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April 9, 2014

Dear Client,

For the first three months of 2014 our average account gained approximately +1.6%.

At the height of the financial frenzy in 2007, the Merrill Lynch seven year high yield index traded at a record low spread of 288 basis points over Treasuries
1.  Late last week that spread was 291 points over Treasuries.   How could credit market participants have learned this little?  We like to admit error in these letters as soon as we spot them, and for Levy, Harkins this one was a doozy.  To all of you who have read here or heard from us personally that the events of “The Great Recession” produced life altering changes in the way Wall Street does business---oops, we were wrong about that.  Mass unemployment, gigantic bailouts and public loathing has given Wall Street three hundreds of a percentage point of wisdom.  Indeed, this folly is even worse than that since absolute interest rates as a block are so much lower today than in 2007.  This means the losses to come are likely to be even worse than 2009 because now they are just junk and no high yield.  A month ago our beloved Akamai issued a convertible bond with a 0% coupon and a strike price at conversion 50% higher than the stock was trading.  It was oversubscribed and closed at a premium.  Who would accept that much risk for a 0% interest rate?  We are proud to tell you we do not know.  Who would want to admit they called that moron a friend?  We are going on about this at some length because while we are currently benefitting from these credit conditions and in many ways beyond just Akamai, we are also mindful of the risks involved.  The trick in great investing is never outperforming on the upside.  Everybody has those moments.  The trick is in not losing what you’ve made.  These letters have been unreservedly optimistic since the crisis.  Fear and great prices were going to make us a lot of money, and they have.  Consider this missive our first reservation.  We need to think about losing as well as making from here on out.  Yet the current moment may hold an even greater risk than foolish credit spreads.

Every two weeks Grant’s Interest Rate Observer lands on our desks, and the centerfold gets ever more salacious.  Here are some monetary growth rates:  MI has grown 12.8% in the last year, and for the last three months the annualized growth rate is 20.5%.  And the growth rates of high powered money, the reserves that in yesteryear would have meant inflation within 6 to 18 months was a certainty, is 33.5%.  This is properly thought of as seed money, though just how fast inflation grows after its planting is anyone’s guess.

Milton Friedman did not live to see this, and maybe that is a blessing.  Explosive monetary growth like this is not a stable circumstance.  Neither are madcap credit spreads.  So which are we meant to fear more?  Hard to say, but a little considered corollary factor is much in our thinking these days.  The U.S. government’s budget deficits are not much talked about these days.  They seem to have gotten better.  But we write “seem” so archly because any debtor can look like Mr. Universe when he can borrow at 0%.  How much pressure will there be on Janet Yellen never to allow interest rates to find their natural equilibrium if to do so will double or triple the deficit, necessitating harsh social spending cutbacks?  And this, to pay gargantuan sums in interest to banks with $2.5 trillion in excess reserves at the Fed.  The same villainous banks that set off the crisis in the first place.  Politically, can this be done?  Financially, can it be avoided?  This has been a very profitable run for Levy, Harkins and we think it will continue to be so.  But underneath, it feels like selling tickets to a horror movie.

Meanwhile, a long held thesis with us has started making us good money.  The energy boom continues in America, and almost only in America.  Canada has participated to a lesser degree, but that is it.  Considering that the world is made out of shale, the fact that no other country has so much as spudded a tight shale well is American exceptionalism at its finest.  Consider that American oil production is up 60% from the end of 2008, and the pace may even be accelerating.  The rest of the world stands mutely watching.  Amazing that.  Of course, in order to do it the citizens of Texas, North Dakota and Pennsylvania are making heroic efforts.  To get an extra million barrels a day out of their fields the Iraqis have needed about 50 wells.  So fast are the decline rates in American tight shale that the same million barrel gain takes a total of about 2,000 wells
2.   That is an awful lot of fracking sand, drill bits, pipe and pressure production.  It is also keeping U.S. Silica and Baker Hughes busy now and, we think, for years to come.  This is the biggest wealth creator to happen in our business careers, and that it goes on barely celebrated is odder than odd.  Maybe it has to get to California and New York before anyone notices.  Maybe Vladimir Putin has to wreck more havoc abroad before we can open up more production here.  Without for an instant endorsing Putin, wouldn’t the Europeans breathe a lot easier tonight if they were importing their natural gas from Louisiana instead of Urengoy?  Maybe this is our future.

As for our present, Goldilocks rules.  $4,186 trillion in money is precisely the right amount of money to give us 0% short term rates, and by happy circumstance that is precisely the amount of Bank Credit the Federal Reserve has printed.  But go back a few paragraphs.  Anything growing at a 33.5% rate doubles in two years and three months.  What then?  We’ll see.

1 The Financial Times
2 The Oil and Gas Journal

                                                                                                                        Sincerely yours,

                                                                                                                         Edwin A. Levy

                                                                                                                         Michael J. Harkin