JR Snell Capital Management, LLC

For months and months (or maybe even a year) I’ve been banging on the table about how I expect that a decent portion of account returns for 2010 might just come from long-term (20+ years) government bonds.

I anticipate that US Treasury securities will continue to be our baseline method providing the ability to persevere for the next who-knows-how-long.

and…

I would expect that between positioning in and out of Treasuries as appropriate and positioning in and out of equities as appropriate, our clients will continue to persevere… and quite possibly prosper.

You can read these quotes in context here. You can also review some of my other musings about the long US Treasury Bond “opportunity” here and here.

This is how we felt about long-term treasuries last year at Thanksgiving, from our post called, “Picking at Your Turkey”:

Following this premise, it wouldn’t hurt to accumulate some longer treasuries… like in the 20 year (give or take 5) range. I hear people whining about only getting 4.20% on a 20 year treasury… but I think if a person accepts what might be the ”new normal”… 4.20% might not look that bad, in hindsight.

We’re not married to holding on to the things for 20 years though. If we were presented with some outsized gains on our treasuries over the next year or two, we wouldn’t be afraid to take the profits and find a new home for the proceeds.

We are in line with mainstream thought in that we believe that bonds as an asset class (and specifically long-term government bonds) might be a good thing to have in your portfolio at most times. However, we depart from the mainstream because we do not statically allocate a portion of a clients’ portfolio to bonds and then hang on for hell or high water. Radically, we believe that there might be times when it is not a good time to make new purchases of the “long bond”.

And in a further logical departure from current financial dogma, we believe that there are even a few times where it’s in our best interest to actually sell them out of our accounts completely.

NOW WOULD BE ONE OF THOSE TIMES.

I usually write a letter to clients that we include with the quarterly performance reports that all clients receive. I believe, in light of recent market movements that this quarter’s letter might be of interest to a broader range of folks. Please contact us if you have any questions or you wish to begin our free Roadmap Analysis to see if you’re on track to meet your financial goals.

Dear Client,

To say that the last three months have been dramatic is to REALLY say something because it comes on the heels of a heart-stopping stock market selloff followed by a mind-bending reaction rally… the likes of which haven’t been seen since Herbert Hoover was in office.

And who could forget that that it has been only about a decade since the stock market last showed us it’s “teeth”? It’s certainly been an era to feel like one could easily get “bitten” as an investor.

Of course recently, just at the point that it feels like we deserve to have some stock and bond market stability, we are again subjected to the kind of volatility extremes that have been cropping up more and more often the last few years. Have we been shown that we’re only living in the “eye of the financial storm” at the moment?

The first quarter of 2010 seemed to come and go quietly as we moved toward ever higher highs. I jotted a web site update in mid-May as I noted that I was feeling a certain level of complacency creeping back in to investor’s attitudes about the markets. Since then I’ve also been reminded by a client of a web site update from February of 2009 in which I wrote the following…

At present, I’m thinking that we’re probably looking at some serious deflation for a while and then a very muted, long term half recovery that could stretch out to a decade or so.

This leads me to a place where cash is king at the moment for most of our money.

Fortunately, these things usually unveil in slow motion. So slow in fact that people begin to dismiss their earlier premises and question their previous conclusions even though they are probably still correct.

Could it be just that simple? Could it be that many investors have dismissed their earlier correct assumptions because it is all taking so long? Is this “thing” so massive and lumbering that it can only unfold in “slow motion”?

During the second quarter, the buzz suddenly became about sovereign debt, which we’ve known for a while was going to become a problem one day soon. It appears that “one day soon” might be nearer than we thought and the market has been asking the question, “If the rescuers need rescuing, who is left to bail out whom?”

The tacit assumption has long been that China will provide some base level of support for the balance of the world via overwhelming demand for everything in the face of an otherwise global economic slowdown. However, there’s been recent chatter about a growing housing bubble in China and speculation that this might just be “the other shoe” to drop on an otherwise fragile global economy, bringing Round Two of the Global Financial Crisis with it.

But it hasn’t been just the stock and the bond markets that have been particularly quarrelsome the past few years. It’s been downright difficult, if not treacherous being an investor in any arena. For instance, real estate did something that it has never done before: It decreased in value. Conventional wisdom had it that despite the leverage routinely used by real estate investors, it was still considered a “safe” investment because real estate prices have never, ever gone down… not even during the Great Depression. The only safe bet now is that investors will never look at real estate investments the same way again.

Other types of investments have all experienced similar difficulties: Private loans, small business loans, real estate loans and partnerships, even previously assumed long time successes such as Bernie Madoff and a host of other Ponzi-schemers that have all been discovered to be “swimming naked” the moment the money tide went out.

So, while the financial turmoil of the past couple of years wipes out or changes much of the world’s conventional wisdom, it also performs a “cleansing” that presents new opportunities with new players in a new financial landscape.

All of the turmoil of the past few years will one day pass and the opportunities will be there for those of us who refuse to focus on the past. We need to keep our focus on keeping our minds open to the new and different opportunities that most certainly will present themselves in the future… while persevering through the “creative destruction” that we find ourselves in the midst of today.

Our Current Outlook

Bill Gross of PIMCO (Pacific Investment Management Co) speaks of an economic era that we are entering that he is calling the “new normal”. In recent papers he has been going into great detail as to the justification behind his theory, but basically “new normal” means an extended period of sub-par growth throughout world economies.

A favorite theory being embraced by what I believe might be the majority of investors is this theory that some day in the not too distant future we will be wrestling with some significant inflation pressures… possibly even a stagflation situation (stagnant economy, rising prices).

Over the past year or so, I’ve been inclined to side with those that anticipate inflation, but now I am beginning to modify my view of our future world. I’m beginning to consider the possibility that our current Keynesian monetary policy of flooding the economy with money MAY NOT lead to inflationary pressures. After watching unemployment not respond to unprecedented government spending, and housing not respond to historically low interest rates, I’m starting to see the US economy and perhaps the world economy as a “leaky bucket”: We continue to pour more and more into the bucket, but it is leaking out just as quickly (or even more quickly).

What is the “leak” in the bucket? I believe the “leak” is the process of deleveraging… up and down the line… from the smallest of consumers struggling to pay off their JC Penney charge card all the way up to the nation of Greece struggling to pay down their country’s debt.

Until the world deleverages, nations can pour as much money as they want into their respective economies and still not see net economic gains. They can throw it toward bailing out the banks, or homeowners, or other countries. At the end of the day it is just moving it from one side of someone’s balance sheet to the other side of someone else’s balance sheet.

The only solution is time. We need time as individuals and as nations to deleverage ourselves. I’ve expressed my thoughts to many of you that our financial issues are “generational”… meaning that it will take a generation for them to work themselves through. For example, our exit from the housing crisis could come as a result of enough people walking away from their mortgages… but it will only transfer the debt to the bank and then to the government as the bank is again bailed out and then ultimately on to you and me in the form of higher taxes or an extended slow-growth economy. Another way to exit the housing crisis is to wait for enough people to have paid down enough of their mortgages to again be “above water” allowing normalcy to return to the housing market. I’m assuming it is to be a combination of both… but the end result is the same: It will take time. This is my version of Bill Gross’s “new normal”.

While one set of opportunities has been winding down for the last few years, a new set of opportunities has yet to reveal itself. This leaves us in a bit of a “no man’s land” in the investment landscape. But again, to simply persevere and avoid chasing “old” opportunities will insure our ability to take advantage of our as yet unseen future.

Specifically

I anticipate that US Treasury securities will continue to be our baseline method providing the ability to persevere for the next who-knows-how-long. I believe that part of the new normal involves some moderate level of deflation for the foreseeable future, allowing your purchasing power to increase even without any real investment returns.

I expect that we will continue to see extended and significant moves up and down in the stock markets… probably quite similar to what we experienced between the end of 2007, down to the March of 2009 lows and then up to the April of 2010 highs. Our opportunities in the stock market will come by accepting that there is a disconnect between the stock market and the economy and by taking advantage of the volatility that we are sure to experience because of it.

Although the market may show little to no net increase over the next decade or two, I would expect that between positioning in and out of Treasuries as appropriate and positioning in and out of equities as appropriate, our clients will continue to persevere… and quite possibly prosper.

As always, I am honored to be your guide through these historical times. Please feel free to call or email if you have any questions or need any assistance.

Jeff Snell

Managing Member, JR Snell Capital Management, LLC

Looking back over the last couple of months worth of posts, I’m thinking that it might appear that I’m a little opaque as to what areas of what markets you should be focusing on.

I’m not, so I’ll clear things up before I go AWOL for the week. First, understand that anything can happen over the short-term. What we always work on here in our laboratory is more macro-type thoughts for overall “big picture” positioning for ourselves and our clients. That’s what this is about.

[Sidebar... I think I might have mentioned that we are all about the "return of thought" when managing investments... That is, come up with a prospective course that we believe things will take and position for it. A little more active than reactive, and certainly not passive.]

If there’s no magic bullet or secret formula to this investing thing, the elephant in the room says that those investors who wish to survive (and thrive) in tomorrow’s markets might have to think for themselves (gasp)… or (at the very least) think for themselves enough to know they should hire those people who think for themselves.  – From “How We’re Fixing It”

First, the average inflation rate for the last 100 years or so is about 3.0%. The TIPS market (Treasury Inflation-Protected Securities) is showing the breakeven inflation rate at 1.9%… significantly lower than the 3.0% average. Translation: The market says that economic stimulus and other Fed stimulators (very low interest rates) will not work as planned… Translation: Extended period of very slow or non-growth. Translation: Buy TIPS because the treasury structured them to provide downside protection against deflation (which, of course the Feds assumed would never happen)… and this is really one of the very, very few investments that I can think of that offers this.

We’ve been buying the individual bonds for clients and mixing it up between 7 and 14 year maturities. If you can’t buy the individual things, you can consider the ETF (TIP)… This ETF makes sense for smaller accounts, but they have some additional internal management fees which is why we shy away from them in larger accounts

Following this premise, it wouldn’t hurt to accumulate some longer treasuries… like in the 20 year (give or take 5) range. I hear people whining about only getting 4.20% on a 20 year treasury… but I think if a person accepts what might be the ”new normal”… 4.20% might not look that bad, in hindsight.

We’re not married to holding on to the things for 20 years though. If we were presented with some outsized gains on our treasuries over the next year or two, we wouldn’t be afraid to take the profits and find a new home for the proceeds.

Dividend-spewing, old-line, consumer staples stocks look tasty for a couple of long-term reasons. First, we can get between 3 and 4% on many of these stocks (i.e. HNZ) and their business model isn’t so sensitive to the economic cycle.

Don’t get me wrong… anything and everything will go in the tank if the economy falls off a cliff again (people will even go without ketchup if things get bad). But generally, if our extended-malaise scenario becomes fact, then these consumer staples companies will still be chugging along same as always.

Just be sure to do your homework and feel comfortable that the stocks you’re choosing have low debt and decent enough margins to keep coughing up the dividend if things stay marginal for a long time. Email us if you need some help in this area.

Technically, in the stock market we’re acting a little short-term “toppy”… meaning it’s not a good time to be going after your favorite growth stock. Long-term? At the moment, none of the classic, fundamental, long-term stock market indicators are suggesting that now is a good spot to become a new “buy-and-hold” type of investor. Sorry. Be patient.

The upside to the “new normal” is that we can afford to be patient in the stock market. These days, nothing is going to run away from us for very long. No matter what the economy does, we still believe in volatility. Since volatility is how we’ve always made our money in the stock market, we still believe that there is money to be made in stocks.

As far as the thoughts of chasing stocks for fear of being left behind? We’re content to let everyone else risk heartburn while we just pick at the turkey.

Yesterday (11/19/09) on Capital Hill, Rep. Kevin Brady R-Texas got into a little a little “tiff” with Timothy Geithner (Treasury Secretary) during a Joint Economic Committee hearing.

It seems that Rep. Brady rankled Mr. Geithner a bit by insisting that he resign, blaming him for rising unemployment, growing federal deficits and accounting flaws in the number of stimulus jobs created, among other economic problems.

All of the articles that I’ve read about the exchange focused on how unusually forceful Mr. Geithner was and how hot the debate ended up getting. Included in most articles is this statement by Mr. Geithner:

“The economy fell into the worst crisis in generations after almost a decade — certainly, eight years — of basic neglect of basic public goods, in health care, in education, in public infrastructure, in how we use energy.”

Whaaaaaat?  I thought it was a credit crunch, lax regulation, an irresponsible banking system colluding with an irresponsible public piling on debt they couldn’t afford to buy things they didn’t need. Since when was the current economic crisis caused by not addressing health care? Or education? Or how we use energy?  That’s pretty far out there… even for you Tim.

Seriously, Timmy… If this is what you believe caused the economic crisis, then maybe you should step down. That kind of a statement is either simple felony stupid or reckless historical revisionism to get political points.

I was just reviewing and reorganizing my “…for further study” page and I tripped upon this quote. I had to post it again because I am still baffled and befuddled by what this means.

Maybe what it means is what he says? Is it even reasonable to postulate that our current economic conundrum is the simple result of one man’s mistaken economic theory? Could it all be that simple? 

REP. HENRY WAXMAN (D-Calif.): And my question for you is simple: Were you wrong?

ALAN GREENSPAN: And what I’m saying to you is, yes, I found a flaw….a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.

REP. HENRY WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working?

ALAN GREENSPAN: That is–precisely. No, that’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.

Occassionally, for one reason or another I’m forced to take a moment and tame some of the squirrels that are running on the treadmills of my mind.

My most recent session was prompted by a friend who wrote me an email asking about an article she’d read. The article discusses the French Revolution and how the government ran their printing presses churning out money to the point that it destroyed their economy and precipitated a revolution.

Actually, rampant inflation is just about the one thing that the common folk just can’t take. Not only did revolution in France present the opportunity for Napoleon to jump onto the world stage, a similar situation in Germany after World War I put the German economy in such a rotten place that Hitler’s promises of prosperity at any price resonated with a desperate populace.

So, yes I think by trying to print ourselves out of the current crisis we might be putting ourselves in a precarious position… but I differ a bit from the article because I think we will probably recognize this as our next problem before anyone goes to the guillotine. The next solution becomes to raise interest rates and keep them elevated for an extended period.

I imagine that this will be necessary, but in the process it will dampen our future economic prosperity for a very long time to fight some very stuborn inflation. I feel certain that our leaders will choose this option over revolution.

Anyway, here’s the meat of my reply to her email:

Interesting… Obviously, I’ve been a huge fan of cash the past 16 months or so! It’s funny also because adding TIPS (inflation protected treasuries) is a part of my “Going Forward” plans that I’m presenting to clients next week.

As for gold… Well, I just can’t quite stomach it at $1000 per ounce… I’m feeling it’s a bit like oil at $145 per barrel last summer. Everyone said it was easily going to $200.

I look to implement a lot of the ideas from the article.  But I’m hoping to do it in a manner that doesn’t just kill my client’s prospects forever if we are wrong. Everyone’s uncomfortable right now and maybe even a little bit scared, so I don’t want to do anything too radical, no matter how rational it sounds at this moment. Sometimes these decisions and rationalizations that are made during very turbulent times end up being huge mistakes and we look back and can’t imagine how we thought such thoughts.

So, I’ll march forward incrementally. At present, I’m thinking that we’re probably looking at some serious deflation for a while and then a very muted, long term half recovery that could stretch out to a decade or so.

This leads me to a place where cash is king at the moment for most of our money. But, somewhere in the future there is going to be the opportunity, as interest rates rise, to buy these TIPS and hunker down for the possibility of some real ball-busting inflation.

Fortunately, these things usually unveil in slow motion. So slow in fact that people begin to dismiss their earlier premises and question their previous conclusions even though they are probably still correct.

As an example, I thought the housing market and the stock market were overpriced going back into late 2005. But, after another year-plus of both markets continuing to escalate, it was only reasonable that I doubted my own previous conclusions. I was right, but early. Being too early is the same as being wrong as far as our pocketbooks are concerned and I was on the edge on this one. Honestly, it coulda’ gone either way.

So this is kind of my big-picture picture. What I don’t say in the above letter is that while the economy may stagnate for the better part of a decade or more, I firmly believe that the stock and bond markets will experience continued strong rallies and significant selloffs. It’s not a longshot bet that the stock market will end up right where we are today in another decade or two.

If that’s the case, I wouldn’t want to be a “buy and hold” investor, but if you’re willing to be nimble and cynical, there’s a lot of money to be made during this whole period of economic malaise. If you need an historical precedent, go back and look at a chart of the market during the Great Depression after the initial, monster selloff. What a great time to be an investor with actual cash!

All we have to do is have some cash left at the end of the monster selloff that we find ourselves in today.

A couple of months before I started writing blog entries, I “looked into the abyss” on my own personal trading screens here at the office.  It was mid-September or so, right after the Fed let Lehman fail and before the significance of what just happened was really felt by anyone but a few… yet.

Early the morning of the 15th of September as I look at my screens, I’m thinking that I’m seeing a “blip”… you know, a data error, an internet outage, the ghost in the machine… whatever.

Specifically, what’s confusing is that the couple of trust preferreds that I follow (like bonds, but traded on exchanges in $25 hunks rather than the off-Broadway $1000 chunks that a regular bond trades), traded at around $15.00 or so a minute ago and now many of them are now being “bid” at an odd $.50 or so. For a few minutes, I thought the system totally freaked. After a while the 50 cent bids finally were replaced by 3 to 5 dollar bids… then up to about 7 to 8 bucks… finally settling in at about two-thirds of what was bid the day before.

Of course today, I now know it wasn’t the ghost in the machine… it was the abyss. I had looked “over the edge”. I had seen the financial “white light”.

And apparently Hank had seen it too. He met with Congress, made the talk show rounds (white as a ghost, btw) and said SOMETHING to Congress and they gave him the money. So, what was the SOMETHING that scared him so badly?

OK, so thanks to Representative Kanjorski of Pennsylvania (maybe he was talking out of school??), we’ve got a pretty decent idea what happened that day. He says that…

“On Thursday, September 15, 2008 at roughly 11 a.m., the Federal Reserve noticed a tremendous draw-down of  money market accounts in the USA to the tune of $550 Billion dollars in a matter of an hour or two. Money was being removed electronically.

The treasury tried to help with $150 billion. But could not stem the tide. It was an electronic run on the banks The Treasury intervened, but, had they not closed down the accounts, they estimated that by 2 p.m. that afternoon. Within 3 hours. $5.5 trillion would have been withdrawn and collapsed within 24 hours the world economy.”

Watch the video, his explanation starts at about 2 minutes and 20 seconds into it. I also double-checked some additional congressional testimony tapes where Rep. Kanjorski questions Mr. Paulson about this very thing because I didn’t want to foist some “conspiracy theory” crap off on my loyal readers. In the tapes, Mr. Paulson does not deny what happened.

[[He also mentions that there was only the 'lone gunman' and there was no alien autopsy.... Sorry gang.]]

Now we know.

Should we have an opinion about the stock market, or even about the direction of the economy? Is it important to set a firm course of action based upon our expectations of what we think will occur in the coming months?

Most readers when asked, would think these questions a bit silly. They’re a bit silly because everyone “knows” you must have an opinion to be a successful investor. Or do you?

Of course, being who I am, I would tend to think just the opposite. Did you ever think that the investors who have a firm opinion about what they believe will occur in the future are taking a risk with their flexibility? They’re messing with an essential investing skill that is the ability to change and adapt to a very fluid and dynamic situation?

Take, for example the annual Barron’s survey from a year ago about what 12 prominent strategists thought would be the course of the economy and the market for 2008. First, not a single one of them predicted a recession even though we were already in a recession at the time of the survey (December 2007). Second, their ending estimates for the S&P 500 were between 1525 and 1750. The S&P 500 closed 2008 at 903.25. That’s an embarrassingly huge miss!

Rather than throw these collective strategists into the “idiot-pile” for their lousy foresight,  I’m more inclined to think them fools for even attempting it. And so publicly too! Oops.

Of course, it would be a bigger shame if they managed or advised others based upon an unflinching adherence to their predictions. That’s a portfolio-wrecking miscalculation and strategy. And this isn’t just one “strategist”… it’s all of them.

So, it’s pretty obvious that it’s a fool’s errand to try to predict the future for any reason, let alone the stock market. This is why it doesn’t matter what I think about the future. The good news is that when I’m stacked up against some of the greatest economists in the world, I figure I’ve got about the same odds as them as being right. The bad news is that those odds are somewhere between slim and none.

What to do?

I think that it is more important to imagine a number of potential scenarios and their corresponding courses of action. From this brainstorming session, you could put together a number of “if-then” statements, much like a computer program would be written. Then you can develop a written plan for the future of your investments in a sequence of decision statements. Maybe a statement would go something like, “If interest rates decrease to below 2%, I will sell my Treasury bill investments.” [This is not advice, only an example.]

As I advise clients and manage portfolios I’m always playing this little “game” with myself. I never make an investment for myself or others without an “if-then” rundown… and right now I’m playing it with the stock market.

Here’s the playbook from my mind at this moment:

1. IF I see that a short term rally is developing, THEN I will invest about 50% of my clients’ growth stock capital.
2. IF any of these stocks loses 10% of their value, THEN I will liquidate the position.
3. IF any of these stocks gains 30%, THEN I will exit the stock and take my (our) profits.
4. IF I see that the rally is coming to an end, THEN I will sell any of these new positions at the slightest weakness.
5. IF I see that the short term rally has turned into a new Bull market, THEN I will commit the second 50% of my client’s growth stock capital to the market.

For the record, I’m still waiting for #1 to be True. I have some other “if-thens” that I’m playing with Treasuries, Investment Grade Bonds, our Utilities Select Strategy and the Dogs of the Dow Plus Strategy but I don’t want to annoy you with the incessant squeaking from my mental squirrel cage.

Last night’s treasury auction demand was so high that investors bid the rate negative. There’s a solid rundown of the situation here.

According to Bloomberg, If you invested $1 million in three-month bills at today’s negative discount rate of 0.01 percent, for a price of 100.002556, at maturity you would receive the par value for a loss of $25.56. 

Deflation impacts everything

As if it wasn’t easy enough to lose money in the stock market, now you’re guaranteed to lose money in short-term treasuries! I’m not sure that this is what everyone has in mind when they talk about Treasuries being “guaranteed” investments.

For those worried about the possibility of deflation, this should be a little reality check… It’s heeere. The point at which people are willing to PAY money to lend it should be a sign that maybe a huge contingent of very smart folks think that cash will be worth more in the future than today.

Here’s other evidence…

• Stocks? Deflated… down 40% or so, depending on the day.
• Real Estate? Deflated… down 20%-40% depending on where you’re looking.
• Gold? Deflated… It’s an inflation hedge and it’s down 20% plus recently.
• Oil? Deflated… down around 70%
• Garbage? Deflated… Don’t laugh, it’s true. They’re calling it the “Trash Crash”!

The Trash Crash? Yes, mixed paper has dropped to $20 to $25 a ton from $105 in October, tin is down to $5 per ton from $327 a year ago, cardboard that sold for about $135 a ton in September is now going for $35 a ton, plastic bottles have fallen from 25 cents to 2 cents a pound, aluminum cans dropped nearly half to about 40 cents a pound, scrap metal tumbled from $525 a gross ton to about $10.

Ouch… throw in the fact that most larger US cities have recycling programs whose costs are offset by what they get for the recycled material, and you’ve got another municipal owie to deal with.

So, yeah… wake up… deflation’s here, now, already. Rather than fret about it, I’m going to focus my energy with my clients and on this blog putting forth and implementing strategies to deal with it and maybe profit from it. I’m interested in now trying to detect if we’re in for an extended period of deflation or and what signs will I need to see that shows us the trend is reversing?

For now, I’m thinking about selling off about $4 million in 3 month Treasuries that I bought for clients about 2 months ago. They’re selling very near face value a month before maturity. Who’d a thunk it?