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July 8, 2014

Dear Client,

For the first six months of 2014 our average account gained approximately +5.82%.

We wrote to you in our last letter that financial conditions were in a “Goldilocks moment.”  Not too hot, not too cold, but just right.  We had our eyebrows arched at the time, but now they are dropping back to their more familiar scowl.  The senselessness in the world’s bond markets has grown beyond exasperating.  Monday’s Financial Times reports that the government of Italy is $102 billion behind on payments to its suppliers.  The new prime minister admits this, admits that government had promised to get even by June 30th, but now allows that maybe December 31st is a more achievable date.  Then again, maybe not.  And the market yawns, with Italian yields at record low levels.  The rating agencies are equally blasé, this while some of Italy’s suppliers are filing for insolvency.  Anyone who has ever doubted the soporific qualities of very easy monetary policy on the financial world’s watchdogs now has his own tail between his legs.  That these sort of shenanigans are going on a mere 5 years after near catastrophe is amazing and appalling.  Shouldn’t we have had a Darwinian moment when the biggest fools in finance were driven out of the game never to return?  Seemingly not.

Of even greater threat both to you and to us is that the bond market’s numbness to risk has spread to the inflation readings.  The Consumer Price Index as it currently exists is either a nascent Saturday Night Live sketch or a Jimmy Fallon monologue.  It is no longer even remotely a description of average household, business, or endowment experience, Government is foolish to lie so blatantly as this, even if they are all so cleverly lowering their interest expenses, Social Security payments, and welfare disbursements in the here and now.  That is all well and good but, eventually the public twigs that it is being lied to, and then all hell breaks loose and the common man believes nothing they say from that point on.  We are thinking of starting a movement to replace the face of Benjamin Franklin on the $100 dollar bill with the visage of Richard Nixon.  It would make what’s coming next very much more open and transparent.

We are very proud of the returns we have produced for you, but we are also proud of the candor in these letters.  Money managers are all too perfectly willing to be complicit in the inflation lie.  It makes our returns look all the better.  But we want nothing to do with going along with that line of thinking.  You should look at what we have done for you so far this year with a jaundiced eye. Cut it in half if you want to know what you can spend without impairing your wealth, and you will be close to the truth.  And this problem is likely to get much worse rather than better.  We will leave it to the estimable John Crudele at the New York Post to take you through the details of just how the Census Department is fudging.  But a story this hot won’t stay in his hands alone for long.

So what can the holders of 2 ½ % Treasury bonds be thinking?  Are they thinking?  And the junk bond holders behind them?  They have so many ways to lose, and no possibility of winning.  Can you imagine Warren Buffett ever taking a risk like this without getting exorbitantly paid for it?  And at 2 ½%, there is no payment mechanism in place.

American Express, Qualcomm, Apple, Google, and Buffett’s own Berkshire Hathaway all have easy ways to implement strategies for dealing with five, ten, or even fifteen percent inflation rates.  They don’t have factories that are under-depreciated or inventories that can’t be replaced in a shortage.  This is what so exasperates us about the constant chatter about “an overvalued market.”  At 16.5 times this year’s earnings the S&P Index is a little pricey, but what of it?  You have the chance to preserve your wealth in stocks, and no chance at all in cash.  When the crisis started people were selling their stocks out of fear.  We wonder if before it’s all over people won’t be buying them in terror.  Last week the Daily Telegraph revealed that the average first time home buyer in London was paying 9 times his income on the average flat.  Run those numbers with any mortgage, tax, income and maintenance estimates you care to make and your eyes will start bugging out of your head.  This is what people will do when they are fearful that money is about to die, as Adam Fergusson so wisely titled his book on the Weimar Republic* .  Then remember British mortgage rates aren’t fixed like ours.  They float.  Blimey what a risk.

In this firm’s long history cash was our default position whenever we were unsure about what to do next.  Now we are unsure about that.  But we still believe we can profit from uncertainty.  So long as they keep their wits clear, investors have a better lot than any other segment of society, and we might as well make hay while this sun shines.

                                                                                                                  Edwin A. Levy

                                                                                                                  Michael J. Harkins
* "When Money Dies", Adam Fergusson, Public Affairs 2010