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Christopher Pavese, CFA
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Mr. Pavese holds several positions within the Broyhill family offices, serving as Chief Investment Officer of Broyhill Asset Management and BMC Fund, Inc., an SEC registered investment company. His primary responsibilities include macroeconomic research, strategic asset allocation, portfolio... More
My company:
Broyhill Asset Management, LLC
My blog:
The View From the Blue Ridge
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  • Stocks For The "Long Run"

    We have sympathetically mentioned Jeremy Siegel’s well-timed Stocks for the Long Run in previous commentaries, who’s analysis begins at very low PEs and ends most periods with much higher PEs, reaching the unforeseen conclusion that stocks outperform all other asset classes in “the long run”.  Similarly, a few days before the stock market crash of 1929, the leading economist of the time, Irving Fisher, ensured Americans that stock prices had reached what looked like a “permanently high plateau.”  And Jeremy Grantham recently reminded us of E.L. Smith’s Common Stocks as Long Term Investments, published in 1924.

     As Grantham so eloquently stated, There is always someone of the “Dow 36,000” persuasion to reinforce our need to believe that as markets decline, higher prices in previous peaks must surely have meant something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum.

    And as much as we’d like to believe the same, history tells us that truth could not be further from Dow 36,000!! In the latest Investment Outlook from Bill Gross, PIMCO's Bond King appropriately warns that “one must be careful of beginning and ending data points in any theoretical ‘proof’”.  As they say Professor Siegel, the theoretical proof is in the pudding.  Contrary to popular belief, drum roll please, starting valuations matter and remain the single largest determinant of expected long term returns.

     Price to Avg 10 Year Earnings

    The chart above clearly demonstrates that today’s market is no longer cheap, and quite obviously overvalued based on cyclically adjusted earnings.  In fact, at nearly 20x Average 10-Year Earnings, the S&P 500 is not far from the most expensive quintile of valuation experienced since 1881, which has historically returned just 2.8% annually over the following ten years!! 

    But clearly the world is not that black and white.  So let’s briefly revisit the Bond King’s observations regarding starting and ending points, because most of “the street” would much rather tell us a story with a happy ending.  With one stroke of Goldman’s magic wand, we can wipe out the first fifty years of data that Yale’s Robert Shiller took the time to analyze and reach the conclusion that stocks are marvelously cheap even after a 62.3% rip off the March lows to October highs!!

     GS PE ratio

    We wonder why anyone would want their clients to believe this market is cheap when it is so clearly overvalued based on historical data?  Perhaps that’s a question that is better addressed in Goldman Trading Huddles.  In the meantime, we will continue to focus on observable conditions and take our evidence as it comes.  And right now, it is difficult for us to imagine that a market that traded substantially greater than one standard deviation above long term trend for most of the last decade (see below), will simply bounce back to these extremes and hover at inflated valuations, going forward.  Indeed, given the likelihood of increasing regulation, increasing government intervention, increasing public spending, increasing taxes, and ongoing private sector deleveraging, the more likely outcome is an extended period of below trend valuations.  So before getting too excited about The Wizard of Wharton’s Stocks for the Long Run, investors would be wise to revisit Professor Shiller’s Irrational Exuberance. 

    Schiller PE

    Tags: Valuation
    Oct 29 4:11 PM | Link | Comment!
  • A Gold Mine is a Hole in the Ground With a Liar On Top

    Mark Twain once wrote “A gold mine is a hole in the ground with a liar on top.”

    While that may be true in certain instances, the hole investors should be most concerned about is the one with Helicopter Ben Bernanke standing proudly on top – the cavernous hole in household net worth created by the bursting of the Greatest Credit Bubble in our history.  Our current Chairman of the Federal Reserve, trapped by Milton Friedman’s view of the Great Depression, and aided by the most aggressive fiscal policy we’ve ever experienced, has promised to resort to all means necessary to reflate this burst bubble and refill the gaping hole in credit, primarily through a policy referred to as “quantitative easing” – a fancy term economists coined for “printing money”.

    It is safe to assume that if our Fed Chairman is determined to debase the currency, he will succeed.  Historically, gold has rallied in the face of geopolitical instability or inflation, but we don’t believe either is necessary to drive gold prices higher today.  Gold should move higher because investors throughout the world are become increasingly apprehensive holding fiat currencies.  At home, the size of the Fed’s balance sheet is exploding, and the impact is clearly seen in the Dollar’s Dive.  But unprecedented global monetary and fiscal stimulus around the world, have created a sea of liquidity to offset the deflationary forces associated with deleveraging.  Investors, who are by definition net long in paper currencies, will increasingly look for insurance in the form of gold.

    Undoubtedly, our favorite View from the Blue Ridge is looking down on Wall Street analysts chasing immaterial changes in corporate earnings or economic indicators.  Perhaps our greatest advantage is being nestled away in the mountains of North Carolina, where we are better able to focus on the big shifts and important trend changes that drive markets over the long term.  We believe it is here, that the greatest opportunities lie.  Let’s take a quick look at such shifts in the supply and demand picture for gold:

    The official sector became a net BUYER of gold in Q2-09, a significant change of heart for a market accustomed to absorbing substantial volume by central banks over the last two decades (see chart).  Note that this shift was largely due to a sharp decline in sales from the Central Bank Gold Agreement but purchases were sufficient to push the sector into positive territory. We think it is likely that purchases continue for the foreseeable future as concerns surrounding the Buck’s status as the world’s reserve currency continue to mount.

    Net Official Sector

    China and a growing number of large holders of our increasingly worthless Treasuries have been increasingly vocal about their concerns for the almighty buck.  The State Administration of Foreign Exchange announced this year that China boosted its gold reserves to 1054 tons.  A trend we expect to continue.  To put this figure in perspective, consider that this investment represents 1.9% of China’s $2.1 trillion in reserves.  The US, for example, holds 77.4% of domestic reserves in gold.  The Euro Area comes in at 59.7% whereas the global average is 10.3%.  It’s not hard to imagine the impact that Chinese purchases would have on a gold sector with total supply and demand of roughly 3500 tons over the past three years.

    We’ll assume for a moment that most investors understand the potential for significantly higher demand for gold as discussed above.  So naturally, the next question we should be asking concerns supply.  Surely, as gold prices have risen from a low around $250 per ounce in 1999 to today’s price over $1000 per ounce, miners have aggressively expanded production to maximize the gold they can sell at all time highs, right?  Wrong.  Gold production has steadily declined annually, since gold prices bottomed around the turn of the century (see chart).

    Gold Production

    Since rational miners (note we are talking miners here, not investors) would logically aim to sell more gold at higher prices, we can only assume that they cannot find more gold, or it is much harder to find and taking them a lot longer to increase production.  Either way, until we begin to detect shifts in these underlying secular trends, we will ignore the short term noise in daily gold prices, and refer back to the most fundamental concept in economics, which even Helicopter Ben and his trusty sidekick Timmy can understand – increasing demand, plus declining supply, equals higher prices.

    Ben&Timmy

     

    Disclosure: At the time of publication, author was long streetTRACKS Gold Trust Shares, Market Vectors Gold Miners and iShares Silver Trust, although positions may change at any time.

    Tags: Gold
    Oct 22 11:04 AM | Link | 1 Comment
  • The Outlook Beyond “The Great Recovery”

    We are standing by our constructive view on risk assets for now, as our best guess is that markets continue to rise alongside leading indicators through Q1-09, but the outlook quickly becomes murky, beyond the first half of 2010, where we see several major challenges for the domestic and global economy:

    1. Another wave of financial stress on the banking system driven by the impact of sharply rising delinquencies and foreclosures on newly reset Alt-A and Option ARM mortgages (not to mention major losses on commercial real estate assets yet to be realized).  Note in the chart below that the first wave of resets, notably in subprime mortgages which caused the failure of several major financial institutions, peaked in the fall of last year and has since sharply declined alleviating the primary stress on the banking system.  Unfortunately, just as our beloved banksters have been led into a false sense of security, an even larger wave of resets is set to flow through the banking system, which will pressure bank balance sheets through 2012.  Note that the majority of these loans were written at the peak of the housing bubble and represent the greatest excesses in price and lending standards.Mortgage Rates
    2. As our administration continues to pat themselves on  the back for the Great Recovery that policy has orchestrated in 2009, the prospect for additional stimulus deteriorates daily.  As shown in the chart below, the fiscal tailwind driving this year’s growth, is set to become a massive headwind beyond the first half of next year.  History shows that  prematurely exiting from an accommodative policy setting in 1936, derailed the recovery in the late 1930s and led to another leg of the Great Depression. If auto sales post Cash for Clunkers are any guide, we wonder what economic growth will look like once the punch bowl is taken away from the party this time around.Fiscal Headwind
    3. Coincident indicators of the domestic economy (GDP, Industrial Production, etc.) will begin to demonstrate substantial improvement in coming weeks and quarters.  As the recovery shifts from a second derivative story to one of first derivative improvements, interest rates are likely to follow the trend in economic indicators higher, while investors begin to price in the likelihood of future rate hikes.  Given, points one and two above,  combined with extreme levels of indebtedness at both the private and public sectors, the overall economy’s ability to deal with higher rates is greatly reduced.  The reason is simple – the larger the outstanding debt load, the larger the impact of rate hikes on debt-servicing costs.the hole

    We believe the relief we’ve experienced in 2009 has been driven solely by two temporary factors which will soon begin to fade – a predictable lull in the mortgage reset schedule, coupled with an unsustainable burst of deficit spending and explosive growth of the Fed’s balance sheet.  These tailwinds will turn into significant headwinds in 2010 and beyond.  Therefore, it is likely that the stabilization in house prices and rise in economic indicators investors are cheering today, will prove to be one of the greatest head fakes in history.

    Tags: Housing, Macro
    Oct 22 10:59 AM | Link | 1 Comment
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