2011Apr25 Turning Over Rocks
It was a short week with the market closed for Good Friday and Passover. It was the first positive week in the last three. On our radio program and in our correspondence, we have repeated the importance of incorporating "relative strength" (RS) analysis in portfolio construction and risk management. RS is not a static pie chart replicated on quarterly reports. It is a simple process that has been used by successful investors for centuries.
We recently learned of David Ricardo in an 1838 book available in the Google on-line library, The Great Metropolis: Vol. 2 by James Grant.
David Ricardo was born in 1772, which ought to give you some idea just how robust trend following is and for how long it has worked. His father was a stockbroker, so he had some familiarity with financial markets. After an estrangement from his family from marrying outside his faith, he started his own brokerage business.
He retired in 1814 (age 42) with a fortune of $65 million (in today's dollars; 600,000 pounds sterling then) and bought Gatcombe Park, in Gloucestershire. (Today, Princess Anne lives at Gatcombe Park, a modest 730-acre estate, described as having five main bedrooms, four secondary bedrooms, four reception rooms, a library, a billiard room and a conservatory, as well as staff accommodations.)
"As I have mentioned the name of Mr. Ricardo, I may observe that he amassed his immense fortune by a scrupulous attention to what he called his own three golden rules, the observance of which he used to press on his private friends. These were, " Never refuse an option* when you can get it,"-"Cut short your losses,"- "Let your profits run on."(emphasis added, pg 55 ff).
By cutting short one's losses, Mr. Ricardo meant that when a member had made a purchase of stock, and prices were falling, he ought to resell immediately. And by letting one's profits run on he meant, that when a member possessed stock, and prices were raising, he ought not to sell until prices had reached their highest, and were beginning again to fall. These are, indeed, golden rules, and may be applied with advantage to innumerable other transactions than those connected with the Stock Exchange. "
Economy:
Globalization is allowing corporate profits to rise as CEOs are forced to confront competition in foreign markets. U.S. companies have been increasing hiring, though growth in international factories and staff has been greater than in the U.S. Corporate rationale embraces proximity to users, labor and tax costs and easier regulations. Our changing demographics combined with the realities of a global economy make the consensus assumptions about domestic employment growth overly optimistic.
Caterpillar has more international than domestic sales. Combined with a reduction in shipping costs, it seems prudent to manufacture equipment close to the consumers. Oracle has indicated there will be no more data released on the location of employees. GE's overseas business has doubled from 30% in 2000 with an increase in employees from 46% to 54%. GE, for example, claims it is simply getting closer to its consumers.
Household debt remains a major stumbling block for sustainable economic recovery. In 1975, household debt was 45% of GDP and grew to 96% of GDP at the end of 2007. It has fallen to 90% of GDP largely due to defaults. This is still twice what it was three decades ago. Some economists believe the "reduction" in debt levels means US consumers are ready for another round of credit financed spending. Demographics and stricter lending policies suggest otherwise as does the history of Japan.
Fundamental problems counteract the increased spending assumption. First is the need for Boomers to save money for retirement by debt reduction and a requisite increase in savings. Government handouts now exceed tax revenues. The government is surviving on borrowed money just to pay operating costs without considering the politically touted "investments."
The Federal Bank policies have been integral to the Tech Boom, the Credit Bubble and the "attached at the hip" Real Estate Bubble. The Taylor Rule for managing inflation and interest rates has either been abandoned or is materially flawed. Nearly 80% of financial assets are owned by 10% of the population which seems to us to be insufficient to restart a consumer driven economy.
Real Estate:
Financial reform is concentrating lending in the major banks which already control 43% of the market. Competition in local markets will be reduced with an increase in costs. That reduces the available number of potential borrowers to "stimulate the economy."
In an effort to reduce mortgage application fraud, the government has seriously wounded the housing industry. Rather than changing the regulations of lax underwriting, mortgage brokers are having wage controls placed upon the industry - an action that has not seemed fit for Wall Street.
Without extra compensation for placing difficult loans, small firms will not survive. The "too big to fail" lenders won't want the marginal loans in their portfolio. The borrower/buyer pool has been reduced to those households with good credit and job security, and they aren't the ones creating a demand for housing. Even cheap credit cannot cure the housing surplus when demand is virtually non-existent.
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