Oh that dreaded government intervention!  To describe the contrast between the inflation situation in the United States and China as “stark” might be a bit of an understatement.  As we’ve previously described (see here), the inflation issues in the United States remain benign for one primary reason: aggregate demand is weak.  The U.S. consumer is grappling with a traumatic balance sheet recession (see here).  But none of these problems existed in China to the extent that they did in the United States.  Remember, China’s economy was growing relatively fast even at the depths of the recession in the U.S.  -  a whopping 6.1% at the trough.  Most importantly, their consumers were not saddled with debt.  Nonetheless, Chinese officials felt that it was necessary to inject the economy with a stimulus package that rivaled that of far more embattled nations.  The results have been tremendous.  M2 is growing at 25.2% while M1 is expanding at 35%.  Unlike Americans, the Chinese are borrowing and they’re using those borrowings to fuel their speculation.

The headline CPI is running at 2.7% year over year.  Food prices are up 6.2% year over year.  Real estate prices rose at a record 10.7% in February. Equity prices in China are up over 45% in the last 12 months.

In early February we ran this superb interview with the largest commercial real estate developer in China.  Her thoughts are almost eerily similar to those of Sam Zell’s when he was predicting a real estate debacle in the United States in 2007:

What is your overall approach to the real estate market today?

Basically – other than Qianmen [Street] in Beijing, which is the only project we decided to hold long term, our strategy for today is to sell everything we have. The real estate business should really be looking at rental yield; build a building and then lease it out with the rent giving a decent return. But, because of where China is with asset bubbles, people want to buy the assets regardless of whether they can be leased out or not. People just want to hold [property], even if it is empty.

Prices are too high, rent is too low, so if you hold property in order to get yield you are likely to get very little. For us it makes no sense to hold property, so our strategy is to sell everything. We see ourselves very much as a manufacturer. We buy land, we build, and then we sell. And the asset bubble has compelled us to be even more of a manufacturer.

When do you think the bubble will burst?

I don’t know. We don’t really have a view on when it will end; [but] we do have a view that this is a bubble. Real estate is very much driven by government policy. This year we have RMB 4 trillion through the stimulus package, another RMB 6 trillion from municipality bonds, another RMB 10 trillion from bank loans: We have RMB 20 trillion in the system and it all finds its way to real estate. If the government next year decides to continue the relaxed monetary policy the market will continue like this, regardless of whether this is a wasteful investment or not – people will still buy and we will still be building and selling.

These buildings are not fully occupied and people should be worried about it. I am sure the government is worried about it, but what do you do, they want the stimulus and if you want to create jobs then this is a by-product. There are a lot of dilemmas in this area – it is not a black and white easy decision.

What is your time period for selling properties?

As soon as possible. We came in [for the Exchange] when it was 30% full and now it’s selling out very quickly. I think in the next few months it is all going to be sold out. People want to buy. It has already reached 50% occupancy.

[Beijing's] CBD has 35% vacancy but our buildings are all over 95% occupied because we push all these Chinese companies to come in. [Normally] if you go to Guomao as a small Chinese company there is no chance they will lease it to you, they won’t even talk to you.

The smart money in China is concerned, but for some reason government officials are talking these problems down, describing them as “moderate”.  They wouldn’t be the first central bankers to misjudge an exit strategy….

Analysts are now scrambling to alter their outlooks.  UBS predicts a rate hike in the “early second quarter” – much sooner than their previous estimate for the third quarter.  Barclays is also adjusting their timeline to Q2.   Morgan Stanley has been ahead of the curve on the global rate tightening fears and believes China could be facing multiple months of tightening starting in April.  Goldman Sachs is growing increasingly concerned with regards to the nonchalant stance by the Chinese government who continues to call the inflation concerns “moderate” (sounds similar to Bernanke circa 2007 & 2008 when prices were skyrocketing in the oil and real estate patch):

“Recent comments by a number of policymakers that there are no signs of inflation yet are worrisome as it indicates a lack of willingness to take more decisive measures until higher inflation actually occurs.”

Let’s not overreact to this news, however.  This is a slowly unfolding phenomenon.  China’s growth is the envy of the world, but they have quite a battle on their hands in 2010 and 2011.  They are confronted with the ever difficult task of threading the monetary policy needle – a task that ultimately led to the demise of Alan Greenspan (and certainly made Bernanke appear foolish in 2009).  This is, in many ways, the most difficult timing trade ever made.  Can you inject enough money into the system so that it doesn’t boil over and more importantly, can you sap the system of that necessary liquidity when the time is just right?  China would be wise to get ahead of these issues as we here in the United States are all too familiar with – pockets of mal-investment are too often a direct result of poor monetary policy.

Government aid might be the global economy’s greatest hurdle in the coming years, but it won’t be our own stimulus that is the great concern – it will be that of the engine of the global economy – China.   Luckily, with aggregate demand still very low in the United States and much of Europe there is little to no concern of inflation here, however, if China’s economy were to take a spill as government officials mishandle monetary policy it would almost certainly result in a global double dip.   And unfortunately, a global double dip would only strengthen the deflation that is hard at work around much of the globe.  Let’s all hope China gets ahead of this sooner rather than later.

Gold is hotter than ever.  You can’t turn on the TV these days without seeing a gold commercial.   Several well known hedge fund managers have leveraged up positions in gold while John Paulson even went so far as to start his own gold hedge fund.  As an asset class gold has outperformed just about everything over the last 10 year period.  It’s been an impressive run.   But is it all justified?  Bear with me for a bit while I take a long-term macro look at gold as an asset class….

After having experienced deflation through much of 2008 and the beginning of 2009 the economy began to reflate as the Fed’s printing press (or button pressing if you prefer) went to work.  Asset prices began to stabilize and bank balance sheets were suddenly flush with cash as the Fed provided liquidity like it was going out of style.  The inflationistas immediately began crying wolf.  All of this extra cash was certain to cause inflation.  And that meant one thing: buy gold and short dollars.  Right?

All was not what it seemed, however.  Underneath the surface, there was no real reflation – only continuing signs of deflation or at best, very benign inflation.  Asset prices surged as money flowed out of low risk assets (for which investors were no longer rewarded) and into high risk assets.  This herding of the Federal Reserve has given many the impression that the economy is “recovering”.  But underneath the surface lies the continuing problem of double D’s (and not the good kind) – debt and de-leveraging.  While asset prices have improved the liability side of the ledger remains in tatters in the U.S. economy and around the world.  De-leveraging continues and demand for more credit remains subdued.  Yet, the price of gold rallied.  I believe a large portion of the move is based on the misconception of gold as an asset class.

When analyzing the price of gold it’s important to understand that gold prices do not move like most other commodities.   It has certain built-in unquantifiable characteristics that drive price.  The price of gold is actually a function of four things: 1) its replacement potential for the U.S. dollar; 2) the future rate of inflation, 3) Sentiment – generally fear based and 4) true supply and demand.  Let’s take a look at each.

Nouriel Roubini recently quoted Keynes in describing gold as a “barbarous relic”.   While I can’t entirely agree with that opinion I think there is a certain level of truth there.  Let me elaborate.  There is a certain premium built into the price of gold because it is viewed as a currency – currently an alternative to the dollar.  It has served as a reliable currency for thousands of years and continues to be seen as an alternative to fiat currencies.  Going forward, I think this is a dying belief which has led to considerable confusion in the current economic environment.

The fact of the matter is, the fiat currency system is here to stay (or at least some form of it).  The odds of reverting back to a purely gold based system is next to zero in my opinion.  The truth is, the gold standard as a currency system is a barbarous relic.  It is a currency system that worked well in the old world economy, but simply does not have the flexibility to meet the demands of the growing global economy.   The global economy has become too complex and too intertwined to be constrained by the gold standard. The fiat currency system is a product of economic evolution and the growing demands and strains of international trade.  Famous examples of the break-down of the gold standard and its inflexibility to meet trade demands include the UK in 1931 and the U.S. government’s destruction of the gold linked currency system under the Bretton Woods agreement.

Gold investors generally make the false argument that the gold standard somehow stabilizes prices (as if the price of gold is stable) or will restrain governments from excess spending, but the truth is, under sound stewardship, the fiat currency system provides all the benefits of the gold standard and all the flexibility that the gold standard didn’t contribute.  In addition, the  gold standard had a tendency to cause severe strains on countries due to trade imbalances and the inability to provide flexibility to countries with trade deficits.  The argument that inflation, instability, corruption and mal-investment cannot occur under the gold standard is historically false.

If we were to alter our currency system it is most likely that we would move to a currency basket of some form, a global currency or move to a commodity basket – of which gold would likely be a component.  Realistically, however, the odds of moving back to the gold standard (or even a commodity basket) are next to nothing.  Nonetheless, gold investors remain hopeful of a currency collapse and a rewinding of our economic evolution.  Don’t count on it.  The current monetary system provides sovereign issuers of currency with a powerful monopoly over their currency and they are unlikely to relinquish this power into the hands of gold producers or an international currency (or bank) any time soon.

The popular idea of hyperinflation is one of the primary arguments in favor of gold. Of course, as we’ve already discussed, this is inherently flawed because the likelihood of reverting back to a gold based monetary system is virtually nil so anyone hiding gold bars under their bed is unlikely to find themselves trading them back and forth at the local Wal-Mart any time soon.   Regardless, speculation, corruption and mal-investment will occur in any currency system that allows such things to persist.  If these inefficiencies are allowed to persist they can lead to inflation and economic ruin.  The favorite arguments used by inflationistas are the Weimar Republic and Zimbabwe, however, any true historian understands that the United States is not even remotely comparable to these corrupt and inefficient economies.  The comparisons are completely and entirely debunked by Bill Mitchell at Billy Blog.  This is not to imply that inflation cannot occur in the modern currency system, but under sound stewardship the fiat currency system is no more potentially destructive than a gold standard (where sound stewardship remains a necessity).

Of course, there is nothing in a gold standard that keeps a country from becoming a poor steward of the currency. In fact, the restrictions of the gold standard have resulted in more government defaults than any flexible exchange rate fiat currency.  The argument that 99% of all fiat currencies have failed is simply an outright falsehood.   Fiat currencies restricted by the gold standard or pegged to another currency have failed repeatedly.  That is not the system in which we reside today.  It’s important to understand that the currency system in which we reside is vastly different from the pre-Nixon Shock currency system in which  currencies did not freely float and currencies were convertible.   As I described last week, a sovereign issuer of currency with no foreign denominated debt cannot go bankrupt in a floating exchange rate system unless it effectively decides to.   Inflation is another story altogether, but we’ll touch on this further.

Most of the hyperinflationists or gold investors I know are worried that the Fed’s printing press (or button pressing if you will) will ultimately result in inflation.  This is not entirely correct.  As I have previously explained, when you pour an iced tea packet into a pitcher of water you don’t automatically get iced tea.  You have to stir it in.  Our banking system is much the same.  There is no demand for credit as of now and therefore there is no expansion in the amount of actual money in the system.   Because the private sector is busy repairing their balance sheets aggregate demand remains historically low.  Therefore, the hyperinflation argument remains bunk.  The latest readings on wage inflation, demand for credit, etc all point to continued de-leveraging and low demand for credit, and in our banking system that means inflation is not yet a concern.  For all his faults, even Bernanke would not be ignorant enough to leave rates at 0% when there are signs of inflation.  Mr. Bernanke is actually acting as a relatively good steward of the currency now (we’ll see how long that lasts – I am not banking on it).*  For a more detailed explanation of the deflationary risks please see here.

In terms of sentiment there is an inherent premium built into gold because it is viewed as a safehaven currency.  This opinion is generally sold to the public by investors who genuinely believe the world is going to end or that the modern economic system will ultimately fail as the dollar crumbles.  These people genuinely believe that the entire global economy will collapse one day and we will all be sitting around trading our gold bars back and forth.  This is pure and simple fear mongering.  This is not to imply that the U.S. dollar can’t fail or that the fiat currency system will always exist in its current form, but the idea of reverting back to a time when we carry gold in our pockets in order to purchase goods is simply ludicrous.  “Barbarous” as some might call it.  The truth of the matter is that the fiat currency system is simply an evolutionary step in our economic progress.   Those who latch onto the days of the gold standard simply don’t understand how fiat currency works in the current floating exchange rate system.  If you want to believe the global economy will one day collapse that is just fine, but should that scenario actually pan out the last of your concerns will be which local market is accepting gold in exchange for food.  The man with the most lead will be the man with the most food in that scenario.

Where gold does contain real value is as an actual commodity.  I don’t believe that gold has no intrinsic value as many gold haters believe.  I believe it has intrinsic value in the same way that diamonds have intrinsic value.  I just don’t believe gold should have any intrinsic value as a currency.  None.  From a purely supply and demand perspective the gold market actually looks fairly constructive.  Nouriel Roubini pointed to several reasons why gold is not necessarily a bad investment:

“the global supply of gold—both existing and newly produced—is limited, and demand is rising faster than supply over the medium term. The recovery of the global economy has started a revival of retail gold demand especially in India. Central banks looking to diversify their portfolios account for further demand—see for instance, the recent increase in gold holdings by emerging market central banks. Most of the increase in demand comes from private investors using gold as a hedge against low probability tail risks of high inflation and another near depression caused by a double dip recession. Inflation risk and the risk of a double-dip are both low, suggesting lower gold prices, but increasingly investors want to hedge against such risks early on. And given the inelastic supply of gold, it only takes a small shift in the portfolios of central banks and private investors to boost increase the price of gold significantly.”

Passport Capital recently laid out the bull case as well:

• Demand in India and China is surging and demographic and wealth trends should bolster prices.
• Demand from central banks has undergone an important shift in recent years in response to the credit crisis.
• Mined supply peaked in 2001.
• The ability of above-ground gold stocks to satisfy demand is undergoing structural change, and markets may be overestimating their ability to satisfy an increase in demand at current prices.

One might conclude that I think gold is a terrible investment after reading this.  That couldn’t be farther from the truth.  I simply believe gold is a misunderstood asset (particularly as an alternative to the dollar).  I know that the overwhelming majority of investors see value in gold and therefore it is ignorant to ignore its potential as an asset.  The modern fiat currency system is still largely misunderstood and very young.  It will take time for investors to learn to trust it and fully understand its benefits.

Of course, these misconceptions are likely to persist for years if not decades and ignoring the beliefs of a huge amount of the investment world is no different than the fundamental analyst who ignores the millions of chartists in the world.  The belief is there therefore the price action is there.  I believe there are good reasons to hold gold in ones portfolio, but those reasons should be purely based on the underlying laws of supply and demand at work as they pertain to gold’s value as a commodity.   The idea that we will one day revert back to the gold standard is simply not pragmatic in my opinion.   If I were a betting man (and I am) and if I had to bet my lead on it I would bet that the idea of gold as a currency will be almost entirely extinct in 500 years.   But that doesn’t necessarily mean the price of gold won’t be much much higher.

In conclusion, I continue to fail to grasp the rationale for gold as a safehaven in this environment.  As we learned in 2008 the true safehaven in the modern floating exchange rate fiat currency world is actually the reserve currency.   With little to no inflation the inflation hedge argument remains bunk.   As for sentiment and the collapse of the modern economy, well, I don’t think gold will be the thing you really want to own in that world.  It is not gold we will all be clamoring for, but lead and God save you if you don’t have something to load that lead into because those gold bricks are mighty hard to throw at someone….

*It’s important that I enter one caveat here.  As regular readers know, I believe the current print and spend policy will do little to fix the long-term structural problems in the real economy. The real problem in the U.S. economy is that we remain in a stranglehold by a banking sector that is too large, too powerful, unproductive and poorly allocates capital.  The problem with Bernanke & Cos. plan is not that they are necessarily being poor stewards of the currency, but rather that they continue to allow bankers to allocate capital in an entirely unregulated manner.  This should not be fixed via currency restructuring or even austerity necessarily, but through harsh regulation and permanent downsizing of the banks.  But MUCH more on this in a later article….

As the Q4 2009 earnings season comes to a close it’s important to take a look at the overall earnings picture.   With over 98% of the S&P 500 reporting it looks like Q4 earnings will come in a little shy of $16.80.  As we fully expected the analyst’s estimates once again proved to be well below the mark as 72% of all companies outperformed expectations.   This has resulted in substantial estimate increases and has been one of the primary reasons why we have maintained that investors could not short this market for the entirety of the last year.  The earnings upgrade cycle has served as wind at the market’s back, but the optimism is now becoming an impediment.

In the last year analysts have substantially contributed to the equity rally as they upgraded stocks and increased their estimates.  The “Monday upgrade” rally has become a hallmark of the move higher in stocks as analysts spend their weekends adjusting estimates and preparing for Monday morning upgrades and downgrades (though mostly upgrades).   In just the last 8 weeks analyst’s Q1 2010 estimates have jumped 4%.   In addition, they are growing increasingly optimistic about the latter portion of the year (where I believe things get potentially messy).   The H2 estimates have continued to creep higher as Q4 earnings were released.  Analysts are now calling for $78 in operating earnings for FY 2010.  The 2011 estimates have also surged.  Analysts now expect $94 in operating earnings for 2011.  That would represent back to back years of 20% earnings growth - something that has never happened before in the history of the United States equity market.

The real problems lie in the latter portion of 2010.  Analysts are currently calling for 38% year over year growth for Q2, 30% year over year growth in Q3, and 27% growth in Q4 2010.  Granted, these are coming off of easy comps, however, we have yet to see any real revenue growth.    Including the very easy comps with financials, sales grew just 5% year over year in Q4.  If we exclude the financials revenue growth was nearly non-existent at just 1.1% year over year.   This is best visualized in the image below which shows the S&P 500 by revenue per share.  The trough is clear, but there is certainly no v-shaped recovery here.  At best, we are bumping along the bottom.

We are well into the economic recovery (ISM at 5 year highs and record highs in the ECRI’s leading indicators) and the ultimate L-shaped recovery remains in corporate revenues.  The vast majority of the rebound in earnings is non-organic and unsustainable.  Margins have expanded to pre-crisis highs as companies squeeze every last drop down to the bottom line.  Analysts expect earnings to return to near 2007 levels without any real revenue growth.  I find that hard to believe.  If you’re still confused as to why insider buying is non-existent in this market look no further than the revenue line of corporate income statements.

As sentiment has becomes very optimistic in recent weeks the Expectation Ratio has taken a bit of a spill.  The ratio peaked in the back half of 2009 along with the market and is now forecasting a far more difficult future for corporate earnings.  Without a substantial acceleration in revenues it is unlikely that this market is headed anywhere fast.  While it looks as though we likely have one more quarter of very easy earnings comps (Q1 2010) the real test will come in the latter portion of the year where estimates are extremely optimistic.   With little to no signs of organic growth I find it hard to believe that the bull market in earnings can continue.  That will serve as a major hurdle for the equity markets in 2010.*

*  The ER is a longer-term indicator that not only forecasted the 2007 & 2008 downturn, but also forecasted the 2009 bottom in stocks well in advance.  It’s a cyclical indicator and should be viewed with a bit of a longer time horizon.

By Absolute Return Partners:

This week’s Guru Outlook brings you Paolo Pellegrini.  Although he is not the most well known of investment gurus Pellegrini has built quite a name for himself in recent years.  Before founding his own hedge fund PSQR (a play on PP Squared) Pellegrini was John Paulson’s right hand man at Paulson and Co (see Paulson’s guru outlook here & most recent strategy comments here).  Of course, Paulson and Co. made waves during the sub-prime crisis when they made billions shorting the market during the crisis.  Pellegrini was instrumental in devising the strategy.  Like Paulson, however, Pellegrini wasn’t a one trick, short the market, pony.  In 2009 he crushed the market with a 61.6% return in his fund after he made big bets on a rising oil market and a tanking treasury market.

So where does Pellegrini see the market going now?  In a recent letter to shareholders he said:

“the structural problems that precipitated the Great Recession around the globe remain unresolved”

He says we are essentially papering over the problems with more debt.  We are simply adding more debt to a debt-laden world while China adds more exports to a saturated market.  He says the problems in Europe are a harbinger of these continuing issues.    Thus far the massive stimulus has been successful in jumpstarting the global economy, but is nothing more than a temporary respite from the longer-term structural problems that remain.

Pellegrini’s favorite trades in 2010 are the following four:

• Short US fixed income
• Short US equities
• Short US dollar
• Long commodities

The short trade on fixed income is a reflection of the likelihood for higher yields as investors grow increasingly fearful of the U.S. as a steward of its debt.  Pellegrini believes demand for treasuries will decrease in the coming years.

In terms of equities Pellegrini says valuations are becoming stretched as organic growth fails to match expectations. He also believes higher taxes could ultimately be a net negative for equities.

Pellegrini is short the dollar based on the expectation of more stimulus.  He predicts that policymakers will come back to the taxpayer asking for another handout as they explain their first stimulus plan was not a failure, but simply too small.  He says the dollar will “plunge” if this occurs.

The one sector of the market Pellegrini likes is commodities.  He says they remain attractive long-term as China exports inflation and demand for hard assets remains high.

One of Pellegrini’s primary concerns is the stimulus based growth occurring in China.  He says China is one of the greatest risks to the recovery.  He says:

“I was in China late last year.  One particularly enlightening meeting was with the top official of a major bank, who pointed to all the empty office buildings surrounding his own, observing that his country’s stimulus money would have been better spent paying people to stay home”

Pellegrini expects China’s CPI to exceed 5% in H1 2010 due to excessive demand from the stimulus programs.  He says China will respond aggressively with policy measures throughout 2010.  He expects the equity market to respond negatively.  One of this favorite China investments is the Yuan.  He is long the Yuan based on his “impossible trinity” trade:

“a country can control its interest rate, its exchange rate or its capital account – but not all three.  If the US keeps interest rates low, the only way China can raise rates is by first addressing the currency undervaluation.  Otherwise, it would just attract hot money inflows, as it did in 2006-2008.  Indeed, it is our expectation the the experience of that period – when gradual CNY appreciation was chosen – will lead China’s policymakers to prefer a more aggressive, upfront, one-off revaluation this time around.”

In the US, Pellegrini says we are coming face-to-face with the critical structural problems.  The end of the stimulus and the Fed’s programs will mark an economic top in Q1 2010 and set the stage for economic weakness in the latter half of 2010.   He says the headwinds we face are likely to occur sooner rather than later:

“Eventually, there must be a reckoning.  In our judgment, that day may be much sooner than the markets suggest.”

Warren Buffett is the most glorified and respected investor of all time.  And rightfully so.  After all, he became the world’s wealthiest man by essentially picking stocks.  But Warren Buffett is also remarkably misunderstood by the general public.  I personally believe the myth of Warren Buffett is one of the greatest tricks ever played on the small investor.

To the average investor Buffett is a folksy frugal regular old chum who just has a knack for picking stocks.  You know, he just picks those “value stocks” and let’s them run, right?  Well, nothing could be farther from the truth and here we sit with an entire generation of investors fooled by the idea that value investing/buy and hold is the single greatest way to accumulate wealth.  With the poor results of the last ten years investors have finally started to challenge this thinking.

To a large extent, the myth of Buffett has fed an investment boom as a generation of American’s aspire to make their riches in the equity markets.  And who better to sell this idea than Wall Street itself?  After all, a quick investment in Bill Miller’s Value Trust or the great Peter Lynch’s Fidelity Magellan (now essentially defunct) will get you a near replica of the Warren Buffett approach to investing, right?   Not so fast.

Let me begin by saying that I have nothing but the utmost respect for Mr. Buffett.  When I was a young investor I printed every single one of his annual letters (including his Buffett Partnership letters which can be found here) and read them page by page.  It was and remains the single greatest education I have ever received.  I highly recommend it for anyone who hasn’t done so.  But in digging deeper I realized that Warren Buffett isn’t just this value stock picker that he is widely portrayed as.  What he has built is far more complex than that.

In reality, he formed one of the original hedge funds (The Buffett Partnership Ltd) and used his gains to one day purchase Berkshire Hathaway.  His evolution into the value investor we now think of today has been long in the making.   Make no mistake, Buffett is a hedge fund manager.  Yes, he comes from the ilk of the oft vilified and awful hedge fund clan. Today, he hides behind the curtain of incorporation, but in many ways Buffett hasn’t changed one bit since his Partnership days.

Buffett Partners is particularly interesting due to Buffett’s recent berating of hedge fund performance and fees.  Ironically, Buffett Partners charged 25% of profits over 6% in the fund.  This is how Buffett grew his wealth so quickly.  He was running a hedge fund no different than today’s funds.  And it wasn’t just some value fund.  Buffett often employed leverage and at times had his entire fund invested in just a few stocks.  One famous investment was his purchase of Dempster Mill in which Buffett actually pulled one of the first known activist hedge fund moves by installing his own management at the firm.  Buffett the activist hedge fund manager?  That’s right.  He was one of the first.  Don’t let the folksy charm fool you.  His venture to purchase Berkshire Hathaway was quite similar.

Buffett likes for you to think that he just picks up an SEC filing, makes a phone call and seals the deal before he purchases a stock (and Wall Street wants you to think this as well), but Buffett is far more savvy than he leads on.   This is exemplified by the complexity of Berkshire Hathaway.  Berkshire Hathaway isn’t just your average insurance company.  The brilliance behind Buffett’s investment in Berkshire is astounding.  He effectively used (and uses) Berkshire as the world’s largest option writing house.  The premiums and cash flow from his insurance business created dividends that he could invest in other businesses.  But Buffett wasn’t just buying Coca-Cola and Geico as many have been led to believe.  Buffett was placing some (short-term AND long-term) complex bets in derivatives markets, options markets, and bond markets.   The myth that Buffett is a pure value investor is just that.  And it has been fed to the public hook line and sinker by people who entirely fail to understand Buffett’s genius, but benefit from an investing pubic that continues to pour money into the “hold and hope” myth.

Berkshire has grown into one of the most complex financial businesses in the world. The investment portfolio he has become famous for is the equivalent of just about 25% of Berkshire’s market cap. His most famous holdings (Coke, American Express & Washington Post) account for roughly 10% of the total market cap. Interestingly, two of Buffett’s most famous investments weren’t traditional value picks at all, but distressed plays. His original investments in American Express and Geico occurred when both companies were teetering on the edge of insolvency.  These deals are more akin to what many modern day distressed debt hedge fund managers do – NOT what Bill Miller and other “value” players do.

Make no mistake – this folksy frugal regular old chum is a killer businessman.  Just look at the deal he struck with Goldman Sachs and GE in 2008.  He practically stepped on their throats, demanded high yielding preferreds and the results speak for themselves.  Of course, the deal was described by Buffett (all smiles of course) as a long-term value play.  Right.  If this same move had been achieved by a distressed debt hedge fund (which is a role Berkshire often plays) reporters would have described the fund manager as a thief who was attacking two great American corporations while they were down.  But not Buffett, so long as he smiles, talks about Cherry Coke and makes himself sound like a regular old chum the public just smiles and looks for the next Coca-cola with the hope that they will be the next Buffett.  Send your stock broker a check, Warren still believes in America!

The statistics behind Buffett’s success and wealth are another thing altogether. Warren Buffett is an outlier amongst outliers. Whether his investment decisions are that of genius or pure luck is something I’ll leave to the expert statisticians.  What is undeniable is the myth that any small investor can become the next Warren Buffett by employing the techniques of Graham and Dodd.  If only it were that easy.

Perhaps most interesting in the many myths of Buffett is his involvement in the bank bailouts.  Clearly, Buffett had an enormous amount at stake in the financial crisis.  Despite his repeated condemnation of derivatives, Buffett actually has a great deal at stake in the derivatives markets.  In addition to the Gen Re business and the billions in options he has written on index put options, Buffett’s own portfolio and insurance business were at the heart of the crisis.  I think it’s a stretch to say that the solvency of Berkshire was at risk in the Fall of 2008, but just imagine how things might have unfolded if Goldman Sachs had indeed failed?  The dominoes in Buffett’s portfolio and behind Berkshire would have started to tumble quite quickly.  Something makes me wonder if the lore of Buffett would have survived without government aid.

Not surprisingly, Buffett had a hand in the bailouts (but don’t let the mainstream media tell you that).  During the height of the credit crisis, Buffett sent Hank Paulson an interesting letter which I have attached.  The letter is priceless.  Not only does Buffett again take potshots at hedge fund managers (those bastards and their fees!), but he describes personal conversations with Bill Gross and Lloyd Blankfein about how they would all contribute to the bank bailout.  Of course, Buffett was talking his book.  He knew what was at stake.  But it all makes me wonder – was the great Warren Buffett bailed out?  Did genius nearly fail?  Or has the myth of Warren’s genius failed us all?  I have no idea, but what I am certain of is that the media’s misportrayal of Warren Buffett has been astounding and perhaps even damaging to the small investor.

Warren Buffett is a great American and a great investor, but do your homework before investing in the stock market with the idea that you will one day sit atop the throne of “world’s richest man”.  It just isn’t that easy despite what Wall Street will have you believe.

The latest from Goldman’s Chief Economist, Jan Hatzius, is not exactly a ringing endorsement of the stock market (see their 2010 outlook here & their top trades for 2010 here).  Hatzius says the recovery is likely to continue to be very slow and that unemployment is likely to spike higher in the near-term accompanied by little to no inflation.  Hatzius claims that the second half recovery in 2009 was entirely driven by the stimulus and inventory restocking.  In other words, it is nothing to get excited about as neither are sustainable trends.   What concerns Hatzius most going forward are 5 continuing negative trends:

1.  Continued saving by households

2.  Weak labor income

3.  Fiscal drag from states and local governments

4.  Vacant homes and unused industrial capacity resulting in low private sector investment

5.  Limited credit availability

Although the labor markets are showing signs of improvement in recent weeks Hatzius sees a continuing “jobless recovery” and persistent weakness into 2011.  He is calling for a climb in the unemployment rate from the current level of 9.7% to 10.5%.  He continues to believe inflation will remain well below trend and that the Fed is on hold for the remainder of 2010 AND 2011.

Based on this data Goldman is now calling for just 1.5% growth in GDP in the second half of 2010.

JP Morgan continues to view the current market downturn as a buying opportunity.  Although they are paring back some near-term risk they also recommend that investors with a medium term outlook remain long.  This is very similar to my own thinking as of now.   Nonetheless, JP Morgan is not convinced that the sell-off is over in the short-term:

“We remain of the view that the recent sell-off is as a correction in a medium-term bull market in riskier assets, but a correction that is probably not over. We thus retain bullish medium-term forecasts for all risky assets, and bearish ones for government bonds.

Their medium term view remains quite constructive as they see continuing upside based on the economic recovery, strong earnings, and supportive government actions:

“Our still-positive medium-term view on risky markets is based on a solid global recovery and fading risks around it. Think of this as the mean and standard deviation of the growth distribution. Our growth view is itself based on strong corporate earnings and supportive government policies stimulating corporate spending on people, inventory, and capital.”

In terms of China tightening and the Greek debt problems, they say investors are overreacting.  That doesn’t mean fears regarding both won’t continue to hold down markets though:

“We believe markets are overreacting to the impact of Chinese policy tightening and the Greek fiscal situation, at least with respect to global growth. China is aiming to stabilize a red-hot economy and is using all the tools at its disposal. China has a good track record, though not perfect, in stabilizing its economy, and we thus are confident of success. This is not a reason to sell risk. Greece is the subject of a liquidity crisis, but is fundamentally solvent. There is pressure on other countries to tighten spending, but they are not large enough to drive the Euro area economy down.

The pressure from these two risks is unlikely to fade in coming weeks and will thus likely further depress risky markets, even as we do not rate them that highly as macro risks.”

In short, be looking to get long into weakness….

Source: JP Morgan

David Gerstenhaber is a former Tiger Cub and President of Argonaut Capital Management.   His distinguished pedigree is of the long line of successful traders that once traded under Julian Robertson (see Robertson’s guru outlook here).  His global macro strategy fund has never lost money since its founding in 2000 and has averaged an annual return of 19%.  What was a disastrous 2008 for most investors was another excellent year for Argonaut as Gerstenhaber guided the fund to a 12.3% gain.  In 2008 he bet big against high interest rates in the UK and shorted the British Pound in response.  Both were huge winners.  The pound alone fell over 25% in 2008.  He is well known for being a superb risk manager and has proven to be able to thrive in any market environment.

Although there have been signs of economic recovery Gerstenhaber hasn’t changed his bearish outlook all that much.  In a recent interview with CNBC he said we are in a “contained depression”.  He describes this as a period of very low growth and a jobless recovery.  Although it is not technically a depression it will feel very much like one.  He also believes the US consumer has been reset.  Thinking with regards to spending and speculation will never return to what it once was.

He reiterates a belief of our own that the problem of debt continues to hinder the global economy.  On the whole, the bailouts and government spending set a poor precedent.  He says this is particularly true in Greece.  While the bailout in Greece could be a near-term positive it is in fact a long-term negative and sets a very bad precedent.   I couldn’t agree more.  He says the Euro could remain depressed for an extended period of time due to this.  He also says the Eurozone is still suffering from a battle with deflation and it is likely to continue for the foreseeable future.

In terms of the U.S. equity markets Gerstenhaber now says the market is fully valued and that the easy money has been made.  He believes 2010 will be a very difficult year for equities as the U.S. government is making many of the same mistakes that were made in Japan.  He says that we settled for a “workout” period as opposed to taking our medicine or inflating our way out of the crisis.  This could mean years of sub-par growth.

The following commentary comes to us courtesy of Annaly Capital Management’s CEO Michael Farrell:

The title of my remarks today is taken from one of the most beautiful and mysterious passages in the New Testament, 1^st Corinthians Chapter 13, verse 12. “For now we see through a glass, darkly; but then face to face: now I know in part; but then shall I know even as also I am known.” In the context of the Biblical passage, the sentence implies that in the present we only can have an imperfect view of ourselves, as if we were looking at our reflection in a distorted and cloudy mirror, and that we will only have complete self-awareness in the fullness of time.  While we may have debates over how this applies in a theological context, I believe this concept of knowing the truth about ourselves now and in the future resonates in an economic sense as well.

In an economic context, this struggle for self-awareness is best summed up by Milton Friedman’s so-called Permanent Income Hypothesis, published in 1957, which in essence holds that people tend to make consumption decisions in the future based on what they consider to be permanent income today, and that any temporary windfalls, like lottery winnings, inheritances or checks from the government, will be disproportionately saved. Moreover, permanent income is based not just on current income but also on expectations for future income. Friedman concluded that lower wage earners, who typically have less transitory income, such as big bonuses or tax refunds, actually have a higher propensity to consume because their expectations can be more easily set by their current income. Higher income earners, in contrast, have a lower propensity to consume due to the more transitory aspect of their current income.

To me, in adapting Friedman’s permanent income hypothesis model to current economic conditions, the key determinant of consumption is an individual’s real wealth, as opposed to his or her current real disposable income. Even today, the vast majority of real wealth on the US consumer’s balance sheet is real estate which, in the post-War era, had generally always gone up in value. Permanent income is determined by a consumer’s assets; both physical assets like stock, bonds and property, and human assets like education and experience. The constant ebb and flow of these assets influence the consumer’s ability to earn income. Once a consumer makes an estimation of anticipated lifetime income, spending patterns emerge across the different needs and incentives available in the economy.

Today, this perspective on current income has proven to be nothing more than a reflection in a distorted mirror. While asset values were rising, households were fooled into thinking that the transient was, in fact, permanent, and they consumed accordingly. During Annaly’s earnings calls of 2005 and 2006 we discussed the larger market’s critical error in thinking that home price appreciation and improved debt service were the result of rising incomes and earnings performance rather than poorly underwritten liquidity in both the debt and equity markets.

As every American taxpayer knows, coming into 2005 the bulk of a family’s balance sheet was firmly entrenched in real estate.  For most of the past 60 years, the US more or less supported a home ownership percentage of about 60% of the population. In the misguided drive to give the incremental buyer the opportunity to achieve the American Dream, that rate was lifted to about 70%. Not by growing personal income, but rather through creative financing techniques, enhanced through the largest unregulated insurance market in the world, the derivatives market. Since rising incomes did not sustain the home ownership rate, rising risk appetites filled the gap, some by government policy and some by private sector actions.

To demonstrate the distortion that took place in housing, check out Figure 2.1 from the second edition of Robert Shiller’s book “Irrational Exuberance.” Shiller tracked down US inflation-adjusted home prices, building costs, population and bond yields going back to 1890 and it is clear from the data that the 21^st century bubble in home prices was caused by something other than supply-demand issues, income growth, expense increases or inflation. It came from debt formation.

Today, in the shadow of de facto unemployment rates of more than 17%, states and municipalities under growing pressure from shrinking revenues are raising taxes and slicing and dicing budgets across the country, impairing the long term growth of income. In the haste to stimulate a stuttering economy the Federal government is setting a course to further impair incomes as the need to service the sharply rising Federal debt will ultimately be met with frozen spending and then rising taxes and fees.  In 2005, we described the future crowding out of the private sector with the growth of public sector debt, and we illustrated its distorting effect on economic conditions in our first quarter 2009 earnings call, “You can’t always get what you want.”

The dark mirror of Friedman’s concept of permanent wealth is stunningly demonstrated when looking at the year-over-year change in real consumption and real wealth since 1960. As the graph suggests, it is difficult to make future consumption decisions when the present is so, well, impermanent.

The distorted mirror of flawed statistics that is driving current policy and the electorate’s disfavor with those decisions can be summed up by the election results since 2006. Even as recently as the Scott Brown upset in Massachusetts, the electorate is not voting for a party or an ideology, it is voting to throw out incumbents linked to years of juggled books and misallocated, debt-fueled financial decisions.

To draw the circle back to Friedman’s Permanent Income Hypothesis: The voters have looked at their balance sheet, seen their primary assets collapse in value and know that their future lifetime incomes are going to be impaired via higher taxes to pay for this mess. In short, they are voting with their pocketbooks. With a vengeance. Politicians and policymakers who recognize this and are willing to bite the bullet and align with these values, are the winners for the foreseeable future.

These are indeed changes of Biblical proportions, and the economic data are only darkening the looking glass. Last week’s GDP release was a top-line positive, but to me there are many struggles ahead of us. There are about as many people receiving emergency unemployment benefits, 5.7 million, as there are on regular unemployment. The average duration of unemployment is over 29 weeks, a post-war record. Real incomes are down from their 2007 peak. The housing market is truly on life support, with a vast shadow inventory of homes on the path to foreclosure waiting to hit the market and over 95% of all mortgages needing some form of government guarantee. Mortgage delinquencies are still rising and the newest wave of option ARM resets is due to rise throughout 2010 and peak in 2011. Debt deflation continues in all sectors but government debt. The FDIC stepped up its rate of bank seizures in 2009 and shows no sign of slowing down, and the bank sector as a whole is still playing defense. Their loan loss coverage ratios have fallen to about 60% from a historical average of over 140%, despite increasing their reserves, and they are now sitting on as much cash on their balance sheets as they have in C&I loans.  The mirror will become less distorted over time as the new statistics flow through the data to clarify the new decision-making processes and provide evidence of healing, but in the meantime it is going to be a long, painful adjustment for everyone.

In conclusion, this is not a pretty picture for our country, but it is an environment that rewards prudent balance sheet management and favors capital that can take advantage of debt restructuring and renegotiation and invest alongside governmental efforts to revive the economy.

Michael A.J. Farrell

Chairman, CEO and President of Annaly Capital Management, Inc.

February 3, 2010