Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

July 2011

Employment is nature’s physician, and is essential to human happiness.
Claudius Galen

We are all Greeks now, a fact brought home to us in several ways of late. Close to home here in Cambridge the annual Greek Festival took place in June drawing a large and diverse crowd of many nationalities and ethnic backgrounds. In a broader context there are the many cultural, historical, intellectual, and linguistic inheritances from this small area in Southern Europe that form an important part of Western civilization. Unfortunately, the recent news from Greece has been of a much less flattering sort. Heavily in debt (Greece’s liabilities are on track to exceed 160% of its GDP), the country is struggling to avoid defaulting on its obligations. Its leaders are pushing for the adoption of highly unpopular measures, including a strict austerity program insisted upon by the European Union as a condition for extending financial assistance. European Union countries have a strong interest is seeing the Greeks succeed at belt tightening; many German and French banks and insurance companies hold large amounts of Greek debt, and a default could require them to raise significant amounts of expensive equity capital. Hence, the major European powers are desperately seeking a solution (including a massive bail out) lest the situation weaken the fragile economy of the entire Eurozone. Although our financial institutions hold only a modest amount of Greek loans, the U.S. is also affected, as its currency and bonds are viewed internationally as safe havens. A financial breakdown in Europe could send funds fleeing to these shores, strengthening the dollar and suppressing interest rates here at home.

It’s ironic how a small country (Greece’s economic output makes up barely 3% of the entire Eurozone GDP), and one with such an illustrious place in Western history, could come to pose a serious threat to the Western economies. But the economic history of modern Greece since the nineteenth century is one of a series of defaults, and its recent behavior, including the fudging of its financial figures and spotty tax collection, has done little to inspire confidence. General strikes and pictures of protesters besieging the Greek Parliament and rioting in the streets upset creditors, sent the country’s borrowing costs soaring, and negatively impacted stocks worldwide. The parliament’s eventual votes in favor of the austerity program becalmed markets somewhat, but doubts remain as to whether the government can actually carry out the measures to which it has committed itself.

Given all the attention focused on Greece and the turmoil in that troubled land, it seemed fitting to open our remarks with the line from Galen, the second century C.E. Greek physician and philosopher. His modern descendants—as well as those who would “save” countries from financial Armageddon through strict austerity measures—would do well to heed his wisdom. Unemployment is the inevitable result of the type of economic medicine being imposed on the Greeks and other countries, such as Ireland and Portugal, as a cure for their alleged profligacy. The notion that a bitter pill may be needed to cure a disease may work in medicine, but it isn’t necessarily effective when applied to societies. Indeed, it can be counterproductive; unemployment, especially when of long duration and among the youth, is a scourge that undermines social cohesion. When combined with a sense of unfairness an explosive situation can be created. Frustration and high unemployment among youthful populations are the context in which the regime-ending “Arab Spring” took place, for example. Not even the U.S. has been immune: high unemployment during the Great Depression led some to fear for the survival of capitalism in this country. Greece and its European brethren are facing a situation with no easy solutions, and any choice will entail sacrifices. Care should be taken to ensure these burdens are shared in an equitable fashion.

Europe was not the only region where concerns about employment and social stability played a role in recent economic policies and events. It is well known that Chinese leaders place a premium on stability, and their fiscal policies reflect this overarching goal; massive amounts of infrastructure spending are designed to keep employment up and the populace happy.  We have long felt that China’s unusually high growth rates were an unsustainable bubble; recent analyses in the press indicate that other observers are leaning toward this view. Investment spending accounts for nearly 50% of the growth in the country’s economy, an unhealthy balance. Evidence points to redundant highways, railroads, and housing developments that few Chinese can afford; at the end of June, for example, The Wall Street Journal reported on China’s $300 billion high-speed rail project linking the major cities in the country. Plagued by construction problems, and producing a transportation system whose fares will be beyond the means of most Chinese, the investment will be a burden to the state for years, and may never be fully recouped. Reports from Western businesspeople (who have an economic interest in the Chinese construction market) indicate that the bulk of the government’s efforts in this and other infrastructure projects are concentrated in industrial and other highly-populated areas, while much of the country remains “backward.” According to these sources, China can sustain a heavy rate of internal investment for a long time to come. This may very well be the case in the long run, but booms such as the one occurring in China cause imbalances and can come to a crashing halt in the meantime. Given the world economy’s reliance on the Chinese and their Asian brethren during the last few years, it is sobering to think that this source of demand and growth might suddenly contract, even temporarily. On the other hand, the world’s economy, and its people, might welcome some relief from the inflationary impact that the Chinese boom has had on virtually all commodities, from foodstuffs to iron ore and oil.

Concerns about commodity inflation (especially in the form of rising energy prices), European debt problems, and the revolutions in North Africa and the Middle East took a toll on market psychology in the second quarter. Equity prices declined significantly beginning in April (halting a two-year advance), but recovered towards quarter-end, finishing the period with year-to-date gains in the 6-8% range, a good result despite all the hand-wringing, and further proof (if it were needed) that focusing on day-to-day events is fruitless. Stocks of large banking institutions, which were at the heart of the financial crisis, suffered from worries about tighter regulation and higher capital requirements that could shrink their future earning power. Bank earnings and balance sheets were hit by the ongoing settlements and charge-offs related to the real estate debacle. On the other hand, there was some excitement in the technology arena (the perennial speculative favorite) where a few hot initial public offerings drew attention and raised hopes for more to come, but even that mini-bubble seemed to be deflating by quarter’s end.

U.S. fixed-income markets continued to benefit from troubles everywhere else. The year’s first half was the biggest on record for bond issuance. A market participant at Barclay’s Capital summed up the situation well: “When you look at 2011, you walk into an environment where from an issuer’s standpoint it is an historic time period.”  Continuing in a similar vein: “Do you want to lock in money that in a few years will look like silly, low-cost money?” Wall Street has gotten into trouble for not disclosing the true risks in some of its products. The above statements are about as clear an explication of risk and caveat emptor as we have seen.

“Some things are in our power; others are not.” *

The last four years have been difficult for many individuals, businesses, our country, and the world economy.  They have taken a toll on investors as well. When the stock markets peaked in October 2007, who would have believed that within a year a major Wall Street firm would go bankrupt, and within a few years some of the biggest financial institutions would owe their very existence to the generosity of the taxpayers? As the markets rose that Fall, how many investors foresaw the steepest market collapse since the 1930s? Alas, those were the days when real estate prices only rose, and auto execs still flew to meetings in their private jets. We are reminded that the future is unpredictable, and that as investors we must always deal with uncertainty, volatility, and the fleeting emotions of people who are remote both in terms of distance and connection with us. Nevertheless, we soldier on, obligated to make decisions whose ultimate outcome is dependent upon people and events beyond our ken or control.

How can investors deal with circumstances that tempt one to bury one’s head in the sand? We turn once again to the ancient Greeks, this time for our “market wisdom.” Epictetus, the source for the above quote, * was a stoic philosopher whose lifetime straddled the first and second centuries C.E. (roughly a contemporary of Galen). In our opinion, Epictetus should be the patron saint of all investors, and Stoicism their guiding set of principles. In this single line the philosopher distilled all of the wisdom investors require when dealing with the uncertainties inherent in their endeavors. In it we find the basis for the mindset necessary for successful investing: focus on the things that you can know and do; as for the rest, protect against them, but do not dwell upon them.
                       
historic illustrationThe investor can know a lot. There is ample access to a wealth of high-quality information about companies—their managements, history, profitability, and financial exhibits of various kinds—which permits us to assess a company’s risk and earning power (or determine whether such an assessment is possible). This analysis allows us to develop an estimate of what businesses are worth—the key to sound investing. What we cannot know are those things which everyone would like to know, and which Wall Street strives mightily to provide: future economic growth rates and the direction of the stock market and interest rates, to name a few. These matters form part of the daily background noise flooding the investment scene over which we have no control, and which is seldom of interest or value in any case.

Text Box: Epictetus– “Patron Saint of Investors”There is no doubt that the unknowable future poses a risk for the investor, but armed with what we know, we can make wise choices, investing where true value exists, and avoiding speculation and the reliance on unknowable events for our results. Most importantly, we have full control over the price we pay, which is perhaps the single most important factor influencing the ultimate outcome of our commitments.

The great thinkers of antiquity got the principles right, and their teachings still find broad application, even to an activity that would be foreign to them: investing in financial markets.

 

Dennis Butler, MBA, CFA