur positively for the months and quarters ahead. The still continues to be positive, but not very robust. And the data after the debt ceiling debate is not yet out. The economy must grow some percent just to absorb the increase in the labor force, or unemployment will rise. I think we are pretty close to just barely moving ahead, with a positive growth rate of between zero and 1.5%. It’s not robust, but so far the direction of the economy remains UP. And the surprise could be that it continues up.

Over the past three years, there has been a big shift in debt from the private sector to the public sector. This will be a big amorphous and out-of-sight drag on the economy and on the populace, and it will often not often be readily visible.

The Banks I have written many times that I think the housing issue is more about preserving bank shareholder equity capital, than about saving homeowners from foreclosure. Banks raise or accumulate equity capital, and use it to make loans, leases, and manufacture credit cards. From past experience analyzing banks, I (and most others) view a bank with 3 ½% non-performing loans as “in trouble.”


Here is a graph of the current non- performing percentage for the U.S. as a whole. We have been up to 5 ½% non-performing loans, and are now down to about 4 ½%, suggesting that the tide is turning.  Perhaps there is now more room for more foreclosures to go forward through the pipeline.   Deep down in their governmental hearts, most of the government probably does not care about homeowners in foreclosure.  


With time, competence, and chutzpah, the banking system is slowly healing itself.  The Fed can just present an upward sloping yield curve to the banking system, the banks can heal themselves over time by borrowing short and lending long.  Bad loans are slowly written off, and replenished by income from current good loans.  But overall, the condition of the banks currently remains a serious issue.  Most banks do not have enough equity to write off all of their bad loans at once. 


While much of the blame for bank problems is directed against Jose and Lupe, there is quite a bit that was due to the creation by Wall Street of securities and derivatives based on mortgages, rather than the mortgages themselves.  And a significant amount is allegedly due to fraud by those securitizing and packaging the underwritten mortgages, both at banks and at investment bankers.


On Housing

At the base, it is housing.  Housing is the albatross of the current recovery.  Depending who is counting, over twenty percent of current mortgages are under water.  While mortgage  interest rates are low, only a few mortgagors, probably less than ten percent, are effectively able to refinance.  Those with underwater mortgages, and with higher legacy interest rates, have become mortgage zombies, owing too much to refinance.  Because of this, and also because of high debt ratios, personal consumption expenditures will not play the role in an economic recovery that they often have in the past.  [The government appears to be currently formulating policies and programs that will address this issue].   Consumers are still getting their balance sheets back into shape.  Mortgage zombies are unable to move to a better employment situation,  they are less likely to buy a newer car, they will save less for their retirement, and save less for their children’s education.  Just the passage of time makes some contribution to fixing this situation.   New housing starts may be below replacement rates.  Houses will be washed away by hurricanes, burn down, or wear out.  As the economy slowly rebounds, the number of households will expand, and the housing slack slowly gets absorbed. .  Lenders still are maintaining a shadow inventory of REOs, but it may be beginning to shrink.



If not for the efforts to save it, Greece would have already defaulted.  The Europeans really believe in the concept of Europe, and they wish for it to persist and endure, and to grow.  I look for a contorted solution/bailout, that detours around acknowledging default.   


Market Overview

Currently, many of the U.S. large cap and blue chip issues appear fairly inexpensive.  Markets look ahead, and these valuations suggest an economic slowdown, a greater tax burden, or perhaps serious inflation.  I think there is about a 62% chance that we avoid the next recession, and that the expansion continues, weak as it may be.  We are not inherently attracted to “respected names,” and at many times they have not seemed to be attractive investments.  But currently, many blue chips or close-to-blue chips have P/E ratios of twelve or less, going forward ( which is equivalent to an earnings yield [E/P] of 6%), and dividend yields of over 3 ½%, more than U.S. Treasuries are yielding.   This is a seasonally more difficult time, exacerbated by Eurozone troubles, but we may be through the volatility in a couple of months.


Thanks again for your continued confidence,


Gary N. Clark, CFA


March 16, 2011

The U.S. equity markets continue up, with some slight wavering. Despite worries about Tunisia, Egypt, Libra, the euro, Spain, and Portugal, U.S. equity indices are higher than a year ago.


U.S. Leading Economic Indicators also continue to rise, suggesting that the advance will be justified at current valuation levels. Markets look ahead, and the stock market itself is a leading economic indicator. The indicators themselves indicate a weak recovery, particularly for employment, as widely reported, but nevertheless one that is headed up. And, there up green leaves sprouting on the trees suggesting things might be even better going forward. For example, the number of containers going through the Port of Long Beach was up 11% last month, year over year.


The US continues to be an economy with highly unemployment, and high debt levels. The recent fiscal stimulus I believe did some good in bringing about recovery (although it was not the only possible path). Historically high household debt levels suggest that personal consumption expenditures (PCE) will not be a main driver of economic recovery. Federal debt levels evoke concern about the ability to continue to issue large amounts of federal debt. This is likely to be a larger issue two years from now. It will be a big issue, and outstanding debt may hinder long-term growth.



Housing continues to flounder. There is too much debt on many housing units. A recent article by Laurie Goodman (Financial Analysts Journal, no. 3, 2010) looked at housing mortgage data. Existing home sales are about 5.4 million units per year. In addition to existing REOs, there are about 7.1 million of currently delinquent loans that are likely to go into foreclosure. This is a 7.1 million unit shadow inventory. Compared to existing annual homes sales of 5.4 million units per year, this is a big overhang over the market. In addition, there are about 4-5 million units with current loan-to-value ratios over 100%, that have not yet defaulted but are likely to do so, making a total estimated shadow inventory of about 11-12 million units, or over twice the number of annual existing home sales. By itself, this is not a recipe for housing appreciation. Population growth is about 0.9% per year. Other the past decade, population grew a total of 10.0% in California, 16.9% in Colorado, and 8.7% in Oklahoma. About 400- 600,000 units per year wear out, burn down, or are otherwise removed from the existing housing stock. In addition, lenders are taking longer to foreclose, and longer to dispose of REOs


Our view, shared by quite a few other knowledgeable people, is that prevailing housing prices are manipulated as a matter of policy, by the federal government and banking interests, in order to minimize the number of bank failures, and the current price of housing is above the market clearing price. Several observers have suggested that the number of housing units foreclosed exceeds that number that comes back on the market. So in short, foreclosed inventory is being held off of the market, short sales are intentionally or unintentionally being hindered and delayed, and foreclosures are not being accelerated.


And, of course, there is clear evidence that lenders and loan servicers are taking much longer to implement the foreclosure process than previously. And this delays a return to more normal lending world, with about 30 percent of outstanding mortgages under water. These “owners” are not likely to move up to other housing, and are frozen where they are – mortgage zombies.


The rate of new housing starts is less that needed to meet natural growth (i.e, from demolitions, fires, wearing out, removals, natural population growth). We should expect it to be less with such a large shadow inventory. With the passage of time, the problem is slowly correcting itself. Some of those excess second homes are slowly being absorbed. While things are currently dismal, we may not be too far away from the day that housing again starts to contribute to the economic expansion.


Those homeowners who are foreclosed will continue to live someplace. While they may be stretched with a $600,000 mortgage, they may do very well if they go down the street and are able to buy similar home with a $250,000 new mortgage. Of course, this may not be in the interest of banks. Supporting a mortgage balance that is 38% above current market value may not be in homeowners’ best economic interest.


Exchange Value of the Dollar

A good way to induce growth would be to have the exchange value of the dollar decline. This would boost exports somewhat, and also make it cheaper for foreigners to buy second and third homes in this country However, it is not viable for all countries to attempt this at the same time. Several countries are moving to have dollars comprise a lesser percentage of their foreign exchange reserves. And more of the world’s citizens are preferring gold to paper money as a store of value.


Municipal Bonds

The municipal bond market has also become the focus of some attention recently. There are concerns in this area, as an economic malaise has impacted state and local finances. They were exacerbated when Meredith Whitney, a well-regarded analyst, predict forthcoming muni defaults would result from many municipalities going bankrupt or insolvent. Muni bond prices have since fallen, and yields have risen. There are real problems for many state and local governments, but as is often the case, it may be overdone, creating some attractive values in this area. Many of the Redevelopment Agency bond issues in California and Western states are particularly under stress. They are often supported by the increment in Property tax revenues, and with the decline in property values, there may be less of an increment (perhaps even a negative increment) there to support bond debt service. While still not sensational, there are more values in this area that there have been historically.

Gary N. Clark, CFA

September 4, 2010

The trend in the economy of the U.S., and the U.S. equity markets remains up.  Leading economic indicators indicate a continuing economic recovery, albeit a weakening recovery.  The current trend of petroleum prices is flat to slightly negative.

Currently, the U.S. equity market has pulled back a bit. And it seems to us that many issues are cheaper than they ought to be, given accepted expectations.  Many other observers have also noted this.  Markets look ahead, incorporating available information.  And the recent flow of information does not seem to be justifying a big change to our outlook. Some of our recent weakness may reflect a diminished outlook for economic recovery going forward, a diminution of robustness.   


America De-Leverages:


ImageDeleveraging in the private sector remains a trend.   Total household debt and mortgage debt have continued to decrease, sometimes through defaults, sometimes through pay downs.   And the forces supporting deleveraging mean that personal consumption expenditures are unlikely to play the main role in leading us to full recovery.


Housing remains a festering issue, sort of like a policy albatross, floundering on the shoals of impending delinquencies and tougher mortgage underwriting.  We have banks and other investors with some real estate loans on their books, as assets.  And there are some homeowners, whose residences are underwater, who regard their real estate mortgage as a liability.


Well, some paid too much and many never really owned their homes.  I don’t think important people will really care.  For many, a home down-payment was like an option purchase, a chance to benefit if prices rose.   The other thing that may have happened is that, as the expansion proceeded, many in the middle

and the lower economic strata did not experience, earn, nor enjoy commensurate prosperity with those in upper economic strata, and borrowing against their real estate equity was one way to try to keep up. 


Today, bank lenders appear reluctant to loan funds against real estate because, deep down in their heart of banker hearts, they know that the valuations are artificially high.  If valuations were perhaps 25% lower, with the same level of incomes and GDP prevailing, they would have fewer reservations and feel comfortable, warm, and safe loaning against it. 

The current confluence of policies “to

protect homeowners” amounts to significant market manipulation on the part of banks and the financial industry, and government.  While the rhetoric is about protecting homeowners, mortgages lenders, mortgage investors and bankers are big beneficiaries. The big loser is the new home buyer.  And it turns a big part of the population into mortgage zombies, unable to boost consumptions spending after making their mortgage payment.  Several observers have noted and calculated the “phantom inventory” over the market, which would not be there if prices could freely adjust.  And during recessions, the number of households contracts by a couple of percent, as people economize on housing expenditure. 


Housing Starts Stop:

ImageBut there are reasons for hope.  There is some demand for housing to replace those units that are demolished, wear out, or are otherwise removed from the housing stock.  This is perhaps 400-600 K units/year.  The recent pace of housing starts is less than the amount necessary to accommodate population growth

and demolitions (perhaps 1.2 Mil/year total).  Of course, housing starts were greater than long-run demand before 2008.


A recent Financial Analysts Journal article (Laurie Goodman, May, 2010) suggested that there was about a 7 million unit overhang over the housing  market.  Additionally, financial institutions appear to be keeping some of their foreclosed inventory off of the market, perhaps to avoid depressing prices further. 


  There is a natural growth in the number of households, as the population breeds.  And,  when employment begins to meaningfully increase, people will move out and establish additional households. 


 The upshot is that, between housing starts being less than the long-run increase from demolitions and population growth, the housing market is a bit like a coiled spring.  At some point it will bounce back, and perhaps robustly. 


 Also, just because people lose their home in foreclosure does not mean that they do not have a home to live in.  A vacant home is not an asset that banks covet.  At a price of $465/sq ft, a home may morph into a foreclosure, but at $123 / sq ft, it may turn into a nice new home for a young family, or even an old family.


On fixed income. 

This is a challenging period in which to identify and generate an unthreatened stream of income.  Lower interest rates may take some pressure off real estate borrowers, but they also make it tougher for retirees.  US Treasury and CD rates are unnaturally low, being most directly affected by Federal Reserve policy and actions.  The fixed income component of a portfolio plays an important role, and somewhat different roles for different clients.  Fixed income, the “bonds” portion of a portfolio dampens volatility and provides income to be reinvested.  Interest rates are usually expected to offset and compensate for expected future inflation, and the decline in purchasing power.  The intermediate corporate sector of the bond market is less distorted, and gold may provide an even better protection against future erosion of purchasing power.  Thus, many clients may own fewer federal agency bonds and treasuries, and more corporate, and also more gold related securities.  Gold has increased about six-fold in the past nine years, but still does not get a lot of publicity compared to the S&P 500. 


Thanks for your continued confidence.


Gary N. Clark, CFA


December 3, 2009

We view the long-term trend in the equity markets as up. For the year to date, the S&P500 Index is up about 21%, and up more from its extreme low in March. Emerging markets are up about 60+%, followed by other international markets. As usual, the equity markets turned up before the economy, as markets look ahead and process information. The definitive dating of recessions and expansions is done by the National Bureau of Economic Research after careful analysis of many different data time series. Our take is that the economy seems to have clearly begun climbing out of the recession in September. The leading economic indicators have now increased for six months. For now, the economic trend clearly appears to be up, although we do not know how strong or long the expansion will last. And while the trend is up, U.S. valuations are not as attractive as a year ago. There are also causes for concern, which we will note below.

Two dominant trends remain, which partly re-enforce each other:

  1. Deleveraging and the attendant deflation of asset prices. This may look like people paying down debt, or the debt just evaporating, through bankruptcy, default, or renegotiation. This occurs as the economy’s capacity to support debt shrinks, while the inclination, capability, and willingness of foreigners to own our debt diminishes. We noted earlier, as did many gurus, that various Debt/GDP and debt/income ratios had reached cyclical or historic highs. Those ratios are now declining.
  2. The other major development is the readjustment of the role of consumer spending, and its relation with income. The same amount of personal Income will no longer result in the same (as large as) ratio of Personal Consumption Expenditures (PCE) to Personal Income. It is much less feasible to finance additional consumption with additional debt on personal residences, partly due to the greater difficulty of regularly refinancing home equity and pulling out funds for additional consumption. The Chinese aren’t buying Fannie Mae and Freddie Mac bonds as readily. And with global financing generally less forthcoming, and with the prop of refinancing removed, the force is pushing toward deflation and deleveraging.

Many years ago, I was riding around with “Uncle Louie (“Uncle Louie Tomaso, Investments”)” on his boat in Texas. Uncle Louie asserted that, as long as homebuilding and the automotive industry were growing, things were going to be okay. Recently, home starts have been less than the number that are needed just to replace those that wear out or are demolished (about 1.2 million/year), and the current automotive production is below long-term replacement demand.

The diminished robustness of personal consumption expenditure is likely to have several manifestations. First, discretionary consumer items are likely to encounter increasing difficulty in increasing sales. Total revenue spent at local and regional malls is likely to decrease, and with it, the ability to support associated debt collateralized with retail real estate, as well as bank loans collateralized by real estate. This means that banks and other investors who hold debt or securities collateralized by real estate may see some of their assets evaporate.

Traditionally, as our economy recovered, increases in consumption expenditures were associated with expansion of credit. However, unlike any recent previous recoveries, household debt and total private credit is contracting, even as the economy begins to expand. Debt is either being paid down or liquidated.

From now on, this means that the some of the traditional balancers in the business cycle process will not provide the same boost to recovery. The extreme low levels of inventory/sales ratios, for example, will not provide the same bounce-back momentum. And indeed, total household debt is contracting, even as consumption is increasing. This has not happened in the post-WW II period.

As a result, we view the likely and almost necessary policy initiatives as leading to

  • A weaker dollar – already in process of occurring. This will boost exports and dampen imports. It also provides a boost to gold prices
  • Less reliance on domestic consumption and the American consumer to drive the economy
  • An apparently necessary temporary resort to fiscal stimulus
  • A resort to monetary stimulus.


The decline of the dollar is accompanied by the desire of many foreign governments to move away from the dollar was a reserve asset, even as their own currency depreciates. Hence, the case for gold, which is currently in a clear uptrend. However, it has always been more volatile that the overall market. That will continue.

Fiscal stimulus is one controllable way to increase domestic demand.  And an increase in U.S. consumer spending now increases production in China more than it did twenty years ago, and has less impact on Indianapolis and Toledo.  Another way to more controllably stimulate domestic economic activity is to have a war.  On balance, wars have historically provided a healthy boost (unless you were one of the unfortunates who got shot or maimed).  Down the road, continued resort to federal fiscal stimulus and deficit spending will shrink our national options, and create more issues of getting others to finance our debt.  While the U.S. Federal Reserve has increased the monetary base dramatically, the M2 money supply has not increased commensurately.  Some of the increase in federal credit is only offsetting what has evaporated in the private sector. 


I think about unacknowledged “likely unlikely surprises.”  A year ago, I thought it would be Israel attacking Iran with nuclear bombs to slow down the spread of dangerous weapons.  With further study and reading, I have since come to feel that the leaders of both Israel and Iran use the inflammatory rhetoric to help stay in power.  Possibly some U.S. politicians have also done this.


 A looming issue (not fully acknowledged) closely related to and growing out of the above, is the increasing problem with asset quality in America’s banks and asset backed securities.  The easy issues have been well-publicized, are well-known, and have already been dealt with.  The lower tiers are firming up, while the problems are in the middle and upper tiers, and in commercial real estate.   Lenders Processing Services Corp recently reported that the number of mortgages deteriorating in status is three times the number being successfully modified or restructured.  Mortgages are deteriorating at three times the rate that they are improving. Ominously, banks seem to be choosing to sit on some foreclosure inventory, rather than selling all of their REOs.  One out of eight mortgages in the U.S. is a problem (concentrated in Arizona, Nevada, California, and Florida), and an increase in foreclosures appears likely.


Restructuring a mortgage is more of a way to protect an investor, than to help a homeowner.  The homeowner is notably better off if he loses his mortgage (and home), and then goes down the street and purchases a similar home for 40% less.  And he is in a better position to move up later.  With the original principal maintained at a reduced interest rate, he or she becomes an economic zombie if he or she struggles to support an asset that is under water.


Many petroleum issues, which have served our client well over the past few years, seem to be moving into the ranks of average market performers.  Demand for petroleum fell off with the decline in economic activity, and price rebounds are not dramatic.  With time, there will be more substitutes, more alternative sources of supply, and more LNG.  There is a large amount of natural gas in storage in the U.S.  Technology boosted gas from shale, and that may begin to happen in Europe in the coming year.  More of Central Asia’s gas will come to world markets from forthcoming pipelines, and LNG from Qatar will play a significant role in world markets and in England.



  1. Gold remains in an uptrend, for now. 
  2. The dollar is likely to continue to decline, boosting firms with export exposure and international or emerging markets. This could be turned around, and Obama is on the right track.
  3. U. S. equity markets are trending up, although valuations are less favorable than a year ago. 
  4. The economy is improving, which while supported by massive fiscal and monetary stimulus will probably continue. 
  5.  We are anticipating strength in technology and health. 
  6. And there are looming issues for financial institutions and certain investors in real estate loans and their valuation. 


Thanks for your continued confidence.  Wishing you best holiday wishes and a great 2010.


Gary N. Clark, CFA


September 9, 2009

U.S. and most world equity markets have continued to rebound from the recent unpleasantness. The U.S. S&P500 Index is up about 13% from the beginning of this calendar year. To put this in perspective, the average annual gain is about 11%/year, with considerable variation from year to year.

The past year has seen an extreme example of this “variation.” While a market decline began in 2007, the serious damage was triggered by the collapse of Lehman Brothers in September, 2008. The decline in the S&P500 Index over the whole cycle was slightly over 60%, and there were some great values in there.

We think it is more likely than not, that the long-term trend of U.S. equity markets has changed to up. The leading economic indicators are up, the sequence of developments that occurs toward the end of a recession is unfolding as expected, and likewise for equity markets. Inventory levels are low, although inventory sales levels had not declined as much as might be expected. Federal policy is endeavoring to bring about the next upswing.

Two major underlying trends in the U.S. economy are

  1. The trend toward deleveraging, the paying down or evaporation of debt, which tends to depress many asset values, and
  2. The same level of aggregate pr personal income will not support the same level of personal consumption expenditures going forward. This has adverse implications for retailers, commercial real estate REITS and mortgages, rents, and certain other areas. It also implies that policies trying to foster an economic rebound by reviving consumer spending are fighting a headwind. And GM won’t ever be the same.
While housing may recover somewhat (and it is recovering in an uneven way), it will not attain the prior level of robustness, at least not driven by U.S. consumers. We wrote last time that we viewed the bank stress tests as largely theatre. We still do. There are a couple of US financial institutions that are viewed as too big to fail, but with time and a steep yield curve managed by the Fed, they will be able to earn their way out of their current hole There is an overhang of homes that cannot easily be refinanced because the debt is significantly greater than market value and this means increasing problems for many banks, especially in California, Nevada, Arizona, and Florida --- which implies or suggests that policymakers will opt for lower interest rates for the next couple of years. Interest rates have dropped another notch over the past couple of months. A more market-constructive approach might be to grind up incorrect valuations in a giant foreclosure mill. It would get rid of zombie borrowers, create a good foundation for future market growth, ultimately improve borrowers’ balance sheets, and create a more robust move-up market. However, banks would be likely to resist this. There is some evidence that they are already resisting market adjustments by warehousing foreclosures. Restructurings of loans that do not adjust principal will not do much for homeowners or the housing market, although they may help banks somewhat. We remain open to all of the relevant anecdotes about bank loan quality that people (such as yourself) are willing to provide to us.

Fears of inflation continue. However, there is a lot of idle capacity and idle workers in the U.S. economy, and a lot of slack in the system. Much of the increase in the money supply was meant to offset some of the destruction of asset values after the Lehman collapse. And it is clear that the Fed and Treasury are thinking about how to withdraw the extra quantity of money when the recovery becomes more robustly self-sustaining.

On Energy and Gold:
The long-term trend in gold prices is still up. Interestingly, it is not being driven so much by inflation per se, as by a desire to acquire a lasting store of value, partly to offset the decline of the dollar as a reserve currency. The current path of least resistance for policy-makers is to allow the exchange value of the dollar to decline, preferably gradually, and this is currently happening.

While the world may have a lot of oil, it does not have a lot of excess immediate production deliverability. U.S. natural gas production increased a lot, and there is still a glut of the stuff in storage. The price of oil has rebounded from the low $40s to $71/bbl. We believe the rebound in the price of petroleum to $70/bbl was caused more by OPEC cutbacks, perhaps Obama’s visit to Saudi Arabia, and perhaps China shifting from US dollars to petroleum, than by a global economic rebound. As a global economic rebound unfolds, petroleum price is one area that can firm quickly. In terms of energy production technology, a lot will happen in the next three years. Natural gas is more readily producible from deep shales (both here and in Canada), more LNG will be on world markets, and there will be more production from alternative energy sources. We also note that if significant domestic alternative energy sources were developed and became operational (perhaps over the next five years), it would have a material impact on our balance of payments, strengthening the exchange value of the dollar.

We will be attending Schwab Institutional’s IMPACT 2009 investment conference in San Diego this month. Thanks for your continued confidence. I know it may have wavered a bit over the past year. We think the coming years will be much better.

Gary N. Clark, CFA


June 20, 2009

U.S. Financial markets have rebounded recently, from lows over the past eight months. Increasingly, we view the turbulence of this financial episode as triggered by the collapse of Lehman Brothers, and occurring against an inauspicious backdrop of circumstances. To wit:

  1. The nation’s debt/output ratio had increased to peak levels, facilitated partly and and importantly by consumer borrowing against home equity, and exacerbated by use of financial derivatives and synthetic instruments. Unlike some other countries in the world, in the U.S. the largest growth of debt was in the financial sector.
  2. Deleveraging - which can either take the form of paying down debt, or of default, bankruptcy, or debt evaporation. And one person’s debt is, or was, another person’s asset. Deleveraging is one of the current operative themes in the U.S. economy.
  3. The unnoticed growth of inadequately reserved-for Credit Default Swaps and other derivatives;
  4. The collapse of Lehman Brothers in September, 2008, Lehman Brothers was counterparty to many financial derivative contracts.
  5. The sharp increase in the price of oil may have contributed (with a lag) to the recession somewhat. Likewise, the subsequent decline in petroleum prices may provide additional stimulus, also with a lag.


Granted, a market decline began in 2007, but the serious damage began as Lehman Brothers collapsed.

One salient and important factor that we mentioned last time is the changed significance of aggregate personal consumption expenditures in Gross Domestic Product. Others have described various aspects of this but I am not sure they are getting the main point. And that is, from a Keynesian perspective, aggregate demand is comprised of consumption expenditures, govt spending, investment, and net exports. In the Econ 201 textbook, it was often written
Y = C + I + G + X.

Going forward, consumption will not be , and cannot be as great a percentage of GDP. Consumers can no longer borrow against their home equity to the same extent, the wind is blowing against consumer credit, and China and other investors are less willing to buy the securities that partly financed our consumption spending. Which means that there will be less retail spending to support malls, mall employees, and mall landlords; less resultant rent from merchants to landlords to pay mortgages on malls and other retail buildings, less revenue to support luxury goods stores, less sales tax revenue for local governments, more problems for bonds collateralized with mortgages on retail space. It implies that policies designed to increase debt and boost consumption expenditures are likely to be ill-conceived.

And it also means that, to get the same level of employment, one of the other components of aggregate demand will have to pick up the slack. The most likely candidates are government spending (G) and net exports (X). Many observers are rooting for China and the Emerging Market economies, which are performing better than ours. It is not yet clear that the U.S. economy is on a path to a self-sustaining recovery, but the intent is there.

While there is some rhetoric about the quantity of money and credit that Hank Paulson and his colleagues and successors have shoveled into the system, it is very likely that not to have done so would have resulted in a more severe contraction in employment and economic activity, which would have been a less preferred outcome and had greater political costs.

The marked increase in the monetary base, and in credit, raises the fear of inflation. This is a real possibility, and one that investors and citizens should protect themselves against. However, it is not yet a certainty. It is not as if all the TV commentators know about the increased likelihood of inflation and Ben Bernanke does not. He and the other economists have read more economic history and spent more time mucking around in the data than the CNN commentators have. And, the long-term trend of the price of gold remains up.

One side effect of the bailout is that there has been a massive shift of debt from the private sector to the public sector. While some animosity may be directed towards Jose and Lupe, they are benefitting minimally. The bailout benefits the securitized debt and bondholders, and many average people, more than Jose and Lupe.

Here’s our take on a couple of other recent events. We view the bank stress tests as largely theatre. A likely interpretation of events is that our largest banks became insolvent, and it would have been politically practical to close them down – they might be too big to fail. So the stress tests, in our view, create the cover for keeping them alive long enough for them to earn their way, with policy support, out of their financial hole. (For background reading, see the article “The Quiet Coup” on our website under the Geopolitical tab.) We remain open to all of the relevant anecdotes about bank loan quality that people (such as yourself) are willing to provide to us.

Sometimes we are intrigued by minor events that may be a good marginal indicator of a change in trend, or a harbinger of a coming trend, a manifestation of a developing trend, sort of like a dead canary in a coal mine. Along these lines, we, and many other people in the financial domain, were intrigued by the recent report of a couple of gentlemen of Japanese ethnicity who were arrested while trying to enter Switzerland from Italy with $134 billion of dollar denominated U.S. government bonds in a suitcase. Which raises some questions:

  • Were the bonds real?
  • Were they an attempt by Japan to diversify away from dollars?
  • Was this a staged event by Russia, China, or Brazil to further call into question the U.S. dollar’s role as a reserve currency?
  • Did they come from Castro, North Korea, or Columbia?
  • Where did they get the $134 Billion?


On Energy and Gold:
We view the long-term trend in gold as up. Interestingly, it is not being driven so much by inflation per se, as by a desire to acquire a lasting store of value, partly to offset the decline of the dollar as a reserve currency.

While the world may have a lot of oil, it does not have a lot of excess production deliverability. The recession and decrease in economic activity is the principal factor accounting for the decline in the price of petroleum. The price of oil has rebounded from the low $40s to $71/bbl. We believe this is caused more by OPEC cutbacks, perhaps Obama’s visit to Saudi Arabia, and perhaps China shifting from US dollars to petroleum than a global economic rebound. In terms of energy production technology, a lot will happen in the next three years. Natural gas is more readily producible from deep shales, more LNG will be on world markets, and there will be more production from alternative energy sources. We also note that if significant domestic alternative energy sources were developed and became operational, it would have a material impact on our balance of payments.

If you would like a copy of our Form ADV Part II, we would be happy to provide it to you. Please ask. Thank you for your continued confidence.

Gary N. Clark, CFA



March 19, 2009

Financial markets have cyclical fluctuations, and this has been in a big one. The percentage decline from the cyclical peak in October 2007 to the recent low was 53%. In other words, if ranked by size, this would be one of the larger ones of all time. The implied conclusion is that we are closer to the end than to the beginning of this decline – and perhaps sooner rather than later.


In other words, many declines, when they have reached this percentage extent, exhaust themselves, turn around, and begin the next process of ascent. However, it is not yet clear that the long-term trend has changed from "down" to "up."

We are very aware that many clients are depending on us to play an important role in achieving their financial goals and maintaining their financial security and the recent decline is a step backwards, or at least a pause. We know you depend on us.


We have spent much time considering the recent and current episode, it causes, its ingredients, and the possible scenarios going forward. While we and many others foresaw some of the ingredients, we did not foresee the timing. Here is how we view it.


Going into this episode,

  1. Risk was mispriced. This may sound merely academic, but the implied and implicit price of risk was mispriced, too cheaply, the cumulative result particularly of Greenspan boosting the money supply during Y2K, of increasing the money supply to offset the Internet collapse and, recently, over concern about mortgage defaults.
    • The increase in the money supply didn’t bring about inflation in goods prices due to competition from imports of many things, i.e., from China, etc.
  2. Overall debt levels were at historic high levels. Overall debt to GDP was about 350%, and had risen significantly since 2000, and since 1990. Much of this was in the U.S. financial sector. Debt for the U.S. manufacturing sector rose much less.


The debt increase was associated with

  1. an increase in consumption and decrease in savings rate partly financed by homeowners borrowing against home equity;
  2. a current account deficit,
  3. China and Japan (and others) financing our current account deficit by buying more Treasuries and federal agency securities (Fannie Mae, Freddie Mac, etc). The U.S. is now a debtor nation, and shares some of the financing issues of emerging market economies. We benefit from the fact that the dollar is a global reserve currently, and we may be pushing our advantage.


Debt in the financial sector was associated with the growth of Credit Default Swaps (CDS) and associated instruments, which introduced additional risks. I pretty much totally missed the significance of this. I think this area accounts for most of the magnificent losses, rather than sub-prime borrowers – they only add up to about two trillion of debt.

The use of more sophisticated financial instruments as well as communications enabled this to be a more global phenomenon. Credit Default Swaps allowed lesser to quality debt to appear to be higher quality to those in far-off lands, such as Iceland or Indonesia, and they also enabled the creation of similarly behaving synthetic securities. Thus, the recent situation is a manifestation of global systematic risk.

The recent decline seemed like it was almost over at the end of this past September (2008), after which it abruptly gained new force in October and November. When the dust is ultimately settled and analyzed, it may seem that the collapse of Lehman Brothers in September was primary disruptive event, although other institutions (Washington Mutual, Freddie Mac, Merrill Lynch, Bear Stearns, IndyMac Bank, Fannie Mae, and Wachovia) also encountered serious difficulties.

Mr. Obama walks into a situation where economic activity is contracting (a genuine recession), and certain financial institutions are melting down, which is

  1. Having a dampening effect on the real economy, and
  2. Threatening to foster a snowball effect, where further declines in collateral values threaten the remaining financial institutions.


The Fed and the US Treasury can play a role in rationalization of US financial institutions. They play the main role in increasing the quantity of money, in an effort to prop up nominal asset values and to stop further declines in bank collateral values.


In addition to a monetary policy response, the current situation also cries out for Keynesian fiscal policy response. Washington is responding appropriately with stimulus packages.

George Karahalios, in a recent piece appearing in the Gloom, Boom,& Doom Report, notes the similarity of the current situation to the John Law’s Mississippi River Company in 1720. The similarity is that in both cases, there is a tremendous macro-shift of debt. In 1720, investors traded almost the entire national debt of France for shares in the Mississippi River Company. The debt was shifted from the public to the private sector. (The situation ended poorly for the investors). In the current U.S. situation, we are witnessing a very massive shift of debt from the private to the public sector. After, the dust settles, I suspect that most of the relevant assets will still be in the private sector. This will have social and political impacts that are not yet apparent.


I attended the American Economic Association annual convention in San Francisco in January. There were a several papers presented that were relevant to the current situation. Historical analysis of (generic) past financial crises suggests an “average“ crisis may have a 2.5-3.5 year impact on selected variables, such as unemployment or credit spreads. Thus, we may have a year or so more to go. However, one smart economist noted that we have already corrected 80% of the way. This ‘adjustment’ has been more rapid (and painful) than the historical average.


The Executive Summary:
Many valuations are reasonable, and the major trend is still down. (This is not a prediction that it will continue to decline.)



  • The long-term trend of gold remains up.
  • While the overall trend is still down, there are pockets of strengthening;
  • Current economic policy has the intent and is working to improve this situation, unlike some other periods. (So sooner or later things might get better?)
  • Credit default swaps (which are not necessarily bad) are being unwound, as a matter of policy;
  • Petroleum prices have fallen dramatically, and they are below the marginal cost of some new sources of production. The growth of alternative energy and efficiency improvements over the next few years will not be enough to preclude petroleum prices from rebounding significantly when economic output recovers. And, it may be taxed more in the future. We think most investors do not appreciate how fast technology is advancing in the area of energy alternatives.
  • China and other nations are moving away from as great a reliance on the dollar as a reserve currency.
  • There is often a lot of fear and pessimism at market bottoms, which is a rough description of the current mood. However, the trend is not yet turned up. The rationale for being invested is that the timing of a turn is difficult to predict, and some of the largest gains often occur at the beginning of a change in trend.


Additionally there are four major structural changes or trends that appear very likely to be underway or imminent:

  • The deflationary effect of the shrinkage of aggregate debt;
  • The shift in debt from the private to the public sector;
  • A decrease in the percentage of personal income allocated to personal consumption expenditures – an increase in the savings rate- , and
  • The movement away from the dollar as a global reserve currency.

It has been a challenging quarter, in a historic decline. We are in a period when macroeconomic analysis is much more pertinent and relevant than usual.


Gary N. Clark, CFA