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| January 17, 2007 |
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| Dear Client, In 2006, our average account increased in value by +14.02%, inclusive of all fees. In as much as this performance was about exactly in line with our historical norm, it does not occasion much by way of commentary; it was an average year. Also, we have just moved offices, and if brevity were ever the soul of kindness, it is this week, when our staff has literally been dealing with work piling over their heads. In 25 years of writing these letters we have never printed a chart, mostly because we think “technical analysis” is Rorschach testing for the really dim; the process tells you far more about the analyst and his hopes than it does the analysand and its likely future price movements. But just this once we are going to break with precedent and show you what the U.S. dollar looks like to a Chinese saver. This is a picture of the Chinese renminbi over the last three years: |
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| Does this look like a stable relationship to you? We pointed out in our April letter how important this relationship was to American finances. The December trade report neatly illustrated the point, when 39% of our deficit was with China, 18% was with Europe and 14% was with Japan. What we find amazing, and perhaps alarming, is that everyone knows the price of the Euro, the Yen, and the pound Sterling, or at least where to find them, but all of the leading money managers and journalists we talk to pay no attention to the biggest trading relationship, and therefore the most important currency exchange rate of all. The Chinese don’t help matters by having two names for their currency, which they call both the yuan and the renminbi, seemingly interchangeably. The financial press pays rapt attention to every utterance of Federal Reserve President Benjamin Bernanke, and the popular press regularly styles him as “the second most powerful man in the world.” We demur. He isn’t even the most powerful central banker. That man is Zhou Xiaochuan, the Governor of the People’s Bank of China, who nobody has ever heard of, partly because he never gives interviews. We can write this with such certainty because the Fed’s balance sheet backs us up. In the fourth quarter foreign central bank holdings of Treasuries were double that of the Fed’s, and Mr. Zhou is the principle buyer. Now look back at the chart. He seems to be showing up later every night. What are his intentions going forward? Now we are really stepping into the world of speculation, because he rarely gives speeches to complement his no interview policy. However, we think his intention is to massage this rate gently lower for the next year and a half, at least through the August 2008 Olympic Games. Yes, you read that right. We know perfectly well that nobody but television executives and participating athletes care anything about the Olympics, in America. But in China, it is on everyone’s minds all the time. The Games will be played in Beijing, and they are so desperate to make a good impression, they are actively singling out industrial sites that are to be closed down a month ahead of time, so as to clean up the fetid air. The problem for Mr. Zhou, and us, is that he is not the only player in the game. Other central banks are voicing displeasure at how much of their currency holdings are in constantly depreciating dollars. Do these owners own too much to sell? People thought that way about high priced growth stocks in the early 1970’s, and it didn’t have a happy ending. In writing about this again for the second time in a year, we are not trying to pass ourselves off as China experts. But an obscure Chinese central banker could play an outsized role in all of our financial lives if one of three things happen. First, Chinese manufacturers do not have fat margins, so the prices they charge Wal-Mart and every other American importer are likely to climb quickly in dollar terms. Our authorities have been able to justify their absurd claims of low U.S. inflation by what goes on in big box retailers. When that changes, the U.S. consumer is going to notice it, and she isn’t going to like it. Next, the Chinese are not going to let their currency go up, and all others stay flat. They want to keep the American consumer as a customer, and they have it within their power to demand other nations revalue with them. The dollar’s decline, therefore, is likely to be near universal. Finally, Mr. Zhou could slip, meaning the dollar decline could accelerate so fast that American interest rates would have to rise enough to stop it. That would be unpleasant. They are all interest rate sensitive stocks in a currency crisis. So when does the tocsin sound, and what does its ringing sound like? We don’t know, and we know you are not paying us a fee just to read our worst fears in print. Worse yet, a strategy we once used quite profitably fifteen years ago, when we bought European bonds heavily, isn’t open to us again. Their interest rates are half what they were then, and their populations are imploding. This last statement is no exaggeration, as anyone who has read Mark Steyn’s new book America Alone can attest. The population of Spain, to take one example, is halving every 25 years. Their existing pension obligations, already onerous, are on their way to crushing. Bonds can’t be better than their underlying issuers, and while the Euro at the moment is stronger than the dollar, we aren’t about to take a flyer at these low interest rates on nation-states that are at the brink of, to use Steyn’s arresting phrase, “auto-genocide.” So what to do? Well, for now, mostly what we are doing. We own America’s biggest exporter, Boeing, and they are doing land office business with China; indeed, they are having banner years while barely ruffling the American plane market. We own Qualcomm, Nike, American Express, and Moody’s, and they are world beaters in each of their respective fields. Not to sound too much like Sally Field, but we really, really like our stocks. However, our average account is up over 85% in the last four years, and at the end of 2002 stocks weren’t exactly cheap by historical norms. Now they are not cheap by any norms, complaisance reigns, and investors’ expectations are starting to get outsized again. We have written time out of mind that the trick in investing isn’t in having great years when times are great. Anyone can do that, and it is what J.M. Keynes had in mind when he said, “Financial genius is a short memory in a rapidly rising market.” As we wrote you once before, “Compound interest works only if you have no big down years, and this we have avoided. Maybe this skill will come into play again sometime.” We wrote that in January of 2000, just before the dot com bust. We intend to keep track of the doings of Mr. Zhou, and perhaps plaster our own warnings on our new office walls. For now, though, we are off to a good start in 2007, and if Mr. Zhou can keep his juggling act going for another year and a half, we stand ready to applaud him. Our new space is still in the punch list phase, and while not yet ready for our close up, we’d still love to see you if you are anywhere near 45th and Madison someday soon. Sincerely yours, Edwin A. Levy Michael J. Harkins James B. Lebenthal |
| Levy Harkins Rates of Return Since Inception 1980 Rates are Compounded Rates of Return After Fees 2006……………………………………….……………+14.02% Last 10 Years………………………….….…………….+14.74% Since Inception 1980…………………………………….+14.6% NOTE: The figures above represent the composite performance of all fully discretionary, balanced accounts. These figures exclude accounts managed for less than 6 months, accounts using short selling and accounts consisting only of fixed income investments, to more accurately reflect the past performance of fully discretionary, balanced accounts. These numbers are after all fees. However, past performance is no guarantee of future results. |
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