Category Archives: Economics & Politics

Graham on Growth Stock Investing Part 1; Readings on Hyperinflation

Posted on October 31, 2012 | 6 comments

Graham said that investors should stay away from growth stocks when their normalized P/Es go above 25. On the other hand, when the product of a stock’s normalized P/E and its price-to book ratio is less than 22.5—Normalized P/E x (price/book) is less than 22.5—it is at least a good value. So, if a normalized P/E is below 14 and the price/book is below1.5, the stock should be attractive.

One of the common criticisms made of Graham is that all the formulas in the 1972 edition of The Intelligent Investor are antiquated.  The best response is to say, ”Of course they are!” Graham constantly retested his assumption and tinkered with his formulas, so anyone who tries to follow them in any sort of slavish manner is not doing what Graham himself would do, if he were alive today.  —Martin Zweig

We continue our discussion from the last post: http://wp.me/p2OaYY-1pv

Graham on Growth Stock Investing 

Graham displayed extraordinary skill in hypothesis testing. He observed the financial world through the eyes of a scientist and a classicist, someone who was trained in rhetoric and logic. Because of his training and intellect, Graham was profoundly skeptical of back-tested proofs. And methodologies that promote the belief that a certain investing approach is superior while another is inferior. His writing is full of warnings about time-period dependency….Graham argued for slicing data as many different ways as possible, across as many different periods as possible, to provide a picture that is likely to be more durable over time and out of sample.

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Now we want to hear what Ben Graham has to say about valuing growth.  Graham later described his way of thinking as “searching, reflective, and critical.” He also had “a good instinct for what was important in a problem….the ability to avoid wasting time on inessentials….a drive towards the practical, towards getting things done, towards finding solutions, and especially towards devising new approaches and techniques.” (Source: The Memoirs of the Dean of Wall Street, 1996). His famous student, Warren Buffett, sums up Graham’s mind in two words: “terribly rational.”

Graham in the Preface to Security Analysis, 4th Edition

We believe that there are sound reasons for anticipating that the stock market will value corporate earnings and dividends more liberally in the future than it did before 1950. We also believe there are sound reasons for giving more weight than we have in the past to measuring current investment value in terms of the expectations of the future. But we recognize that both views lend themselves to dangerous abuses.  The latter has been a cause of excessively high stock prices in past bull market. However, the danger lies not so much in the emphasis on future earnings as on a lack of standards used in relating earnings growth to current values. Without standards no rational method of value measurement is possible.

Editor:  Note that when Graham wrote those words (1961/62) the bond yield/stock yield ratio was changing. In the early 1940s and 1950s for example, stock dividend yields were fully twice AAA bond yields, meaning that investors were only willing to pay half as much for one dollar of stock income as they were willing to pay for one dollar of bond income. In 1958, however, stock and bond yields were equal, meaning investors were at that time willing to pay just as much for a dollar of stock income as for a dollar of bond income.  And in recent years, investors have come to think so highly of equities, that they are now (March 1987) willing to pay three times as much for a dollar of stock income as they are for a dollar of bond income.   The main points you should extract from this and the following posts on Graham’s discussion of growth stock investing is his thinking process.  Graham was adaptable. Ironically, Graham was known for his net/net investing but he made most of his money owning GEICO.

Newer Methods for Valuing Growth Stocks (Chapter 39 of Security Analysis, 4th Ed.)

PART 1 of 4 (entire article to be posted as a pdf next week)

Historical Introduction

We have previously defined a growth stock as one which has increased its per-share for some time in the past at faster than the average rate and is expected to maintain this advantage for some time in the  future. (For our own convenience we have defined a true growth stock as one which is expected to grow at the annual rate of at least 7.2%–which would double earnings in ten years, if maintained—but others may set the minimum rate lower.) A good past record and an unusually promising future have, of course, always been a major attraction to investors as well as speculators.  In the stock markets prior to the 1920s, expected growth was subordinated in importance, as an investment factor, to financial strength and stability of dividends. In the late 1920s, growth possibilities became the leading consideration for common stock investors and speculators alike. These expectations were though to justify the extremely high multipliers reached for the most favored issues. However, no serious efforts were then made by financial analysts to work out mathematical valuations for growth stocks.

The first detailed basis for such calculations appeared in 1931—after the crash—in S.E. Guild’s book, Stock Growth and Discount Tables. This approach was developed into a full-blown theory and technique in J.B. William’s work, The Theory of Investment Value, published in 1938. The book presented in detail the basic thesis that a common stock is worth the sum of all its future dividends, each discounted to its present value. Estimates of the rates for future growth must be used to develop the schedule of future dividends, and from them to calculate total recent value.

In 1938 National Investor’s Corporation was the first mutual fund to dedicate itself formally to the policy of buying growth stocks, identifying them as those which had increased their earnings from the top of one business cycle to the next and which could be expected to continue to do so. During the next 15 years companies with good growth records won increasing popularity, but little effort at precise valuations of growth stocks was made.

At the end of 1954 the present approach to growth valuation was initiated in an article by Clendenin and Van Cleave, entitled “Growth and Common Stock Values.”[1] This supplied basic tables for finding the present value of future dividends, on varying assumptions as to rate and duration of growth, and also as to the discount factor. Since 1954 there has been a great outpouring of articles in the financial press—chiefly in the Financial Analysts Journal—on the subject of the mathematical valuation of growth stocks. The articles cover technical methods and formulas, applications to the Dow-Jones Industrial Average and to numerous individual issues, and also some critical appraisals of growth-stock theory and of market performance of growth stocks.

In this chapter we propose: (1) to discuss in as elementary form as possible the mathematical theory of growth-stock valuation as now practiced; (2) to present a few illustrations of the application of this theory, selected from the copious literature on the subject; (3) to state our views on the dependability of this approach, and even to offer a very simple substitute for its usually complicated mathematics.

The “Permanent – growth-rate” Method

An elementary-arithmetic formula for valuing future growth can easily be found if we assume that growth at a fixed rate will continue in the indefinite future. We need only subtract this fixed rate of growth from the investor’s required annual return; the remainder will give us the capitalization rate for the current dividend.

This method can be illustrated by a valuation of DJIA made in a fairly early article on the subject by a leading theoretician in the field.[2]  This study assumed a permanent growth rate of 4 percent for the DJIA and an over-all investor’s return (or discount rate”) of 7 percent. On this basis the investor would require a current dividend yield of 3 percent, and this figure would determine the value of the DJIA. For assume that the dividend will increase each year by 4 percent, and hence that the market price will increase also by 4 percent. Then in any year the investor will have a 3 percent dividend return and a 4 percent market appreciation—both below the starting value—or a total of 7 percent compounded annually. The required dividend return can be converted into an equivalent multiplier of earning by assuming a standard payout rate. In this article the payout was taken at about two-thirds; hence the multiplier of earnings becomes 2/3 of 33 or 22.[3]

It is important for the student to understand why this pleasingly simple method of valuing a common stock of group of stocks had to be replaced by more complicated methods, especially in the growth stock field. It would work fairly plausibly for assumed growth rates up to say, 5 percent. The latter figure produces a required dividend return of only 2 percent, or a multiplier of 33 for current earnings, if payout is two-thirds. But when the expected growth rate is set progressively higher, the resultant valuation of dividends or earnings increases very rapidly. A 6.5% growth rate produces a multiplier of 200 for the dividend, and a growth rate of 7 percent or more makes the issue worth infinity if it pays any dividend. In other words, on the basis of this theory and method, no price would be too much to pay for such common stock.[4]

A Different Method Needed.

Since an expected growth rate of 7 percent is almost the minimum required to qualify an issue as a true “growth stock” in the estimation of many security analysts, it should be obvious that the above simplified method of valuation cannot be used in that area. If it were, every such growth stock would have infinite value. Both mathematics and prudence require that the period of high growth rate be limited to a finite—actually a fairly short—period of time. After that, the growth must be assumed either to stop entirely or to proceed at so modest a rate as to permit a fairly low multiplier of the later earnings.

The standard method now employed for the valuation of growth stocks follows this prescription. Typically it assumes growth at a relatively high rate—varying greatly between companies –for a period of ten years, more or less. The growth rate thereafter is taken so low that the earnings in the tenth of other “target” year may be valued by the simple method previously described. The target-year valuation is then discounted to present worth, as are the dividends to be received during the earlier period. The two components are then added to give the desired value.

Application of this method may be illustrated in making the following rather representative assumptions: (1) a discount rate, or required annual return of 7.5%;[5] (2) an annual growth rate of about 7.2% for a ten-year period—i.e., a doubling of earnings and dividends in the decade; (3) a multiplier of 13.5% for the tenth year’s earnings. (This multiplier corresponds to an expected growth rate after the tenth year of 2.5%, requiring a dividend return of 5 percent. It is adopted by Molodovsky as a “level of ignorance” with respect to later growth. We should prefer to call it a “level of conservatism.” Our last assumption would be (4) an average payout of 60 percent. (This may well be high for a company with good growth.)

The valuation per dollar of present earnings, based on such assumptions, works out as follows:

  1. Present value of tenth year’s market price: The tenth year’s earnings will be $2, their market price 27, and its present value 48 percent of 27, or about $13.
  2. Present value of next ten years’ dividends: These will begin at 60 cents, increase to $1.20, average about 90 cents, aggregate about $9, and be subject to a present-worth factor of some 70 percent –for an average waiting period of five years. The dividend component is thus worth presently about $6.30.
  3. Total present value and multiplier: Components A and B add up to about $19.30, or a multiplier of 19.3 for the current earnings.

[1] Journal of Finance, December 1954

[2] See N. Molodovskiy, “An appraisal of the DJIA.” Commercial and Financial Chronical, Oct. 30, 1958

[3] Molodovsky here assume a “long-term earning level” of only $25 for the unit in 1959, against the actual figure of $34. His multiplier of 22 produced a valuation of 550. Later he was to change his method in significant ways, which we discuss below.

[4] David Durand has commented on the parallel between this aspect of growth stock valuation and the famous mathematical anomaly known as the “Petersburg Paradox.”

[5] Molodovsky’s later adopted this rate in place of his earlier 7 percent, having found that 7.5% per year was the average over-all realization by common-stock owners between 1871 and 1959. It was made up of a 5 percent average dividend return and a compounded annual growth rate of about 2.5% percent in earnings, dividends, and market price.

Part 2: Valuation of DJIA in 1961 by This Method…….stay tuned.

 

HYPERINFLATION

Audio Interview: http://www.econtalk.org/archives/2012/10/hanke_on_hyperi.html

A History of Hyperinflation Hanke on Hyperinflations

Great Hyperinflations in World History

October 26 2012 3 Trillions Reasons for Concern   (Conditions today)

Opportunities hard to find: http://www.gannonandhoangoninvesting.com/

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Posted in Economics & Politics, Investing Gurus, Valuation Techniques

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How the Stock Market and Economy Really Work

Posted on October 20, 2012 | Leave a comment

Readings: Munger-Talk-at-Harvard-Westlake and don’t forget to subscribe to kessler@robotti.com and www.santangelsreview.com to be up to date on all news related to investing.

How the Market Really Works

Editor: The author argues that GDP growth, as measured in money and stock market values as reflected by broad indices like the S&P 500 and the DJIA, rises as a result of the increase in money caused by the expansion of bank credit.  Note that the DJIA went from 809 on Jan 2, 1970 to 12,800.18 on January 4, 2008, a gain of 1,582 percent, even greater than the increase in the (m-2) money supply in that period.

If money supply was held constant or grew slowly (as would be typical under a classical gold standard), then capital gains could be made only by stock picking–by investing in companies that are expanding market share, bringing to market new products, etc., thus truly gaining proportionately more revenues and profits at the expense of these companies that are less innovative and efficient.

The stock prices of the gaining companies would rise while others fell. Since the average stock would not actually increase in value, most of the gains made by investors from stocks would be in the form of dividend payments. By contrast, in our world today, most stocks–good and bad ones–rise during inflationary bull markets and decline during bear markets. The good companies simply rise faster than the bad.

An interesting, important read: http://mises.org/daily/4654

In fact, the only real force that ultimately makes the stock market or any market rise (and, to a large extent, fall) over the longer term is simply changes in the quantity of money and the volume of spending in the economy. Stocks rise when there is inflation of the money supply (i.e., more money in the economy and in the markets). This truth has many consequences that should be considered.

Since stock markets can fall — and fall often — to various degrees for numerous reasons (including a decline in the quantity of money and spending), our focus here will be only on why they are able to rise in a sustained fashion over the longer term.

The Fundamental Source of All Rising Prices

For perspective, let’s put stock prices aside for a moment and make sure first to understand how aggregate consumer prices rise. In short, overall prices can rise only if the quantity of money in the economy increases faster than the quantity of goods and services. (In economically retrogressing countries, prices can rise when the supply of goods diminishes while the supply of money remains the same, or even rises.)

When the supply of goods and services rises faster than the supply of money — as happened during most of the 1800s — the unit price of each good or service falls, since a given supply of money has to buy, or “cover,” an increasing supply of goods or services. George Reisman offers us the critical formula for the derivation of economy-wide prices: [1]

In this formula, price (P) is determined by demand (D) divided by supply (S). The formula shows us that it is mathematically impossible for aggregate prices to rise by any means other than (1) increasing demand, or (2) decreasing supply; i.e., by either more money being spent to buy goods, or fewer goods being sold in the economy.

In our developed economy, the supply of goods is not decreasing, or at least not at enough of a pace to raise prices at the usual rate of 3–4 percent per year; prices are rising due to more money entering the marketplace.

The same price formula noted above can equally be applied to asset prices — stocks, bonds, commodities, houses, oil, fine art, etc. It also pertains to corporate revenues and profits. As Fritz Machlup states:

It is impossible for the profits of all or of the majority of enterprises to rise without an increase in the effective monetary circulation (through the creation of new credit or dishoarding).[2]

…….

The Link between the Economy and the Stock Market

The primary link between the stock market and the economy — in the aggregate — is that an increase in money and credit pushes up both GDP and the stock market simultaneously.

A progressing economy is one in which more goods are being produced over time. It is real “stuff,” not money per se, which represents real wealth. The more cars, refrigerators, food, clothes, medicines, and hammocks we have, the better off our lives. We saw above that, if goods are produced at a faster rate than money, prices will fall. With a constant supply of money, wages would remain the same while prices fell, because the supply of goods would increase while the supply of workers would not. But even when prices rise due to money being created faster than goods, prices still fall in real terms, because wages rise faster than prices. In either scenario, if productivity and output are increasing, goods get cheaper in real terms.

Obviously, then, a growing economy consists of prices falling, not rising. No matter how many goods are produced, if the quantity of money remains constant, the only money that can be spent in an economy is the particular amount of money existing in it (and velocity, or the number of times each dollar is spent, could not change very much if the money supply remained unchanged).

This alone reveals that GDP does not necessarily tell us much about the number of actual goods and services being produced; it only tells us that if (even real) GDP is rising, the money supply must be increasing, since a rise in GDP is mathematically possible only if the money price of individual goods produced is increasing to some degree. Otherwise, with a constant supply of money and spending, the total amount of money companies earn — the total selling prices of all goods produced — and thus GDP itself would all necessarily remain constant year after year.

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Money and Inflation Video; Jim Grant on QE3; Mason Hawkins

Posted on September 28, 2012 | 1 comment

Hopefully–and thanks to all the good wishes–I am in recovery or….a moment of silence.

Money and Inflation

Video: Money and Inflation with Greg Rehmke http://youtu.be/efDGIMpE3OE

 Perpetual Fed Intervention and Manipulation

James Grant   Blasts Fed AgainThu 20 Sep 12    http://video.cnbc.com/gallery/?video=3000117340We are in a market without the yield. We shouldn’t have this. There is a great stampede in the corporate debt, in speculative grade debt by   people that are not getting paid for the risk.They’re looking for yield.  The credit markets when they are left un-manipulated convey information.A struggling issue will pay more than a sound issue. You read the financials, and that is priced in the marketplace. When there’s a stampede for yield bond, the credit markets convey no information except for the one and only important piece of information — this is what they want to have it be priced at.Maria at CNBC: “Let me ask you about the implications or –you’re talking about long-term implications.”

James Grant: “The implications for the saver — there are some very short term implications as well. yeah, I mean — if you are and you are confronting zero percent. Your options are all together unpalatable.  And they are the options the government presents you. I heard somebody — I heard a former fed guy the other day castigate Mitt Romney for daring to challenge the independents of the fed. Who said the fed was the   fourth branch of government?  These guys are answerable to Gongress, right? Congress, under the constitution has the power to coin money and regulate the value thereof. Where do these guys get off?

Maria of CNBC: “And yet the Congress is not doing anything, in terms of their own fiscal policy.”

James Grant:  “They’re on vacation. Exactly.  What is the best way to invest around these realities that we face?

We recognize that the Fed keeps bailing everybody out, we recognize this is going to be the case until 2015. How do I make   money on this story? We have written favorably, recently about General Motors. GM was trading 6.5 times or so, the 2013 estimate. It’s got all manner of hair on it, beneath the hair, there’s a sound post balance sheet — post bankruptcy balance sheet, we think even adjusted for immediate pension difficulties.

There is the fact that the American   odometer is at near record highs. People are driving old cars. We think GM is in a pretty good place with respect to its product, And the stock is cheap on the numbers. So what we think one ought to do is to look for a margin of safety in equity like investments that will stand to benefit from these monetary exertions.    We are all living in a world of   speculation and manipulation. It’s not so easy. But there are things to do.

Your latest cartoon, “Darling, you’re so quantitative.”  “Yes, not   everyone hates this policy. This is a policy for Greenwich, Connecticut (Home   of Hedge Funds). It’s great if you can fund zero%. if you are on the inside   and know when they are going to do what they’re going to do, it’s great. Your asset prices levitate. It’s good for commercial real estate probably; good for a lot of things, but we don’t know all together what it’s bad for. We have a general sense, but we’ll find out more in about three years.

“When do you think the Fed should start raising interest rates?”

James Grant: “Two years ago. I think that rates are prices, and price control is a demonstrated failure as a public policy. Chairman Bernanke himself castigated the Nixon administration for imposing price controls 1971. He was right, price control fails. What he’s doing is controlling prices. He’s suppressing interest rates, and this phrase, the investment portfolio balance channel or some such. He’s attempting to press — to lift equity markets, because that will, he says, induce economic growth. Shouldn’t equity markets respond or discount wholesome growth rather than be muscled higher? The answer to that question is yes.”

Maria, “You’re a free markets guy, I agree, you want the markets to work the way the markets ought to work. Is there any reason to believe that you don’t want — you want to get in front of this train, that is the stock market?”

James Grant:  “I think it’s where security analysis comes in, I think it’s where an investment in gold and silver comes in. Central Banks around the world are bound and determined — either through actions or   words to debase their currency. They’re telling us. How high can gold go in   this scenario? The nice thing about gold, it has no PE multiple. There’s no   telling. Gold is a speculative assets — it earns in yields, gold is a   speculation on an anticipated macro economic outcome. That macro economic   outcome being the systematic debasement of currencies by the central banks. They’ve done qe 3, right? The economy appears not to be in the best of   health.

Why wouldn’t they do Quantitative Easing 4? What intellectual argument do they have against doing it again and again and again? That’s one of the risks, right? Well, it’s open ended already. Maybe they didn’t need it, because we know it’s open ended. They can save the paper in the press release.

Maria: You mentioned real estate. One of the unintended consequences in Hong Kong because of the dollar relationship. There is an argument to be made that you want to be buying hard assets like a gold, like real estate.

James Grant: I think it depends how it’s valued. in some markets in this country, you can finance them at all time — certainly generational low interest rates in the mortgage market. That’s not a bad way to hedge against the currency.

Maria: “I know Bernanke knows you have been so critical. What is his   answer to you, when you raise these points?”

James Grant:  “We don’t talk any more.”

Maria: ” Thank you   so much. Jim Grant for joining us, founder of Grant’s Interest Rate Observer.

Look at the distortion of MBS compared to US Treasuries

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Mason Hawkins of Longleaf Partners Interview with GuruFocus

Sep 17, 2012 | About: DIS -0.06%DTV +1.05%LVLT +0.04%TRV +0.12%L +0.51%BRK.A -0.63%BRK.B -0.34%

Mason Hawkins is chairman and chief executive officer of Longleaf Partners, an investment advisory firm with $34 billion in assets under management. He recently took investing questions from GuruFocus readers. Here are his responses:

Investment Philosophy

Question: You manage more than $30 billion, but most of the assets are in the top 10 names. Why do you run such a concentrated portfolio?

We believe that holding a limited number of financially strong, competitively entrenched businesses at a significant discount to intrinsic value has lower risk of capital loss and better return opportunity than owning a large number of inferior businesses at higher prices. Statistical analysis shows that security-specific risk is adequately diversified after 14 names in different industries, and the incremental benefit of each additional holding is negligible. We own 18-22 companies to allow us to be amply diversified but have the flexibility to overweight a name or own more than one business within an industry. Finding investments that meet our disciplines at any given time is normally difficult. When one qualifies, we want it to have an impact when value is recognized. Limiting the portfolios to our 20 most qualified investments allows us to know the companies we own and their managements extremely well while providing ample security-specific diversification. As Longleaf’s largest investor group, we want our capital in competitively advantaged companies run by competent managements that sell at materially discounted prices.

Question: We know that you assign every investment an appraised value. How does quality play a role here? Question: In your opinion, what kind of companies are high-quality companies?

We view quality through the lens of a business owner. We want to own companies with the following qualitative characteristics. 1) Unique assets having distinct and sustainable competitive advantages that enable pricing power, long-term earnings growth, and stable or increasing profit margins. 2) High returns on capital and on equity as measured by free cash flow rather than earnings. 3) Capable management teams with operating skills, capital allocation prowess, and properly aligned, ownership-based incentives. While most agree that growing businesses that generate high returns meet the quality definition, many also want earnings stability. Our long-term horizon gives us the opportunity to own quality businesses at deep discounts at points when their earnings may be temporarily depressed. By focusing on a company’s competitive advantages and what the value will be in 3-5 years, we can buy companies such as Disney (DIS) after September 11, 2001, or Philips today that are dominant leaders in their industries and will grow with high returns, but have short-term earnings challenges.

Question: A fan of yours from nearby, in Jonesboro, Ark. – I’m curious what initial measures/qualitative factors catch your attention? Is it a depressed stock price? Secular shifts in an industry? Great business or management? Price/FCF?

We are attracted by all of the above and more. We run numerous screens to source new ideas including price to cash flow, insider purchases and ownership, corporate buy backs, industries/sectors out of favor, and the new low lists for example. We also keep a master list of appraisals for 600+ good businesses that we would like to own at the right price. Because of the short investment time horizons in the markets today, we often get the chance to buy businesses that we have previously owned. Generally, companies and managements that we have lived with successfully in the past come with fewer unknowns and therefore less appraisal risk.

Value Investing Environment

Question: Your investment performance target is 10% plus inflation. You historically achieved this goal over ten year periods through mid- 2007. What factors have been preventing you from achieving this goal in the 10 year periods since then? Do you think the value investing landscape has changed?

The value investing landscape is certainly out of favor today with investors clamoring for what they perceive to be safety – whether in bonds, high dividend stocks, or stocks that are viewed as “higher quality” meaning more stable. Most companies with a degree of economic cyclicality or some financial leverage have been ignored for much of the past year. We have faced previous periods when intrinsic value investing was out of favor, and we know that the key to delivering outsized long-term returns is owning good businesses at large margins of safety of value over price and remaining patient. Any time a performance period includes a negative return, an absolute return goal becomes challenged. Fortunately, in our almost 40 years as a firm and 25 years managing Longleaf Partners Fund, we have had few down years. The worst of those, however, was in 2008 with the economic crisis. Strong absolute returns are required to make up for that year, but we do not believe the world has changed in a way that will make achieving inflation plus 10% difficult. Over Southeastern’s history, including the post 2008 period, we have achieved our absolute return goal 78% of the time over quarterly rolling 10 year periods. The current end point for reviewing performance incorporates an environment that the U.S. had not encountered since the Great Depression. That was the only other period when bonds outperformed equities over 10 years, and the S&P dividend yield was higher than the 10 year Treasury yield. We think that the view that broad equity returns are limited to around 3% going forward based on an expected low GDP growth plus dividend yield misses the importance of retained earnings and its significant capital compounding benefit. As an active manager who is selecting good businesses and capable management teams that are undervalued out of the broader universe of equities, we expect to deliver better than the broad market returns over time as we have over Southeastern’s history.

Stocks

Question: You have been a long-term investor of Level 3. The company has been doing poorly and in a lot of financial stress. What is your thesis in investing in Level 3 (LVLT)? Isn’t it a value trap?

Level 3 is among the world’s largest internet backbone service companies offering a unique combination of long-haul and metropolitan fiber routes spanning 45 countries on 3 continents. No other single provider offers the same range of global coverage. Demand is rapidly growing aided by the increase in mobile and cloud computing as well as growth from voice, data and video traffic across the internet. Over the last ten years, rising demand combined with industry consolidation have enabled pricing strength as excess capacity from overbuilding in the dot.com era has declined. Because of the high contribution margins in this largely fixed cost business, revenue increases will drive large free cash flow and value growth. The current top line value growth makes Level 3 one of our most compelling investments.

The company sells far below our appraisal for several reasons including the perception of “financial stress” echoed in your question. While Level 3 has a history of being highly levered, the company has successfully managed its capital structure even through the challenge of the financial crisis. Last year’s acquisition of Global Crossing essentially removed the company’s debt strain as EBITDA to Net Debt greatly improved. The acquisition also added three board members from Temasek, the Singaporean fund, who will bring additional focus on successful sales execution. While some would argue that the company sells near industry EBITDA multiples, those views do not account for Level 3’s lower required capex and a substantial tax advantage relative to competitors.

Question: What is your view on Travelers (TRV)’s competitive advantage? How troubling is the huge fixed-income portion of their investment portfolio (in relation to future inflation)? How much do you like Jay Fishman? I really like the fact they are aggressively repurchasing shares and the fact that it is trading at book value, which I estimate to earn around 13% (ROE).

Travelers’ main competitive advantages are its depth of product offerings as well as its leading edge technology platforms that make the company a preferred provider for insurance agents. In regards to their fixed income portfolio and future inflation, longer-term we prefer higher interest rates since interest income is normally a major source of earnings. While book value could get marked down some with inflation, earnings from interest income would increase. In the meantime, the company is reducing capital invested in the business and wisely buying shares at a discount to book and to our appraisal value. Jay Fishman is both a capable operator and an astute capital allocator as evidenced by the company’s strong ROE and growing value, even during the past soft pricing period in the insurance industry. He’s led the industry’s improved pricing environment.

Question: Considering the margin of safety with which Longleaf invests, how much of the loss in ACS is permanent impairment of capital and how much is paper loss? If there is permanent impairment of capital, what were the mistakes made in the investments? If the thesis hasn’t changed why haven’t you added heavily to this investment due to the bargain that it would theoretically represent at this price?

We believe that ACS represents an unrealized paper loss, not a permanent impairment of capital, based on our conservative appraisal for the company today combined with the substantial dividends we have received during our investment. However, we consider ACS a mistake from our initial purchase in November 2007, as appraisal value has declined over the holding period primarily due to the company’s ill-timed, leveraged purchase of 20% of Iberdrola. ACS’s price over the last year has been primarily impacted by concerns over its stake in Iberdrola and to a lesser extent, its 50% stake in Hochtief. The appraisal decline was driven largely by the company selling approximately half of its Iberdrola stake at around €3.50 a share vs. our appraisal of over €5 a share. Since ACS purchased Iberdrola shares using leverage, the appraisal decline was amplified. In our appraisal of ACS, we carry the remaining Iberdrola stake at market, which is down over 30% from its December price. Broader concerns over the Spanish and European economy have further pressured ACS’s price. Spain’s main index, the IBEX 35 where ACS is listed, contains 35 companies, many with low free float. As a result, ACS has become a proxy for betting against Spain with over 30% of the stock’s free float being shorted. We added to our position in late April 2012 as price fell below €14 and today maintain a slightly overweight position in Longleaf Partners International Fund. While our average cost for ACS is higher, we have received €9.90 per share in dividends over the course of our investment.

Question: How do you think about DIRECTV (DTV) in terms of competitive advantage and valuation?

DIRECTV is the largest satellite broadcaster in the U.S. and has rapidly growing, dominant market share in Latin America. Domestically, the company offers better quality and programming to attract high-end customers that pay premium rates with little churn. Pricing power has driven rising ARPU (average revenue per user). Because viewers will “unplug” for some of their viewing over time, we place a lower multiple on the U.S. than in the past. But live sports where DTV has unique offerings are much less vulnerable to delayed viewing. In Latin and South America, DTV has almost no competition in most countries because cable has not been and will not be installed in less developed places with minimal infrastructure. Although the stock is multiples above our cost in DTV, the price remains below our appraisal as value has grown steadily from management’s reinvestment of the cash coupon into high-returning Latin America and discounted shares.

Question: Have you ever looked at Leucadia (L), particularly since it’s trading at 80% of book value?

We purchased Leucadia in the second quarter in Longleaf Partners Small-Cap Fund. Since it is a new position, we prefer not to comment on the company specifics at this time. We have high regard for our partners, Ian Cumming and Joe Steinberg.

Question: Have you ever looked at buying Berkshire Hathaway (BRK.A)(BRK.B)? If so, what do you think is the best way to value the company?

We recently purchased Berkshire Hathaway for the second time in our history when the stock fell near book value. The appraisal is based on a sum of the parts analysis which has become more relevant as the non-insurance businesses have become a larger part of the company. Berkshire’s capital strength, investment success, and underwriting knowledge provide an advantage in the insurance businesses, which comprise just over half of our appraisal. The competitively entrenched operating companies include the railroad, Burlington Northern, the utility and pipeline business, MidAmerican, and a number of smaller companies. We have superior partners not only in Warren Buffett, but also in the next level of management responsible for the different pieces. His recent share repurchase reflects his view that the stock is discounted. Additionally, the board is structured to insure a consistent approach and culture long past Buffett’s tenure.

As a result of the investment opportunity created by the fear and dislocation we have discussed in this interview, we have decided to launch the Longleaf Partners Global Fund in the 4th quarter of this year. While we have been managing global separate accounts for over 10 years, we believe the current market environment makes this a compelling time to make a global mutual fund available to our partners.

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Burry Letters; Dalio (Leveraging and Deleveraging) and Leucadia ARs.

Posted on September 27, 2012 | 4 comments

Thanks to a generous reader:

Burry Letters

BURRY_Scion_3Q_2006 and BURRY_Scion_1Q_2008

Leverage and Deleverage Updated March 2012

Dalio_Leveraging and Deleveraging

Buy high and sell low-Managing Money Managers

Hiring Money Managers or Buy High and Sell Low

Leucadia Annual Letters

1978    1979    1980     1981    1982    1983    1984     1985

1986      1987      1988     1989      1990       1991      1992      1993

1994

1995       1996      1997      1998      1999      2000    2001   2002

2003

Out of surgery and probably in recovery.

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The Great Default–Inevitable Consequences

Posted on September 26, 2012 | 2 comments

Conclusion: “By replacing large decentralized markets with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended economic consequences.” This is true. It lies at the heart of the mess we are in.

….The FED tried to unwind over the last 12 months. They do not mention this. The result: the FED’s panic return to QE3. There will be no unwinding.

The Great Default is a critique of this Wall Street Journal article:”The Magnitude of the Mess We’re In.”  An importnat read.

I welcome readers to explain how unfunded liabilities (Medicare, Social Security, Pensions) will NOT be defaulted on.

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Mathematical Prediction of the Market and More….

Posted on September 24, 2012 | Leave a comment

Having trouble understanding what I am illustrating, then go here:

My perfect mathematical proofs on where the market will be in eighteen months.

What, are you ignorant? http://youtu.be/OUvKIubY6OY?t=1m40s

Mathematics vs. Economic Logic:

http://mises.org/daily/3540  and Rothbard’s note on mathematical economics   http://mises.org/daily/3638

 and Chapter_XVI

Readings

Is Romney intentionally trying to lose? http://www.economicpolicyjournal.com/2012/09/five-possible-reasons-for-romney-being.html

Learning through deliberate practice: A good investment blog! http://www.whopperinvestments.com/category/deliberate-practice

Major Debt will be defaulted on:  http://www.economicpolicyjournal.com/2012/09/major-insider-vast-majority-of-global.html

Bernanke’s QE3 defies common sense.

In order to boost the demand for goods and services, one must boost the production of goods and services. For instance, an individual can exercise his demand for bread by producing shirts; or a butcher can exercise a demand for potatoes by first producing meat that he can exchange for potatoes.

Furthermore, producers of final goods can also exchange them for various other goods such as tools and machinery in order to expand and enhance the existent infrastructure, which will permit an expansion of final consumer goods that promotes people’s lives and well-being.

The Bernanke-Woodford plan, which is based on relentless monetary pumping, will lead to a weakening of the economy’s ability to generate final goods and services in line with consumers’ preferences. This will diminish rather than strengthen effective demand for goods and services. Read more: https://mises.org/daily/6200/QE3-Sowing-the-Wind

Learn how to negotiate: http://youtu.be/xT5iqTgypVs (Please, women and children, ignore this clip).

Reader’s Question: What is it like to write a blog?

My reply: http://youtu.be/ozDSk9XUkrc

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Our Future

Posted on September 20, 2012 | Leave a comment

The fundamental problem facing the federal government (and for all the governments of Western Civilization), namely, that it has overextended its promises vastly beyond its ability to deliver on these promises.–Gary North

Ok, I have beaten this subject to death, but I will leave the subjects of debt, deficit and default–for now– with this important post for easy reference.

Hyperinflation Is Not Inevitable (Default Is)

Mises Daily: Monday, August 20, 2012 by Gary North

Hyperinflation is always a possibility for any national government or central bank. If a national government is running massive deficits, it can call on the central bank to buy treasury bills or treasury bonds with newly created money. This digital money is transferred to the treasury, which then spends the money into circulation.

There have been cases of hyperinflation in the past that have become legendary. The most famous of all of these hyperinflations is Germany from 1921 through 1923. Simultaneous with that hyperinflation was a hyperinflation in Austria. These were not the worst cases of hyperinflation in history, but they were the worst cases in industrial societies. The worst case was Hungary for two years immediately after World War II. The second-worst case took place a few years ago in Zimbabwe. Both were agricultural nations.

No other nations in western Europe have ever experienced anything like the hyperinflations of Germany and Austria in the early 1920s. Their currency systems were completely destroyed. Farmers were able to pay off debts that had been accumulated prior to World War I by selling one egg and handing the money over to the creditor. This of course destroyed the creditors. It is generally believed that the middle class in both Germany and Austria suffered enormous losses. They had been creditors.

There have been hyperinflations in Latin America after World War II. One of the worst was in Brazil in the 1980s and 1990s. The statistics of catastrophic inflation are available here. This went on for two decades. I know of no other case of hyperinflation that lasted more than three years. This is why I regard Brazil’s inflation as the worst hyperinflation in modern history. The political authorities did nothing to stop it, and the central bank inflated. The devastation to the middle class was almost total. If people did not get their money into gold and silver and foreign currencies, they were wiped out. The country went to barter.

If this form of hyperinflation ever comes to the United States or any other Western industrial nation, it will lead to the complete destruction of long-term creditors. Anyone who bought long-term bonds of any kind, anyone who invested in mortgages of any kind, anyone who is the recipient of a government pension, or anybody who is dependent on Social Security and Medicare could not survive this kind of hyperinflation. It would always be paid off in money that is worth far less than when the debt was contracted. When we think of the delay in payments that already exists with respect to Medicare reimbursements to physicians, we get some idea of what it would do to the healthcare industry. The delay of 90 days would basically eliminate the debt.

Destroying Creditors

When we think of the traditional arguments in favor of hyperinflation from the government’s point of view, we think about the ability of the government to pay off creditors. As I will show, this argument no longer is valid.

It is valid for private corporations. Some large business that has issued a 30-year bond is in a position to pay off those bonds with money that is essentially worthless. The person who extended credit to the company did so when the currency had far higher purchasing power. Then comes hyperinflation. Most bonds allow the debtor to pay off early. This will destroy the creditors.

Wherever creditors exist, debtors are happy to repay their loans with money that has depreciated ever since the time that the loan was established. This is especially true if the loan had a fixed interest rate. If the rate of interest cannot be hiked by the lender, he is trapped in his debt. Long-term interest rates begin to skyrocket because of the effect of hyperinflation on consumer prices. New creditors demand a higher rate of interest in order to compensate them for the expected decline of purchasing power. But when hyperinflation speeds up the process of depreciation even faster, creditors who demanded higher interest rates find that the interest rate was not sufficient to compensate them for the decline of purchasing power. So, the next time around, creditors demand even higher rates of interest.

Every time the rate of long-term interest rises, the market value of the existing bonds declines. So, the creditor class, which had faithfully extended credit to businesses, finds that it gave up money that was of considerable value, and now gets back money that is essentially worthless. This destroys the creditor class, which then proves unable to supply new rounds of credit to borrowers.

In the case of central banks that adopt policies that produce hyperinflation, there is no doubt that creditors are ruined if the lenders have the right to pay off the loan with the newly issued currency. If there are no gold contracts or silver contracts governing the payment of the loans, the creditor is helpless in the face of lenders who use the depreciated money to get out of their obligations.

Short Bursts of Hyperinflation

The important fact in all of this, with the exception of Brazil, is this: this possibility of escaping the burden of debt is available only on a relatively short-term basis, and it is available only where the borrower has the right to repay the loan at any time in the national currency. Whenever these two provisions do not exist, hyperinflation only marginally benefits borrowers at the expense of creditors.

Consider the biggest debtor of all: the US government. It has borrowed money out of the Medicare trust fund and the Social Security trust fund from the beginning. The government has issued nonmarketable IOUs to both of the trust funds. These IOUs are good for decades. They are not short-term IOUs.

The government is in a position to repay only short-term bonds bought by the public. It is not allowed to repay holders of long-term bonds before the date that the bond terminates and the monies are to be repaid.

This places the US government at a significant disadvantage with respect to creditors. While it is possible for issuers of corporate bonds to repay the creditors at any time, this is not possible for the US government. Furthermore, the largest of its debts are related to two programs: Social Security and especially Medicare. These debts cannot be repaid with fiat money, because to do so would involve paying off long-term debts early. This is not possible for the federal government, unless the federal government changes the law. If it does this, it would be an admission of total defeat. It will be open default.

When the Social Security trust fund administrators or the Medicare trust fund administrators estimate the obligations of each program, they use the figure of 75 years. They talk about what is owed over the entire 75 years. This means that any period of hyperinflation that is less than 75 years will be insufficient to abolish the political debts of the US government. It cannot escape the obligation by paying retired citizens whatever they are owed over the entire time period. Hyperinflation will enable private corporations to escape their obligations to creditors, but it will not enable the federal government to escape. The government will be able to escape the burden in the years of the worst time of hyperinflation, but when the hyperinflation ends, and the central bank issues a new currency, this does not solve the problem facing the government.

The hyperinflation ends when the money is worthless. At that point, the government cannot buy goods and services. Neither can its dependents.

The government today faces a political problem. It is not simply that it has issued nonmarketable IOUs to the Social Security trust fund and the Medicare trust fund. It has made specific promises to the entire working population. These promises have the force of law. They also cannot be escaped by means of short-term monetary expansion. It is possible for the government for a brief period of time to get its hands on money that is depreciating, but there are cost-of-living escalators built into Social Security payments.

Furthermore, if the government uses the fiat money to pay healthcare providers, and the money does not cover the cost of providing healthcare, healthcare providers will go out of business. It does no good to go to hyperinflation in order to reduce the costs to the government of healthcare. If the government attempts this, it will find that healthcare providers go into another line of work.

All those forecasters who say that hyperinflation is inevitable in the United States never discuss this problem of the 75-year obligations. They never spell out in detail how hyperinflation will enable the US government to escape its obligations. These obligations stretch out over 75 years. No hyperinflation has ever lasted longer than 20 years, and most of them have not lasted longer than about 3 years. So, the policy of hyperinflation wipes out the middle class, and it wipes out most of the creditors who transferred money to corporations in exchange for long-term bonds. The corporations will simply pay off the bonds early with depreciated money, and will then be the possessors of whatever productive assets they bought with the borrowed money. So, when the government comes to potential creditors and asks for another round of debt, it will find the creditors are too wise to provide this credit.

The on-budget debt of the United States that is owed to the general public has an average maturity of approximately eight years. The Federal Reserve System is using “operation twist” to buy larger quantities of 30-year Treasury bonds. This lowers the rate on these bonds and also mortgages issued by Fannie Mae and Freddie Mac. The private purchasers of these assets will find that, for any period of hyperinflation, the market value of these assets declines. The money, which is not much, that the government will pay to them as interest will not buy much of anything. The government cannot get rid of these debts by hyperinflation. It can pay interest on these debts cheaply only during the time of hyperinflation.

Kotlikoff’s Figures

This brings us back to the deficit in the most important category: off-budget debt. The general public is almost completely unaware of this debt. This debt comprises mainly the obligations of the government for Medicare, Social Security, and federal pensions. These debts extend out for 75 years, according to the calculations of the government. These are extremely long-term debts.

Professor Lawrence Kotlikoff of Boston University has been monitoring the growth of these debts for several years. He relies on the statistics published by the Congressional Budget Office. This is legally a nonpartisan organization that is set up to provide information on various aspects of the government’s budget.

Early in August 2012, Kotlikoff and financial writer Scott Burns published an article on the increase of the unfunded liabilities of the US government. According to the figures issued by the Congressional Budget Office, Kotlikoff concluded that there had been an increase in unfunded liabilities over the past 12 months of $11 trillion.

The total obligation of the federal government to voters that is not funded at the present time is now $222 trillion. This does not mean that, over the entire life of the program, the government will be short $220 trillion. It means that the present value of the unfunded liability is $220 trillion. This means that the government would have to set aside $220 trillion immediately, invest this money in nongovernment projects that will pay a positive rate of return, and will therefore fund the amortization of this debt. I have written about the estimate here.

The federal government at the present time is running annual on-budget deficits of about $1.2 trillion. It spends something in the range of $3.7 trillion. But it needs to have $222 trillion immediately to invest in private markets. It of course does not have this money. There is also the question of which markets could absorb a total of $222 trillion overnight and be able to gain a constant rate of return of, say, 5 percent per annum? It simply is not possible.

Kotlikoff’s figures indicate that the federal government at some point will have to default on large portions of the long-term debt. The numbers do not lie. Kotlikoff’s numbers are larger than most estimates, but other economists have estimated the total unfunded liability in the range of $90 trillion. This number is as unmanageable as $222 trillion.

The Congress of the United States could not come to an agreement in 2011 on how to solve an official deficit of $1.2 trillion per year. Congress kicked the can down the road until January 1, 2013. At that point, the government will have to slash spending, according to the agreement made in 2011. The Bush tax cuts of 2002 will expire unless Congress extends them.

It is obvious that Congress cannot come to an agreement to solve the problem of $1.2 trillion annual deficits. What Kotlikoff and Burns reveal is something far more extraordinary. They indicate that the actual increase of the federal deficit over the last 12 months is in the range of 10 times greater than the increase in the official government deficit. This means that the compounding process that is taking place in the area of unfunded liabilities dwarfs the compounding process that we see in the on-budget statistics.

If Kotlikoff’s figures are incorrect, then some government economist or other expert should publish a detailed study of the correct methodology to examine the figures issued by the Congressional Budget Office. If he has made a mistake, the public deserves to know what this mistake was, and what the correct answer is. I am aware of no such study as yet, but perhaps it will be issued soon. The question will then be this: to what extent did Kotlikoff exaggerate the figures? If it turns out that he is wrong by, say, $50 trillion, the critic will have a point, but the point will be essentially irrelevant to the future crisis of the US government.

Even if Kotlikoff is wrong by $100 trillion, it becomes clear that Congress is completely incapable of dealing politically with this problem. It could not possibly raise the funds to balance the budget if the budget really is increasing by, say, $5 trillion per year. The difference between $5 trillion and $11 trillion is huge, but irrelevant in relationship to the ability of the government to deal with it. The government does not have the money, nor does the free market provide sufficient investment opportunities to enable the US government and all of the other Western governments, including Japan, to solve the problem.

This is not simply an American problem. This is the problem of Western civilization. This is a problem created by every group of politicians in the world who have overpromised what each national government is going to be able to deliver in the future.

If Kotlikoff’s figures are wrong, there should be a hue and cry in Congress over the magnitude of his misrepresentation. There is no hue and cry. We hear the silence of the Congressional Budget Office and also the silence of Congress in general. This persuades me that Kotlikoff’s figures are sufficiently accurate, so that we can make judgments about what is likely to happen to the solvency of the US government and its ability to send out checks every month to its recipients.

Kotlikoff and Burns do not estimate the year in which the crisis will become obvious. I don’t blame them. We cannot be certain about this date, because we cannot be certain about Federal Reserve policy. We can be certain about this: there is no way to repay the obligations that the federal government has negotiated with the voters. It has pretended that it can continue to make its payments on time, but it has not shown how this is going to be possible over the long haul. Meanwhile, millions of baby boomers have started to retire.

The Federal Reserve System

The Federal Reserve cannot solve the problem of the 75-year debt which has unfunded liabilities in the present of $222 trillion. There is no way that the government of United States can solve this problem without simply going into default. So, it does not pay the Federal Reserve to adopt a policy of hyperinflation, which is necessary to destroy the debts of the various levels of civil government in the United States.

The Federal Reserve may go to mass inflation. By mass inflation, I have in mind rates of consumer price increases of 25 percent or thereabouts. We have never seen this in peacetime America, but it is possible. It will enable Congress to sell some of its rollover debt as this debt matures. The average maturity of the federal debt now is about eight years.

This does not solve the major problem, which is the unfunded liability of the federal government for long-term old-age retirement programs. The central bank could hyperinflate for a few years and enable Congress to kick the can down the road for another three or four years. But this does not solve the fundamental problem facing the federal government, namely, that it has overextended its promises vastly beyond its ability to deliver on these promises.

Economists at the Federal Reserve understand this as well as I do. I ask this: What possible incentive is there for the Federal Reserve System to hyperinflate the money to zero value, when the political obligations of the old-age retirement system will survive the time of hyperinflation? What is the advantage of the Federal Reserve to hyperinflate the money supply?

Maybe it would do this in order to intervene to save specific large New York banks, but their obligations are minimal compared to the total obligations of the US government.

I am convinced that, unless Congress nationalizes the Federal Reserve, the Federal Reserve will not adopt a policy of hyperinflation. That would be to the detriment of the banking system in general.

Conclusion

This is why I am not persuaded by those people who say that hyperinflation in the United States is inevitable. I don’t think it is. I think default is inevitable, but I don’t think it needs to be default by hyperinflation. That is because the government cannot get out of its obligations by fiat money. It cannot default by using hyperinflation, because hyperinflation will only last a few years, but the obligations last for the next 75 years.

In other words, the default will be much more open. The government is going to have to renege on promises made to the vast majority of people who are now dependent on the federal government for their retirement income, and it will also default on the workers who are still in the workforce, who are paying each payday into Social Security and Medicare.

Anyone who makes the case for inevitable hyperinflation needs to present evidence on how hyperinflation will enable the US government to escape the political obligations of the promises that it has made to retirees.

If Congress nationalizes the Fed, then we could get hyperinflation, just to meet present bills. But this will not solve the long-term problem: government unfunded liabilities. After the currency dies, the debt will still be there.

Blink! U.S. Debt Just Grew by $11 Trillion

By Laurence Kotlikoff and Scott Burns – Aug 8, 2012

Republicans and Democrats spent last summer battling how best to save $2.1 trillion over the next decade. They are spending this summer battling how best to not save $2.1 trillion over the next decade.

In the course of that year, the U.S. government’s fiscal gap — the true measure of the nation’s indebtedness — rose by $11 trillion.

The fiscal gap is the present value difference between projected future spending and revenue. It captures all government liabilities, whether they are official obligations to service Treasury bonds or unofficial commitments, such as paying for food stamps or buying drones.

Some question whether “official” and “unofficial” spending commitments can be added together. But calling particular obligations “official” doesn’t make them economically more important. Indeed, the government would sooner renege on Chinese holding U.S. Treasuries than on Americans collecting Social Security, especially because the U.S. can print money and service its bonds with watered-down dollars.

For its part, economic theory sees through labels and views a country’s official debt for what it is — a linguistic construct devoid of real economic content. In contrast, the fiscal gap is theoretically well-defined and invariant to the choice of labels. Each labeling choice changes the mix of obligations between official and unofficial, but leaves the total unchanged.

Dangerous Growth

The U.S. fiscal gap, calculated (by us) using the Congressional Budget Office’s realistic long-term budget forecast — the Alternative Fiscal Scenario — is now $222 trillion. Last year, it was $211 trillion. The $11 trillion difference — this year’s true federal deficit — is 10 times larger than the official deficit and roughly as large as the entire stock of official debt in public hands.

This fantastic and dangerous growth in the fiscal gap is not new. In 2003 and 2004, the economists Alan Auerbach and William Gale extended the CBO’s short-term forecast and measured fiscal gaps of $60 trillion and $86 trillion, respectively. In 2007, the first year the CBO produced the Alternative Fiscal Scenario, the gap, by our reckoning, stood at $175 trillion. By 2009, when the CBO began reporting the AFS annually, the gap was $184 trillion. In 2010, it was $202 trillion, followed by $211 trillion in 2011 and $222 trillion in 2012.

Part of the fiscal gap’s growth reflects changes in policy, such as the Bush and Obama tax cuts, the introduction of Medicare Part D, and the expansion of defense spending. Part reflects “natural” growth of existing programs, including growth in Medicare and Medicaid reimbursement rates. And part reflects the demographic time bomb U.S. politicians are blithely ignoring.

When fully retired, 78 million baby boomers will collect, on average, more than 85 percent of per-capita gross domestic product ($40,000 in today’s dollars) in Social Security, Medicare and Medicaid benefits. Each passing year brings these outlays one year closer, which raises their present value.

Governments, like households, can’t indefinitely spend beyond their means. They have to satisfy what economists call their “intertemporal budget constraint.” The fiscal gap simply measures the extent to which this constraint is violated and tells us what is needed to balance the government’s intertemporal budget.

The answer for the U.S. isn’t pretty. Closing the gap using taxes requires an immediate and permanent 64 percent increase in all federal taxes. Alternatively, the U.S. needs to cut, immediately and permanently, all federal purchases and transfer payments, including Social Security and Medicare benefits, by 40 percent. Or it can mix these terrible fiscal medicines with honey, namely radical fiscal reforms that make the economy much fairer and far stronger. What the government can’t do is pay its bills by spending more and taxing less. America’s children, whose futures are being rapidly destroyed, are smart enough to tell us this.

(Laurence Kotlikoff, an economist at Boston University, andScott Burns, a syndicated columnist, are co-authors of “The Clash of Generations.” The opinions expressed are their own.)

To contact the writers of this article: Laurence Kotlikoff at kotlikoff@gmail.com.

To contact the editor responsible for this article: Katy Roberts at kroberts29@bloomberg.net.

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QE3 Could Be Highly Inflationary; Investors’ Responses

Posted on September 18, 2012 | 4 comments

Unintended Consequences

Plosser also warned that QE3 “could be highly inflationary.” http://www.philadelphiafed.org/about-the-fed/senior-executives/plosser/ “I don’t think it would occur immediately,” he said. “Inflation is going to occur when excess reserves of this huge balance sheet begin to flow outside into the real economy.  I can’t tell you when that’s going to happen.”

Bernanke and other Fed officials say that the Fed will be able to contain the outflow of reserves into the economy and thereby limit wage-price pressures by raising the rate of interest it pays on excess reserves.  But Plosser said the  interest rates on excess reserves (“IOER”) and reserve draining tools cannot be relied upon.

“How fast will we have to do that (raise the(IOER)?” he asked.  “How rapid will it have to go up? We don’t have a clue.   Raising the IOER where you have a trillion and half or two trillion dollars in reserves, we have absolutely zero experience with it.”

“We have the tools to do it, but we don’t know the consequences of the tools,” Plosser said. “If the IOER doesn’t work and we have to sell assets, MBS, how will that affect housing?” he asked. “Will we be able to unwind from this at a pace that doesn’t disrupt the economy?”

—–

The Fed’s problem: If those funds start to move out of excess reserves and into the economy rapidly, the Fed will have to take counter measures, such as boosting interest rates on excess reserves (IOER) or liquidating some of their mortgage-backed securities. Plosser is entirely correct, no one knows how high interest rates will have to be raised to stop the flow into the economy. It could very well end up a tiger by the tail situation, the higher the Fed boosts rates, the higher nominal rates climb (Sort of the reverse of what is going on now.

You as an investor need to watch to see if the Fed’s new money printing of $40 billion per month ends up in the system (through bank loans) or as excess reserves. Further, excess reserves themselves have to be monitored to see if any of those funds start to enter the system. In other words, if any increases in required reserves occur, it could result in an Artificial boom to the stock market and economy, but also be price inflationary.

Several Commentaries on the Fed’s Actions

James Grant

The Fed has committed to open-ended expansion of dollars to suppress interest rates. Now it is suppressing the interest rates, muscling the yield curve, and allocating credit. And it is in the business of price control. Price controls have never worked.  Read more: TheWhysAndWhereforesOfQE3_GRANTS

Robert Rodriquez of FPA, All In! FPA Comment on Fed Policy Sept 2012

David Stockman

Uploaded by ReasonTV on Jan 3, 2011

At the very start of the “Reagan revolution,” David Stockman exposed the myth that Ronald Reagan and the modern Republican Party are dedicated to small government.

Since writing The Triumph of Politics he says he has “completed his homework” by reading libertarian economists such as Ludwig von Mises, Friedrich Hayek, and Murray Rothbard. He thinks TARP was a big-government boondoggle and the bailouts of GM and Chrysler unconscionable. Stimulus spending is a hoax. He sees the abandonment of the gold standard in favor of floating exchange rates as the root cause of both the country’s fiscal problems and the 2008 financial crisis. He says that Rep. Ron Paul (R-Texas) is the only politician today “who gets it” and he’s hopeful that Paul’s growing power may begin to shed light on “the scholastic arrogance” of the Federal Reserve. He’s still against the welfare-warfare state and he thinks government should be cut down to size.

Interview: http://youtu.be/86i7FtGXUP0?t=50s

Stockman, “The Bernanke doesn’t have a clue as to why our economy has been failing. The reason it has failed, 130 million payroll jobs today is the same as 1999. So after 13 years of serial booms and busts we haven’t added one job! It has offered free money to Wall Street over and over. A massive speculation.  These actions will bring the chaos of booms and busts.

We need a fundamental change of policy. Extract the Fed from the group of WS. Special interests who provide windfall gains to a small circle of cronies while the rest of the middle class and poor struggle with the mess that we have.

A lecture by David Stockman on Sound Money: http://youtu.be/CAkdB-2qFHY  (65 minutes). Stockman quote: “Two party free lunch competition” He hits the insiders of both the Republican and Democratic parties equally hard. Another dissertation on crony capitalism.

Hyperinflation

Bolivia: http://youtu.be/xF_vfpGb1b4

Zimbabwe: Hyperinflation in Zimbabwe

Confidence in the Fed: http://youtu.be/R5lZPWNFizQ Alan Greenspan critiquing his devastating policies.

 

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Operation Screw: The Fed and Infinite QE or The End of Fiat Currencies

Posted on September 15, 2012 | Leave a comment

Thursday, Sept. 13th, 2012, a day that will live in infamy. The Fed announces a perpetual war on the US Dollar.

An important 17 minute Video on the recent Fed announcement http://youtu.be/LS879r7xeLc

The Fed’s plan is simply an attempt to reinflate the housing bubble–a SUPER HOUSING BUBBLE.  One lesson from Austrian economics–you can’t reflate a bubble in the same asset class twice in a row because of the prior mal-investment in that sector.

The definition of insanity is to expect a different result from the same actions. The cheap money will cause a rise in interest rates, food, commodities and perhaps, for awhile, financial assets. GET OUT OF THE US DOLLAR.

Instead of new jobs, the people’s savings and money will be savaged.  The Fed’s action will lead to tears.  Who will be blamed for the impending disaster? Capitalists or the “Free Market.”

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An informed man on the street view:http://youtu.be/u7aBSu8uNdA?t=3m10s

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What Is Bernanke Really Up To?

By Hunter Lewis Friday, September 14th, 2012

Bernanke says that the new announced round of money printing ( QE3 plus more Twist)) is intended to reduce unemployment. Does he believe that? It is possible that Bernanke really drinks his own Cool Aid, but I doubt it. Does  he think that stock market gains will boost confidence and somehow help employment indirectly? Perhaps. He has in the past  claimed credit for spiking the stock market, although he must know that the empirical evidence does not show a link to employment gains.

Why then this dramatic move only two months before a presidential election? Is it intended to spite Romney who said he would not reappoint Bernanke? I doubt that too.

The most likely explanation is that Bernanke is worried about the treasury auction market. He wants to be able to use his printed money at will to support it. The new printing and bond buying  program is open-ended by date. It can continue indefinitely. Ostensibly the QE3 purchases will be mortgages. That will help the banks, will help treasuries indirectly, and the program can always shift into treasuries at any time. The next step will be to remove the monthly limit and then, presto, the Fed will be able to print and monetize debt at will.

This is also a good time to start the process because other major currencies are committing their own forms of hari-kari. At least for the moment global bond buyers won’t be exiting the dollar in favor of the Euro or Yen– or even the Swiss franc, since the Swiss authorities are madly printing money too.

At some point, however, Bernanke will go too far and spook the foreign buyers. Then his game will be up.

(Editor: We could be nearing that point now….)

http://mises.org/daily/5344/Do-We-Need-a-Weak-Dollar

The fundamentals of a falling US Dollar http://mises.org/daily/1394

http://mises.org/daily/1386/The-Dollar-Crisis

http://www.europac.net/recommended_reading

The Real Fiscal Cliff
July 10, 2012 By Peter Schiff     July 10, 2012The media is now fixated on an apparently new feature dominating the economic landscape: a “fiscal cliff” from which the United States will fall in January 2013. They see the danger arising from the simultaneous implementation of the $2 trillion in automatic spending cuts (spread over 10 years) agreed to in last year’s debt ceiling vote and the expiration of the Bush-era tax cuts. The economists to whom most reporters listen warn that the combined impact of reduced government spending and higher taxes will slow the “recovery” and perhaps send the economy back into recession. While there is indeed much to worry about in our economy, this particular cliff is not high on the list.

Much of the fear stems from the false premise that government spending generates economic growth (for stories of countries experiencing real growth, see our latest newsletter). People tend to forget that the government can only get money from taxing, borrowing, or printing. Nothing the government spends comes for free. Money taxed or borrowed is taken out of the private sector, where it could have been used more productively. Printed money merely creates inflation. So the automatic spending cuts, to the extent they are actually allowed to go into effect, will promote economic growth not prevent it. Even most Republicans fall for the canard that spending can help the economy in general. But even those who don’t will surely do everything to avoid the political backlash from citizens on the losing end of any specific cuts.

The only reason the automatic spending cuts exist at all is that Congress lacked the integrity to identify specifics. Rest assured that Congress will likely engineer yet another escape hatch when it finds itself backed into a corner again. Repealing the cuts before they are even implemented will render laughable any subsequent deficit reduction plans. But politicians would always rather face frustration for inaction than outright anger for actual decisions. In truth though, only an extremely small portion of the cuts are scheduled to occur in 2013 anyway. If it comes to pass that Congress cannot even keep its spending cut promises for one year, how can they be expected to do so for ten?

The impact of the expiring Bush-era tax cuts is much harder to access. The adverse effects of the tax hikes could be offset by the benefits of reduced government borrowing (provided that the taxes actually result in increased revenue). But given the negative incentives created by higher marginal tax rates, particularly as they impact savings and capital investment, increased rates may actually result in less revenue, thereby widening the budget deficit.

In reality, the economy will encounter extremely dangerous terrain whether or not Congress figures out a way to wriggle out of the 2013 budgetary straightjacket. The debt burden that the United Stated will face when interest rates rise presents a much larger “fiscal cliff.” Unfortunately, no one is talking about that one.

The current national debt is about $16 trillion (this is just the funded portion…the unfunded liabilities of the Treasury are much, much larger). The only reason the United States is able to service this staggering level of debt is that the currently low interest rate on government debt (now below 2 per cent) keeps debt service payments to a relatively manageable $300 billion per year.

On the current trajectory the national debt will likely hit $20 trillion in a few years. If by that time interest rates were to return to some semblance of historic normalcy, say 5 per cent, interest payments on the debt would then run $1 trillion per year. This sum could represent almost 40 per cent of total federal revenues in 2012!

In addition to making the debt service unmanageable, higher rates would depress economic activity, thereby slowing tax collection and requiring increased government spending. This would increase the budget deficits further, putting even more upward pressure on interest rates. Higher mortgage rates and increased unemployment will put renewed downward pressure on home prices, perhaps leading to another large wave of foreclosures. My guess is that losses on government insured mortgages alone could add several hundred billion more to annual budget deficits. When all of these factors are taken into account, I believe that annual budget deficits could quickly approach, and exceed, $3 trillion. All this could be in the cards if interest rates were to approach a modest five per cent.

If the sheer enormity of the red ink were to finally worry our creditors, five per cent interest rates could quickly rise to ten. At those rates, the annual cost to pay the interest on the national debt could equal all federal tax revenues combined. If that occurs we will have to either slash federal spending across the board (including cuts to politically sensitive entitlements), raise taxes significantly on the poor and middle class (as well as the rich), default on the debt, or hit everyone with the sustained impact of high inflation. Now that’s a real fiscal cliff!

By foolishly borrowing so heavily when interest rates are low, our government is driving us toward this cliff with its eyes firmly glued to the rear view mirror (much as the new French regime appears to be doing). For years I have warned that a financial crisis would be triggered by the popping of the real estate bubble. My warnings were routinely ignored based on the near universal assumption that real estate prices would never fall. My warnings about the real fiscal cliff are also being ignored because of a similarly false premise that interest rates can never rise. However, if history can be a guide, we should view the current period of ultra-low rates as the exception rather than the rule.

The US Debt will not be repaid

D.C. Current

 | SATURDAY, SEPTEMBER 15, 2012

Could Fed Miscalculations Lead to $10,000 Gold?

By JIM MCTAGUE

That’s what one investment pro views as a possibility if the central bank underestimates the potential for inflation.

These are times that try an asset manager’s soul. The world’s economy is a soft-paste porcelain vase set on a wobbly plant stand in the heart of an active earthquake zone. The Middle East is sending out foreshocks of war. The South China Sea is a smoking caldera of tension. Social unrest in the EU threatens tidal waves. And, according to the agitated rats and snakes of the financial press, China is headed into a recession.

Meanwhile, in the U.S., where the economy is climbing from its financial crater like an underoxygenated mountaineer, congressional miscalculation threatens to topple the weary cragsman back into the abyss.

Hedging against the most pessimistic case without crippling the upside potential of a better or even miraculous case appears to be as unsolvable as the proverbial Gordian knot. Alexander the Great “solved” the intellectually challenging knot riddle by severing it with his sword. Scott Minerd, chief investment officer of Guggenheim Partners, offers a more reasoned but equally simple solution to the hedging conundrum: gold. In extreme circumstances—like miscalculations regarding inflation by the Federal Reserve—the metal could hit $10,000 per troy ounce, he asserts. Thursday, after the Fed disclosed its latest financial-stimulus scheme, the metal rose about 2% to $1,768.

Most economists aren’t forecasting a recession or inflation for the U.S. A sudden acceleration of domestic economic activity leading to a more robust recovery doesn’t seem to be in the cards either, assuming that President Obama is re-elected and continues to focus on income redistribution as opposed to job growth.

Martin Regalia, chief economist for the U.S. Chamber of Commerce, says that, based on current patterns, underlined in the most recent employment report from the Bureau of Labor Statistics, a full jobs recovery will take another five years. With growth below 3%, the economy is creating just enough jobs to absorb new entrants into the labor market, not provide work for everyone who was laid off in the 2007-2008 credit-market crash, he says. They number about seven million. Anemic income growth also is a drag. As the nearby charts show, Americans strapped with debt aren’t bringing home enough money to significantly reduce their debts. The low rates engineered by the Fed merely make it easier for them to service that debt. So much, then, for a consumer-led recovery.

Regalia worries that miscalculations by a bickering Congress in tackling the $16 trillion federal debt or avoiding the “fiscal cliff” might cause chary foreigners to rethink lending to the U.S. at rates near zero. Absent serious belt-tightening, America probably would inflate its way out of debt. For every 1% increase in rates that would be demanded under such circumstances, $100 billion would be added to the budget deficit. In normal times, the foreign lenders would demand at least 3%, says Regalia.

Minerd frets about the Fed’s ability to reduce its swollen $2.9 trillion balance sheet if rates suddenly were to rise. Because the assets have longer-term durations, their market value immediately would tumble. If rates rose 1%, the Fed would have a $150 billion capital deficit, he says. This would have negative ramifications for the dollar. Minerd says the über-wealthy have been migrating toward hard assets like gold, real estate, and art. Every portfolio should be partially composed of such assets, he asserts. Is yours?

E-mail: jim.mctague@barrons.com

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See You Friday at the Mises Circle in NYC

Posted on September 12, 2012 | 1 comment

Mises Circle in Manhattan “Central Banking, Deposit Insurance, and Economic Decline”    September 14-14 2012

The Metropolitan Club, New York, NY

Sponsored by The Story Garschina Charitable Fund, and Anonymous Donor

Mises Circle Manhattan

Join our extraordinary speakers for a seminar and luncheon about free-market solutions to central banking, deposit insurance and the economic decline of what was once a free and prosperous society.

Friday, September 14, 2012 at The Metropolitan Club, One East 60th Street.  Mises Institute Member registration fee is $110 which includes continental breakfast, sessions, and lunch.  Jacket and tie required for men, business attire for women, no sneakers or casual sandals.
The Mises Bookstore will be on site and speakers will be happy to autograph their books

Final Schedule The brief process of registration takes place anytime between 8:30 and 9:20 a.m., Bookstore Open, Continental Breakfast Great Hall, First Floor 9:20 a.m.   Welcome, Lew Rockwell  West Lounge, First Floor 9:30 a.m.   David Stockman “How Crony Capitalism Corrupts the Free Market” 10:00 a.m.  Walter Block “Fractional Reserve Banking” 10:30 a.m.  Discussion and Refreshments, Bookstore Open 10:45 a.m.  Douglas French “TAG: Unlimited Insurance,                     Unlimited Risk” 11:15 a.m.   Peter Klein “Inner Workings of the Fed” 11:45 a.m.   Lunch  Presidents’ Ballroom, Third Floor 1:15 p.m.    Joseph Salerno “The Fed, the FDIC, and Other                       Problems”   West Lounge, First Floor 1:45 p.m.    Tom Woods “The State and Its Competitors” 2:15 p.m.    Discussion and Refreshments, Bookstore Open 2:30 p.m.    Peter Schiff “The Real Fiscal Cliff: How to Spot                       the Ledge” 3:00 p.m.    Lew Rockwell “War and the Fed” 3:30 p.m.    Discussion and Refreshments, Bookstore Open 3:45 p.m.    Speaker Panel with Q&A 4:30 p.m.    Adjourn 5:00 p.m.    Bookstore Closes

This event takes place in the beautiful and historic Metropolitan Club of New York

Event Details

Questions:  Email Patricia Barnett or call 334-321-2147

Accommodations

At the Metropolitan Club, contact Michelle Paulino at 212-277-8699 or Mpaulino@metclub.org. Mention the Mises Institute for a rate of $519.88 for a junior suite available on September 13 or $399.39 for a standard room available on September 14 and 15. Or at the nearby Warwick Hotel (15 minute walk) call 212-247-2700 before August 13 and mention the Mises Institute for a special rate of $320 per night plus tax.
Strict Dress Code at Metropolitan Club

Directions and Parking

Students:  A limited number of student scholarships are available.  To apply complete this form and save as pdf to your computer.   Email the saved pdf to scholarships@mises.org along with a copy of your student ID.

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