Barron’s ran a piece on MLPs (Master Limited Partnerships) over the weekend. Regular readers of our research will know that we have long liked the sector and of course run an MLP strategy. Finding sources of investment income while avoiding the tyranny of conventional bonds manipulated by government intervention is what we do, and MLPs fit with that approach.

The article was positive but nonetheless balanced (at least in my opinion). We’ve avoided MLP funds (such as closed end funds, ETFs etc.) for many reasons, including tax-inefficiency and leverage (investing with leverage is something we avoid). The article made the case for MLP funds in retirement accounts and for smaller retail accounts, and while there’s no reason to contradict what they wrote it remains true that direct investments in MLPs are the most tax-efficient way for high net worth clients with, say, $500K and up to access the strategy. It’s worth reading the article.

Greece is seeking a two year extension of its latest austerity program, arguing that the additional time would improve its chances of ultimately bringing its debt down to a sustainable level. This is hardly news. Many observers had already concluded that the latest plan was as unworkable as prior ones. But it does illustrate that the inconclusive, status quo can persist indefinitely. As with the penalties envisaged in the Maastricht Treaty that ushered in the Euro, fiscal penalties on sovereign states are a nuclear option and as such are only valuable until they’re used.

While many analysts have forecast that Greece will either be dumped out of the Euro or will leave voluntarily, regardless of who initiates such a move the consequences are huge and unpredictable. As long as neither side miscalculates, it’s quite plausible for this seemingly perpetual round of renegotiations in which the Greeks seek forms of debt forbearance but stop short of provoking the EU to kick them out and the Germans keep squeezing but stop short of driving them out. As unsatisfying as this may seem to an outsider, why would it ever end?

By reducing the odds of an imminent Euro disaster it makes equity markets somewhat less risky, and bonds less attractive. Of course we still have to contend with the looming fiscal cliff in the U.S., a potentially far more damaging event for the U.S. economy and one whose resolution has been pushed off to a post-election lame-duck Congress with highly unpredictable results. Whatever your political leanings, virtually everyone must agree that this is an abrogation of responsibility by America’s leaders.

Last week’s Knight Trading (KCG) disaster marked the first time that I can recall when a software glitch actually threatened the surivival of a public company. In recent years computer technology has played an increasing role in the functioning of the equity markets, and KCG’s mis-hap was preceded by the Facebook (FB) IPO mess and the Flash Crash in May 2010. And based on the terms of the $400MM in new capital KCG raised, such that the new investors will own 70% of the company at $1.50 a share, prior KCG investors are all but wiped out compared with the $12 price of recent weeks.

We’ve never considered investing in KCG, but investors might be forgiven for not having contemplated their exposure to bad implementation of a new trading system. KCG’s most recent 10-K is lighter than most in its list of Risk Factors, containing seven although they’re all important. Operational Risk is the relevant disclosure, “…from major systems failures.” which would seem to incorporate what happened. As well as raising further questions for regulators about how well they monitor the increasingly automated activities of the public markets, it also highlights the need for investors in such business to achieve greater comfort around “IT competence” when they invest in such companies.

In late July I had the opportunity to present the ideas in my book, The Hedge Fund Mirage, at the CFA Institute’s Financial Analysts Seminar in Chicago. Flying to Chicago for the day afforded me time to catch up on some reading, and some new ideas.

From time to time we’ve written about the Equity Risk Premium and how it makes stocks a far better investment than bonds. The earnings yield on the S&P500 (which is the inverse of its P/E) is around 7.6% (consensus earnings of $105 divided by current S&P500 level of 1,385). Ten year treasury yields are 1.5%, so the resulting 6.1% gap was last this wide in 1974 following the Yom Kippur War, OPEC oil embargo and rampant inflation. Or to put it another way, as we’ve written before, it only takes $22 invested in the S&P 500 (yielding around 1.9%) to generate the same after-tax ten year return as putting $100 in ten year treasuries (all assuming unchanged dividend yields and 4% annual dividend growth compared with a 50 year average of 5%). The remaining $78 of the $100 could be left in 0% yielding cash and the Math still works. This is how expensive is the relative safety of fixed income. To describe bonds as being for wimps would risk provoking the Market Gods to swiftly prove otherwise, so I won’t go that far. But they are for those willing to accept a guaranteed loss of real wealth after taxes and inflation.

However, the Equity Risk Premium has remained more or less historically wide for some time, and it’s not exactly a secret. Martin Brookes and Ziad Daoud of Fulcrum Asset Management, recently offered a possible explanation. In a paper titled “Disastrous Bond Yields” reported in the Financial Times, they construct a risk/return framework for investors that extends the more normal economic state of two scenarios (expanding or contracting economy) to include a third (“disaster”, a “large decline” in GDP). Such disasters were far more common prior to World War II, and the authors theorize that the subsequent 60 years of comparative serenity caused investors to undervalue the safety of government bonds in such cases, an oversight we might now conclude has been corrected. To the layman, people are scared. Or, as a retired bond trader and friend of mine observed recently, investors are not buying ten year treasuries because they think they’re a great long term investment. I won’t do the paper justice here and it’s worth reading, for the authors go on to show that at a certain tipping point of economic distress the credit risk in government bonds overwhelms their safety. Empirically, when the default probability of a country exceeds 3% its bonds and stocks start behaving far more alike as correlations flip from negative to positive. Greece, Spain, Italy and (interestingly) France have all crossed this threshold.

At the CFA event in Chicago my presentation directly followed that of Professor Robert Shiller, author, Yale professor and co-creator of the S&P/Case-Shiller Home Price Indices. Clearly my inclusion showed the organizers’ flexible standards on speaker selection. Professor Shiller spoke about his recent book, “Finance and the Good Society”, a review of which I had coincidentally just read on my flight. The book makes the case for the benefits of financial innovation to broader society, a lonely position given recent history. One novel idea was that the Federal government should borrow money by issuing securities whose coupons are directly linked to GDP. Specifically, one such bond would pay annual interest equal to one trillionth of GDP, or about $15.09, hence the name “Trills”. I thought it was a clever idea; many investors would surely find use for a security tracking nominal GDP, and while the government’s cost would be pro-cyclical (i.e. fall when the economy’s contracting) it would be less volatile than if the Treasury issued exclusively short term treasury bills and would also provide an inflation hedge to investors. Of course, Professor Shiller noted that TIPS (Treasury Inflation-Protected Securities) were first suggested about 100 years before they became reality so we shouldn’t expect to see these novel securities soon. But I thought it was an intelligent suggestion.

One new idea would be for Congress to resolve the looming “fiscal cliff” before the election, thus acknowledging the supremacy of the economy compared with their respective campaign plans. But any new idea I suggest here will be too dripping in sarcasm to be serious. Suffice it to say that, as we sit here watching the weeks tick by to November with no pre-election solution in sight, it is with a feeling of stunned amazement that we regard the oblivious disregard of Congress for the private sector. Planning for 2013 hiring and capital spending decisions takes place well before the lame duck Congress will limp back to Washington DC in mid-November. Anecdotally, companies are increasingly curbing their long-term commitments until fiscal policy becomes clearer. While we don’t try and time the markets, many companies’ quarterly earnings have shown very weak European demand across varied products and services and a cautious outlook globally. In our Deep Value Equity Strategy cash is a relatively high 10% as a few names have reached price targets we felt fairly reflected their value.

MLPs had a nice month in July following six months of zero total return. The sector had become steadily more attractive as we noted last month, and July’s results made up some lost ground. We think MLPs  remain attractively priced with distribution yields still above 6%.

As we head towards another deadline for Greece, during which they must convince the troika that austerity is on track, there is growing speculation that Greece may be forced out of the Euro. A “Grexit” to use a popular term.

Well, maybe, but here’s why it’s not inevitable. First, from Germany’s point of view, Greece’s presence in the Euro isn’t the real problem; it’s the money Greece owes. In fact, Greece’s recession is if anything creating downward pressure on the Euro which helps Germany’s exporters. The notion that Germany may force Greece to leave the Euro is based on the flawed assumption that this would be in Germany’s interests. No doubt popular opinion in Germany may be moving in that direction, choosing to “punish” the profligate Greeks for their poor budgeting skills. But leaders in Germany must know that such a move would be their “Lehman moment”. The risk of contagion swiftly moving to Spain and Italy would be such that perhaps as much as 1 trillion Euros might need to be available to support those countries’ ongoing borrowing needs. Untold additional dominoes might fall. It’d be a foolhardy German government that contemplated such a move.

Moreover, the instant Greek default on their cross border debts which would immediately follow their ejection would hurt their Euro-zone creditors including Germany. Indeed, the ECB itself might need to be bailed out. So there seems little point in kicking Greece out of the Euro while they still owe any significant sums to other Europeans.

For Greece, while a New Drachma may appear an appealing way to generate inflation and allow a drop in living standards to create a more competitive economy, introducing a new currency over even an extended bank holiday is a daunting task. A well run government bureaucracy like Germany’s would be hard pressed to pull that off. Greece is not Germany. It would be a disaster. In fact, for Greece their interests are best served by continuing to negotiate for an ever decreasing debt burden. Regular brinkmanship around austerity targets and the next release of EU/IMF funds is becoming their strategy. It can continue to work as long as the promise of some ultimate repayment is sufficient to outweigh the risks to Germany of kicking them out.

But Greece has an additional option, which is a stealth devaluation. The government could start paying its bills in IOUs, as California has done in the past. The IOUs would promise to repay the holder in full in five years in the then prevailing currency. These IOUs would of course trade at a discount to face value, but over time the Greek private sector’s holdings of these would grow as their government issued more of them. Their discount to par would no doubt fluctuate with the odds of Greece staying or leaving, but over time as the discount stabilized and their volumes grew the “New Drachma Notes” as they might be dubbed, would provide visibility around the type of depreciation the New Drachma might suffer if it replaced the Euro. In fact, it could co-exist with the Euro, but by creating a plausible alternative currency that was slowly introduced over 2-3 years through the Greek government paying its bills, it would improve Greece’s negotiating stance with the troika and perhaps allow them to achieve greater debt forgiveness than would otherwise be possible.

The Greeks have played a weak hand pretty well so far. Their forced exit from the Euro needn’t be as inevitable as it might appear.

On Wednesday the Federal Reserve released their third set of detailed interest rate forecasts this year. Following Ben Bernanke’s philosophy of open communication, the FOMC publishes forecasts for short term rates from each voting member. While they don’t link a name with each number, you can see what members expect short term rates will be at the end of this year, 2013, 2014 and over the long run (whose start is not defined).

In effect you can construct a crude yield curve incorporating their collective outlook. Comparing their yield curve with the market is fascinating, although market yields and implied rate forecasts have been steadily diverging from those issued by the Fed. In fact, the Fed’s own forecast has been remarkably stable even while ten year treasury yields have traversed a 1% range reaching 2.5% before falling recently to 1.5%. The chart below is derived from the average of all FOMC member’s rate forecasts at year-end. So there’s a clear discrepancy between the Fed’s statement that short term rates will remain low through the end of 2014 and the six FOMC members who expect rates to be higher (three of whom target hikes as soon as next year). At the same time that the Fed extended Operation Twist to the end of this year, they reaffirmed that the long run equilibrium short term rate is around 4%. Long term bonds continue to trade at yields that defy that forecast. The Long Run is still some ways off, but today’s bond buyers are fairly warned.

There is growing evidence that the “Fiscal Cliff”, looming in January 2013, will take a toll on the economy before its arrival. Although reports suggest that both parties are discussing a resolution to the sudden tax hikes and spending cuts that will take place under current law on January 1st next year, there’s little tangible evidence of such. There is growing evidence that companies are managing their businesses by incorporating this uncertainty into today’s spending decisions. It occurs to me that, while most economic forecasts project a substantial (3%+) GDP hit in 1Q13 IF no action is taken, few have considered that waiting until December’s lame-duck session of Congress to do the inevitable is quite likely to depress growth in the meantime. The non-partisan view surely blames both sides for placing the purity of their own political beliefs ahead of the pragmatism of removing at least one element of uncertainty.

The comments from many Congressmen that the planned tax hikes and spending cuts will assuredly be rolled back would be more credible if they didn’t insist on waiting until the last possible moment do do so.

For our part, we remain generally fully invested across our strategies. Owning steady, dividend paying stocks combined with a beta neutral hedge provides an uncorrelated source of return while markets are being buffeted around. Our most recent decisions have been to exit the last remaining shares of Family Dollar (FDO) which no longer provides compelling value given its recent increase in price. We have added modestly to Coeur d’Alene (CDE) which recently announced a share buyback given the large discount of its stock price to the estimated net asset value of its gold and silver reserves.

We have largely exited the short Euro position which has been held in our Fixed Income strategy as useful protection for the holdings of bank debt (given their equity sensitivity). It worked well for quite a while, but a few weeks ago I heard a reporter from the New York Times confidently announce on a radio interview that the Euro was going down and Greece would soon exit. Short Euro is probably too widely held, and isn’t that interesting any more.

Disclosure: Author is Long CDE

The Equity Risk Premium has once again drifted up to all-time high levels in recent weeks. The S&P500 has an earnings yield of around 7.9% (assuming S&P earnings of $105 versus current price of 1,330). Ten year treasuries are 1.6%, so the resulting 6.3% spread is back at levels not seen since the early 70s. Yields remain excessively low; JPMorgan pointed out this weekend in their Global Data Watch publication that the yield curve implies negative real rates on government debt going out for ten years, an outcome outside even the experience of Japan. Whatever you think of stocks, bonds have to be a worse bet.

The Math is as follows: a 1.9% dividend yield on the S&P500 will, assuming 4% annual dividend growth (the 50 year average is 5%) deliver almost five times the return as ten year treasuries – assuming (perhaps crucially) no change in dividend yields in ten years. Or put another way, the holder of ten year treasuries could sell them, place 22% of the proceeds in stocks with the rest in riskless/returnless treasury bills and get to the same place, with 4/5ths of his capital available for other opportunities.

Once you figure in taxes (35% on treasury interest versus 15% on dividends) you only need put 17% of the proceeds from selling the treasuries into stocks. This is how distorted bond yields are – and they’re likely to remain so. Recent weakness in economic data, most notably the June payroll data, may result in further Fed buying of long term bonds. They wouldn’t recommend you do this yourself, as I wrote some weeks ago. The Fed is relentlessly driving the return out of bonds.

Investors have good reason to be cautious. This weekend’s Spanish bank bailout seemed inevitable and also inconclusive at the same time. Few believe the Euro’s fundamental problems have been solved. At the same time, in the U.S. current law requires a series of tax increases and spending cuts starting on January 1. The so-called “fiscal cliff” is estimated to be as much as a 3% hit to GDP and an instant recession. Few believe this will actually happen, reasoning that Congress will roll everything back another year and rely on the 2012 election results to settle the fiscal policy argument once and for all. However, while it seems sensible to assume Congress will act in this fashion, there seems little urgency to do so until the lame-duck session following the November elections. Meanwhile, hiring and capital expenditure decision that rely on some reasonable assumptions about positive GDP growth next year are increasingly at risk. One thing on which supporters of both parties can surely agree is that leaving resolution of near term fiscal policy to so late in the year is irresponsible. The Price of Fear is set in part by our elected representatives in Washington, DC.

Our most recent investment has been to increase our position in Coeur d’Alene. Based on our analysis we think it’s valued at around a 30% discount to the net asset value of its reserves, in common with most miners. Having some exposure to gold and silver at a discount is one way to protect against higher inflation, since that will increasingly appear an attractive solution for most people’s problems (there are more debtors than creditors in the world). In addition, CDE recently announced a stock buyback of $100M< around 6% of their equity market capitalization.

May 17^th, 2012 was the 30^th anniversary of my arrival in the U.S. On that day back in 1982 aged 19 I arrived for the first time in New York City fully expecting to be mugged as soon as I stepped off the plane such was the city’s reputation at that time. Although I grew up in England I had spent Summers in Toronto with my father as a teenager and the contrast between middle class North American life and strike-plagued Britain in the 70s could scarcely have been sharper. The IMF had come to Britain’s rescue while I was in school, and gloomy prognostications on the economy were the norm. America was dynamic, exhilarating, the world’s focal point in so many ways. I concluded that the future lay west, and New York’s financial markets drew me here. I needed to move to the U.S. more than anything I’d ever wanted – like all immigrants, I found a way to make it happen. I was part of the biggest wave of immigration the U.S. had seen since the huge influx of new citizens leading up to World War I in 1914. I became a permanent resident in 1985 and a citizen five years later, the shortest possible route for one with no family connections or refugee status.

During those thirty years I have never once doubted that I made the right move. The passage of time has balanced my perspective; London’s a great city too, and I’m very proud of my English heritage. While I doubt I’ll ever live there again, I love returning and one doesn’t always have to focus on the future; nostalgia can be wonderful too. But few Americans appreciate how their country appears to those on the outside wanting to get in. I remember well my urgent desire to go where the prospects were greatest. From afar, perceived through its culture, its impact on world events and unfailingly wealthy American tourists, one sees a place of huge opportunity, excitement, energy, surprises, danger and optimism. It’s an enthralling vision for anyone looking for those things.

In assessing the balance of potential investment returns and risks around the world, my experience is that many non-U.S. investors hold a keener appreciation for the power of the American story. You can talk to wealthy people from almost every corner of the world save North America and you’ll learn they need only reach back a couple of generations to recall war and existential threats, loss of democracy and civil rights, periods of lawlessness and moments when the future was most dire. The comparatively long political stability, rule of law and military security enjoyed in the U.S. are far better appreciated by those who haven’t always lived here. In addition, the dynamic economy fueled in part by a steady influx of type-A immigrants is widely envied. President Reagan was my first president, and his sunny optimism was uplifting for Americans as well as this immigrant just arrived from the Old World. It was then, and is always, Morning in America.

Which is not to discount America’s many challenges, of which the fiscal and political ones remain seemingly insoluble and therefore threaten much that is great. Top-down investment analysis can easily arrive at pessimistic conclusions. The Math of America’s federal and state deficits defy easy solutions, and increasingly partisan politics seems determined to court disaster by avoiding compromise.

Except that (and here’s the still starry-eyed immigrant talking) things have always worked out in the past, and they probably will this time too. It didn’t take me long after I moved here to recognize the difference between the European and American reaction to the insurmountable. Europeans glumly accept what they cannot change; Americans eventually get angry, and the national psyche dictates that when confronted with an apparently overwhelming challenge a commensurate response dedicating attention and enormous resources alters the path of history.

Successful investing combines a belief in a positive future with a healthy respect for the possibility that in the short run things may not work out as expected. The world’s a big place to be sure, but a constructive outlook expressed through U.S. companies represents a sound long-term approach to growing one’s savings faster than inflation. Market timing is ephemeral at best; our analysis of securities is bottom-up, focused on good businesses with low debt that we believe are attractively priced. The risk profile of our portfolios is largely driven by the opportunity set among the individual situations we’ve analyzed. Of the big picture we are perennially cautious optimists. To be so is to remain squarely on the right side of 236 years of history.

On the radio this morning a journalist from the New York Times confidently asserted that Greece would soon leave the Euro and issue Drachma. Both the new Drachma and the resulting Euro were both likely to plunge as a result and therefore it’s a good time to book an August vacation to Greece (meanwhile German vacationers are avoiding Greece in droves, no doubt wary of an unwelcome reception). While the journalist’s confident forecast of a Greek exit may be right, her analysis of subsequent market reaction (unburdened as it is by the requirement to invest other people’s savings in a commensurate fashion) is subject to the interpretation of the markets. However things turn out, one can be reasonably assured that a Greek exit isn’t going to surprise many people.

For some time we’ve felt that a short Euro represented an attractive hedge on long equity market risk.  Most of the bad things that could derail equities would either start in the EU or hurt the EU harder (such as an Israeli attack on Iran’s nuclear facilities, a concern earlier this year). But now that the focus has moved back to Europe, and we are once again contemplating the previously unthinkable, we think there’s less protection in such a position. The Euro isn’t a good investment, but its current price is more likely an accurate reflection of the balance of risks and as such doesn’t provide much of a hedge any more.

Every time we approach what seems to be a fork in the road, a third option seemingly appears. Such is the case now, with the apparently binary option between Eurobonds and no Eurobonds now joined by a European Redemption Fund, a sort of halfway house between today’s single-issuer bonds and Eurobonds jointly and severally guaranteed by Eurozone members.

But another thought occurred to me. What’s to stop the Greek government from paying its bills with IOUs rather than Euros? It may in any case be an unavoidable choice if lenders refuse to provide additional cash to allow the Greek government to continue operating. The IOU would promise payment in the future (say, 3 years) at whatever is the prevailing currency as determined by the Greek government. These IOUs would presumably trade at a discount, but over time as more of them went into circulation they could start to function as an alternative currency. Not an immediate replacement for the Euro, but a parallel currency that could represent a softer alternative to the shock of a Euro exit. These IOUs might ultimately become New Drachma. No doubt there would be many technical challenges with such a move, but given the large part of Greek GDP represented by the government before long these IOUs could represent a substantial part of the Greek economy. Such a path might offer a more measured form of exit and devaluation, preferable to the chaos of an immediate exit. Countries in the past have operated with two currencies, although typically the US$ has taken hold following a loss of confidence in the local currency. California has even issued IOUs when its disfunctional government has failed to approve a budget.

New Drachma IOUs reverses the sequence, but might offer a less time-pressured solution to the current crisis.

The Facebook (FB) IPO drama has been fascinating and entertaining if you’re comfortable being a Luddite like me and fully confess an inability to “get it” when reading bullish forecasts of their business. A brief glance at their S-1 (the registration document the company filed prior to going public) reveals that FB made $1BN in profit last year. So the trailing P/E of 104 that its $38 IPO price represented shows that it’s only a stock for those unwilling to be distracted by financial statements. A delay in the opening on Nasdaq can scarcely be blamed for altering the value of the company, although many are pointing to that as a cause of its subsequent drop in price.

That a value investor would find FB unattractively priced is perhaps not that newsworthy. But I do think the uproar over how the IPO went, the righteous anger of all those “investors” frustrated in their desire to turn a quick profit, reveals much about what is wrong in investing today. The media-led hype leading up to last Friday’s launch was unprecedented – and it’s not really their fault, CNBC and others are simply providing what their customers want; 24X7 coverage of the Big Event. But the very short term nature of all this interest is so far removed from investing that it barely deserves that description. This is why people call Wall Street a casino. Because so many retail investors look for quick profits with probably little more thought than they use to choose between red or black in Atlantic City.

But it’s not just amateur investors that messed up. One of my favorite quotes is this:

“I’m disappointed that so many seemingly smart people have failed. They raised the range on the offering literally two days after the underwriters called around saying lower your numbers for the second quarter,” said Hugh Evans, portfolio manager at T Rowe Price, one of the largest institutional shareholders of Facebook.

“Those two things don’t go together, ever,” he added.

I wonder if Mr. Evans counts himself among the “smart people”.

If a little more cynicism was applied, and a little more long term investing, there wouldn’t be such destruction of savings that are supposed to cover so many retirements. If you really wanted to invest in FB, the subsequent drop in price to $31 ought to be regarded as an opportunity to add at more attractive levels. Judging from the furor though, and no doubt imminent lawsuits, such an approach is far from prevalent. Investors have only themselves to blame.