DC Frictions Hide Basic Dangers: Balancing Growth And Value

by: Emmet Kodesh

"As QE fails, leveraged positions will be unwound and it will start a general contagion in the financial system…" (David Stockman, 10-4-13)

David Stockman was Director of the OMB (Office of Management and the Budget) during the first Reagan administration. He is among those alarmed by price inflation in major asset classes and concerned that before long stock, bond and real estate bubbles will pop. He believes that PMs (precious metals) will rise when this occurs. This thesis diverges from price action YTD and most discussions of the outcome of current political wrangling in Washington. What role can PMs play in balancing growth, value and wealth preservation at a time when most official metrics, like jobs and inflation are unreliable and QE hinders true price discovery?

It is difficult not to focus on the bickering in DC over the budget, debt ceiling and National Health Care Mandate. This is dangerous for investors because it obscures the fundamental disorder in asset values created by QE and the leverage and margin debt it encourages. It also lets people forget about troubling demographics and the viability of a welfare state into which eight decades of American have paid. Any number of events, domestic or abroad could prompt a sell off exaggerated by HFT (high frequency trading). The correction might last a fortnight, a month or, conceivably, replicate 2008. Bill Fleckenstein, President of Fleckenstein Capital Management believes Americans will pay dearly for the monetary policies of the past few years.

If there is a major correction, the Fed will not be able to stem and reverse it by debt creation, lowering the prime rate (already at zero) or further suppressing bond yields: this already has been done. With the exception of PMs (precious metals) and some commodities (base metals and grains), all major asset classes, -- stocks, bonds and real estate --- are at inflated prices. This and structural impairment of the economy that relies on over-taxed, under-employed consumers must be kept in mind when considering outlook and allocation that takes a challenged outlook into account.

Many folks assume that when political tussling is resolved in the next 1 - 3 weeks, clarity on spending and fiscal policy (continuing or even increased QE) will lift markets, preserve or boost the nominal value of bond holdings and continue to support a housing recovery. This premise may be borne out: to me it seems the most likely outcome. However, the artificial and, thus, the fragile nature of the economy and markets suggest that a defensive posture be maintained and a weather-eye kept on the news and sentiment.

Wariness, however, has its pitfalls as well as theoretical prudence. The downside of vigilance in this over-heated environment is that one may overreact and hastily buy into or sell out a position which 2-10 days of cooling will reveal as an error. When mass media coverage amplifies real or perceived, actual or potential crises the way HFT amplifies moves by strong hands in the markets, investors may succumb to a manic-depressive type of reactivity. Asset values are over-stimulated and so in myriad ways is our culture. Even people whose responses and thinking are rooted in a different era are influenced by the kinetic temper of these times.

How is one to find a balance between vigilance and over-reaction, between participating in liquidity-fueled growth and contrarian defensive positions?

Allocation, including to cash and commodities is affected by net worth and one's income stream, both its size and stability. The greater one's net worth and income, the more one can afford to keep a substantial position in grains (NYSEARCA:JJG), physical gold (NYSEARCA:PHYS) or silver (NYSEARCA:PSLV). In August I began commending wheat (NYSEARCA:WEAT) and nutrients (NYSEARCA:SOIL) for your holdings: since then they have risen 7% and 11% respectively from 52-week bottoms. Copper (NYSEARCA:JJC) and the copper miners ETF (NYSEARCA:COPX) also have risen 11% from secular lows in August. The facts of food shortages, rising prices that reflect currency devaluation and the potential for disruptions in supply stemming from political, geopolitical and/or fiscal frictions is great.

The greatest values among asset classes remain in PMs. Managers of value funds soon may take advantage of extremely low P/E and P/B ratios to acquire assets in the sector. This should help the best companies like First Majestic (NYSE:AG), Endeavour (NYSE:EXK), Silver Wheaton (SLW) and McEwen (NYSE:MUX) as well as major producers Barrick Gold (NYSE:ABX) and Goldcorp (NYSE:GG). ABX clearly has begun turning the corner, selling non-core and higher cost assets, cutting corporate staff and its dividend which has garnered buy ratings from analysts like Deutsche Bank (NYSE:DB)and TD Securities. Its new DB target is 65% above last Friday's close at $18.03.

Having followed the sector closely and written on it often, I believe most investors should have (or at current levels take) a position in ABX and EXK and consider adding to or initiating positions in SLW, MUX, AG, Sandstorm (NYSEMKT:SAND) and Fortuna Silver (NYSE:FSM) if their prices drop another 10-15%. Given volatility and sentiment, this may well happen despite prices already irrationally low. Silver Standard Resources (NASDAQ:SSRI) has been downgraded to sell with a judgment that at low bullion prices, it cannot afford to develop its Pitarilla site in Durango, Mexico. This makes it a natural merger or acquisition target for GG who could finance the work. Note that GG CEO Chuck Jeannes said at the Denver Gold Forum that "growth is not a dirty word" and that GG is open to new acquisitions. Here is one that would add enormous reserves (c. 471 million oz. silver) in a vital commodity metal.

One other note on PMs that hints at the priorities of those who influence or set fiscal policy and market trends: if the prices of gold and silver reflected the basics of sharply growing demand, slowing or diminishing supply from cutbacks in E&D and capex, devaluation of fiat currencies and true inflation, their prices would be at multiples of current levels. Gold priced at $6800 / oz. would cover the $17 trillion Federal deficit. Even at half that price it would backstop our credit rating and the programs funded by taxes or government debt. One would think that makers and drivers of policy would welcome this outcome. That their trading behavior tends to suppress PM prices leading to gold's relocation to Asia suggests lack of interest in pursuing a clear means to resolve debt problems and entitlements.

While all sectors other than PMs and some commodities trade at elevated levels, I have been identifying and discussing companies and sectors that are aligned with cultural trends and that also have strong fundamentals. As to sectors, I again suggest Health Care, Consumer-related and big media. Some of the best companies in the markets are in these areas. A short list that looks at revenue and cash flow / debt ratios, growth and ROE includes CBS (NYSE:CBS), Boeing (NYSE:BA), Time Warner (NYSE:TWX), United Tech (NYSE:UTX), Starbucks (NASDAQ:SBUX), TJX (NYSE:TJX), Whole Food Markets (WFM), Home Depot (NYSE:HD) and Disney (NYSE:DIS). I have explained my reasons for adding Dunkin' Brands (NASDAQ:DNKN) to this list here. Problems for aerospace-defense tied to the government shutdown should be transient.

I believe that few people can adequately manage more than 15 individual equity holdings (aside from buy-&-forget holdings like Johnson & Johnson (NYSE:JNJ)) unless they work at it full time and have the temperament and taste for the work required. Because everyone should own cultural-economic stalwarts like JNJ, Proctor & Gamble (NYSE:PG), McDonald's (NYSE:MCD), Coca-Cola (NYSE:KO), Macy's (NYSE:M) and TWX to anchor their holdings, it is helpful to establish a significant allocation via very low cost Vanguard ETF's like High Dividend Yield (NYSEARCA:VYM) with about 23% allocated to consumer companies and 12-14% each to Health Care, Industrials, Energy and Financials. VYM yields 3.4%.

Participate in these markets but keep your defenses at the ready. The best values remain in the PM sector while big media and the best consumer-oriented companies provide a mix of profitability, growth and alignment with cultural dynamics. Combine individual holdings in top companies with broad exposure through a few ETFs and mutual funds to avoid taking on too great a managerial burden. Investments should serve your life, not vice versa.

With yields having again been brought down by vigorous QE, in my view this is not a time to buy bonds. However, while it seems wise to underweight fixed income, perhaps significantly underweight, nearly everyone should retain a position in them. There are too many variables and too much interventionism in the markets to make all-in bets. Only billionaires can afford that, -- at the peril of ceasing to be billionaires.

Disclosure: I am long ABX, AG, CBS, DNKN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.