For the first quarter of 2004 our average account appreciated +9.00%.
When you learn to fly a plane the first thing an instructor tells you is to always trust your instruments. Intuition will prove deadly if you follow it, and you will be tempted to follow it often enough. When flying through clouds or in the dark you are certain to have moments when you “feel” like you are climbing, but in fact are in level flight, or when you “think” you are making a left and you are indeed making a right. You must learn to trust that the instruments are accurate and intuition is not. There is even a ghastly expression, “controlled flight into terrain”, that is appended to accident reports to explain what happens to pilots who just “knew” they were climbing when in fact they were not.
You do not read these letters to get a flying lesson, and certainly not from us. But we have had our own slavish devotion to an investment principle that has proved very profitable, but is today making us feel queasy, and we are wrestling with “doubting the instrument.” For years now we have told you that the price of a stock was best arrived at by calculating a conservative estimate of its future spendable cash flows and discounting those sums by a present interest rate. Again and again we said nothing else mattered. We even went so far as to write you a letter, in the fall of 2001, telling you that the blazing conflagration at the end of Manhattan island scarcely mattered to the long term value of your stock portfolio, which seemed to be taking a good idea to the breaking point, even to us. The discount rate we always had in mind was a given; it was the ten year Treasury rate. Like an altimeter reading in a plane, it did not pay to question it. Now we wonder.
You may have noticed the prices of all sorts of things are climbing rather rapidly. The government says this isn’t so. This is not unusual. The great and unremarked conflict of interest in a citizens’ everyday life is that the same government that makes money gets to report on how well it is doing in keeping it valuable. If the private sector tried this, Eliot Spitzer’s office would be working double tides to put a stop to the creator and the critic being one and the same. Last quarter the government outdid itself. On the day it was meant to release the February producer price index, it produced nothing, claiming “faulty computers” were to blame for an unavoidable delay. This excuse had something of “the dog ate my homework” about it, even at the instant of its creation, but it is what came next that frightens. For twenty eight days, nothing came next. The price report was not released, the press barely noticed, and the bond market missed not a beat. To put a yardstick next to this strange behavior, an analogous private sector measure of commodity inflation, the CRB index, rose 11.2% in the quarter. Twenty years ago, when bonds yielded 15%, we owned a lot of them, and we can tell you from vivid recollection that the atmosphere before a price report was suffocating. Today, in the midst of rapidly rising prices, bond investors scarcely blink, while they accept a mere 4.25% for a ten year commitment of their money. Their insouciance is more than a little troubling, since whenever people get this confident they are almost invariably wrong.
Their compatriots in the money markets are even more silent, and more amazing. How is it that there are no marches being led from Florida retirement homes to the doors of the Federal Reserve Board in Washington? As a society we pay retirees nothing on their savings, and they seem mutely content. We have now seen six quarters of a Federal funds rate between 1 and 1 ¼%. As James Grant, of famed magazine Grant’s Interest Rate Observer puts it, “Why (is) an emergency level funds rate still in place without a visible economic emergency?” We have answers to this but none of them are good, and “politics” lies at the heart of all of them.
As investors, we need solid answers to what looks to be a preposterously priced bond market. The first one revolves around the piloting analogy; who are we to say the bond market is barmy? Sweeping market timing calls should be best left to damn fools.
However, even if we are willing to don our dunce caps and predict much higher bond rates, we are aware that being right too early is exactly like being wrong. The sweetest moment in an investment cycle is when real interest rates are negative and everyone affects not to know. We should point out to you that not only federal officials love to pull the wool over your eyes when it comes to inflation, but so do money managers. Every one of us loves to take credit for investment returns that are some part fake. Each year we report your returns on investment to you, and then run a table right under it giving at least two measures of inflation to compare it to. We never told you that for twenty years and more we thought the official statistics understated the real rise in the cost of a comfortable upper-middle class living. We should have, and now that the problem seems to be getting rapidly worse, we apologize.
While we are in this spirit of contrition we might as well come clean with the fact that we face two problems at once. A gathering inflation makes the discount rate we apply to an earnings stream much too low, and that is troubling. Even worse, our ability to predict that income stream also goes to hell in a hand basket, and that is really worrying. If you weren’t around for the last one, we can testify that inflation is very lumpy. Just because your costs are going up doesn’t mean you can necessarily raise your prices, and in the wild scrum to get resources managements can make all sorts of innocent decisions that wind up having malign outcomes. Inflation overturns every apple cart. John Maynard Keynes wrote eighty years ago, “The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” So much of the careful checking of corporate minutia that goes on around here will be a colossal waste of time if an inflationary storm gets out of control. Security analysis is painstaking work amongst stable prices, and very rough approximation in an inflationary storm. We are much “smarter” in the first case than the second.
At the end of a nice quarter with good returns it may seem odd that we take such a gloomy view. Also, we have not acted on these presentiments, and that is both because we do not know them yet to be actionable, or what actions exactly to take. But there can be little doubt that risks are rising and potential returns are falling. That is what happens when stocks outperform businesses. We are not getting giddy watching the stock market go higher, and we thought you should know that.
Sincerely,
Edwin A. Levy
Michael J. Harkins