Macro Reflections

Although my basic outlook on the market is value-based, I frequently like to commit the Grahamian sin of thinking through the major economic factors affecting asset classes in order to determine what markets I want to be in. Quantitative analysis only gets you so far.

I do this is by framing hypotheses about the main story in each asset class. Once I have formulated these, I sit and wait. Over time, the markets either prove or disprove them, and I adjust my stance accordingly.

I discard the hypotheses for two reasons. Either 1) They are proved wrong or 2) They have been proven so completely that they are common knowledge, and are therefore fully valued.

An example of the first was my belief at Google's IPO that it was overvalued, and that it would be dangerous to buy a company trading at 50X earnings. So I opted to sit it out. This is obviously a decision I regret, and it has forced me to accept that a few extraordinary companies are worth paying up for.

An example of the second was my belief this year that U.S. financials were extremely weak and quite vulnerable to the problems of rising interest rates. This view was proved correct, and so I reduced my bets against financials . . . although I still do expect this situation to worsen considerably.

Here are the hypotheses I currently subscribe to:

1) ACCELERATING INFLATION.
The world is in a period of accelerating inflation which still remains largely unrecognized, fueled both by 1) decades of underinvestment in commodities (creating the current supply-side problems) as well as 2) loose credit from the world's central banks (demand pulling prices up).

Money supply in many areas worldwide is growing at double digits . . . and the arguments of individuals who defend the CPI calculations leave me pretty blank. To understand why the Fed understates inflation, you have to think about the Fed's motivations as people rather than as an institution. They are afraid of economic slowdowns, but also of wage inflation.

The moment that the average person begins to realize that his or her cash is being destroyed, they demand higher wages, which pushes prices higher, and so on (the wage-price spiral). "Fixing" the CPI to understate inflation is a way to avoid this extremely unpleasant outcome.

POSITIONING:
Stocks (which should continue to rise until people realize that inflation has been driving the bull market)
Hard Assets (which I will begin to buy once wage inflation begins)

2) DOLLAR TROUBLE REDUX.
This is obviously something that everybody and his grandma are worried about. So I agree with Jim Rogers that a rally--probably a huge one--is in the offing soon.

Still, the dollar is in for still more hurt over the long term in my view. As George Soros explains in The Alchemy of Finance, because so much of a currency's value is collateral value, the decline in a currency tends to picks up speed as it goes.

This applies especially well to the US dollar right now. The dollar is valuable throughout much of the world because, as the world's reserve currency, it is seen as a store of wealth. But each decline in the dollar further erodes its value as a safe haven, thus prompting more selling. So the selling spiral is likely to accelerate until there is a crisis.

Add to this the fact that there is no real constituency inside the Fed or outside of it that wants to see the dollar defended, and it looks like the path of least resistance is down.

This hypothesis has been very profitable so far, although there is likely to be some turbulence soon with the coming dollar rally.

POSITIONING:
Gold
Swiss Franc (FXF; an excellent currency)
Berkshire Hathaway (Large overseas currency holdings as well as increasing commitment to finding earnings streams in overseas companies, such as the Iscar purchase)

3) EMERGING MARKETS' PROBLEMS ARE MASKED BY CHEAP CREDIT.

I discussed this point before.

POSITIONING:
Prepare to go short in these areas at signs that credit is drying up. Emerging market banks will be especially vulnerable . . . as their loan portfolios go bad, they will go under.

4) THE WORLDWIDE BOOM IS PULLING OIL ALONG.
I have been long oil for some time for the simple reason that I can't see how oil prices are going to decline when the global credit boom (described above) is throwing so much money into the pockets of the industrializing world for capital expenditures and personal consumptions (cars, specifically).

I'm not a "peak oil" believer, per se, but I think some of their arguments are great, such as the fact that OPEC member nations are incentivized to overstate their reserves, allowing them to ramp up output. This means, of course, that worldwide crude stocks are vastly understated.

This has worked well so far, but I'm beginning to worry that a bullish consensus is forming on oil . . .

As part of this outlook, I also like oil exploration companies. If you look at the bull market in oil stocks over the last several years, the market has gone up almost entirely because of higher earnings. P/Es haven't expanded. I believe that if the bull market in oil stocks is like every other bull market in history, eventually P/Es will rise to reflect the growth these companies have shown, and we could see these stocks double very quickly.

Right now, you can buy the iShares Oil and Gas Exploration Index for 5.6 times cash flow. It's likely to do well even if oil prices collapse, and you have no company risk.

POSITIONING:
Oil (USO)
Companies that are leveraged to higher oil prices (IEO)

Note: I currently hold the following securities mentioned in this article: BRKB, GLD, IEO. I will try to remember to include these disclosures, though you have my word that I am not using this blog to try to move the world gold price in my favor.