Thursday, December 31, 2009


There have been five overriding themes for our investment letters during the past year.
Below we list and review them.

1) Expanding liquidity drives financial markets, particularly when it occurs in the face of a sub-par but recovering economy and weak price inflation. This is the sweet spot in the cycle we so often talk about, and it is the best of all times for stock and corporate bond prices when perception of risk abates.

2) The Great Reflation underway since late 2008 has done its first job - aborted what surely would have been a full scale depression at least on the scale of the 1930s. That was Act I.

3) No one should believe that the huge reflation underway will make the economy and financial system whole again. The private sector debt excesses were far greater by 2008 than they were in 1929. A good part of the reflation effort is to transform private debt into public debt, and this will surely create another, different debt monster. As the year draws to a close, credit rating agencies are starting to downgrade sovereign debt and credit default swaps (CDSs) and are showing increased concern that some major developed countries are going to have problems servicing their debt (e.g. Japan, U.S., etc.). The markets are starting to tell us that Governments with brittle, over-extended fiscal positions will soon have to put in place credible fiscal consolidation -- tax increases, expenditure cuts, decline in services, etc. This means more deflation, more uncertainty.

4) Zero interest rates in the U.S. together with Federal Reserve asset purchases, much of it low quality, has done its job of inflating asset prices which improves balance sheets. Better financial markets greatly help capital raising ability, further strengthening balance sheets. As a result, they are much improved. The question is over sustainability. Fears of renewed asset bubbles have surfaced, complicating Fed and other central bank decision making. Do they risk tightening too soon or too late? Does a middle ground exist? Zero interest rates are an extreme anomaly and cannot last unless the U.S. economy remains permanently depressed and in deflation like Japan has been for 20 years. This seems unlikely but cannot be ruled out.

5) The great flaw in the international monetary system has allowed the U.S. - the key reserve currency country in the world - to run up a $4 trillion tab with foreign central banks and has created excess liquidity and asset bubbles in countries buying those dollars. It has also contributed mightily to the destruction of savings and investment in the U.S., and has created massive disequilibria in the global economy and financial system. Economics 101 tells us clearly that all disequilibria eventually get corrected. The interesting questions are how and when? That will be the story for Act II of the drama and it hasn’t been written yet.

As the year 2009 draws to a close, there is clearly an aura of unreality. We barely survived a near-death experience nine months ago. However, the pain and the fear for most people were brief. It was not like the 10-year depression in the 1930s that changed attitudes
for two generations.

To read the full report: RISK & UNCERTAINTY