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One can't discuss the issue of excessive debt without being treated to this platitude:

"Sure, it may be bad in the US, but it's worse everywhere else."

This statement simply isn't borne out by the facts.  There are many nations out there with far healthier levels of indebtedness than the US.  In fact, out of the 172 countries whose federal government debt is measured by the IMF, the United States has higher debt as a proportion of GDP than all but 12 of them!  And most of those countries aren't piling on further debt at a rate of 8% of GDP per year like the US.

The following is excerpted, with minor edits, from a letter sent to investment clients on October 11, 2011.

"Fear is the foe of the faddist, but the friend of the fundamentalist." -- Warren Buffett

Our Investing Approach

When times are tough and we are all worried about the markets and the world we have to be sure that those emotions don't dictate the course of our investments.  Without the benefit of an explicit and disciplined investment approach, the emotions of fear and greed often take over and lead to irrational, random, and contradictory decisions.  The stereotypical emotional investor "chases returns" by simply reacting to recent price changes, resulting in far lower returns over the long run.

“If something cannot go on forever, it will stop.” -- Herb Stein, chairman of the Council of Economic Advisers under Presidents Richard Nixon and Gerald Ford 

Budgets, Deficits, Debt Ceilings and The Debt

In terms of our fiscal situation, the government reminds us of a character in the old Looney Tunes cartoons who is being chased and is running at full speed as he goes off a cliff.  You might recall that those guys kept running for a while after they had already gone off the cliff.  Then the character finally realizes that there's no foundation supporting him and that he can't go any further... he looks down... his expression says "oops," and soon he begins falling to an ungraceful landing.  Our government and our people seem to be at the point where we're off the cliff, we're still moving, but we're at the "oops" moment and we're starting to look down to see how far we have to fall.  Fortunately, the animated characters always survive and keep going and we're confident that our country will survive and move on as well.  For an amusing clip of the classic cartoon example, click here. :-) 

The following is excerpted from a letter sent to investment clients on January 29, 2011.

Valuations

If the stock market were cheap enough, we might be willing to accept some of the risks outlined in our prior article, The Recovery Will Continue Until Something Blows Up. The problem is that, from our historical perspective, the general stock market is very expensive at this point. People are sometimes surprised when we tell them that, but just because it's less expensive than it was at a credit-bubble-induced top doesn't mean that it's cheap!

The following is excerpted from a letter sent to investment clients on January 29, 2011.

The recovery will continue until something blows up.

That, in a nutshell, is our economic forecast covering the next year or so.

Let's look at each part of that sentence in turn. First, the recovery. Yes, there is an economic recovery underway, though it is an extremely weak one in light of the preceding downturn's severity. But there are some indications that the economic rebound may begin to pick up the pace in 2011.

One such clue comes from the recent upward revisions in employment data coming from the Bureau of Labor Statistics. The way these stats work is that the BLS makes an initial estimate of how many people have jobs, and then revises that estimate the next month based on more refined data. Their estimates tend to lag what's really going on in the economy. If the BLS is habitually revising job data downward, meaning that they have been overestimating employment, that is probably a sign that employment is on the decline. But right now, the opposite is happening -- the BLS has revised its employment estimates upward for the past four months in a row. This is a sign that job growth may be picking up the pace.

The following is excerpted, with very minor edits, from a letter to investment clients sent out on January 20, 2010.

Inflation Risk

We've explained many times our strongly-held conviction that in the years ahead, the dollar is going to lose a significant amount of purchasing power against things that people need to buy. 

A longer explanation for our reasoning can be found on the site -- just adjust for the fact that this was written in late 2008 and the dollar's fundamentals have deteriorated enormously since then. 

Here is a shorter version.  We believe that the dollar's purchasing power is at risk due to the following:

The following is excerpted from a letter to investment clients sent out on January 20, 2010.

The Recovery(?)

In a client letter written in April 2009, we made the bold (at the time) suggestion that regardless of the long-term structural issues facing the US economy, it was entirely possible that the jaw-dropping levels of economic stimulus underway at the time could create some sort of cyclical economic rebound.  This claim seems less crazy now, as there has clearly been a rebound in various sectors of the economy. 

People focus on unemployment, which remains quite high, but employment is a lagging indicator of economic activity.  This graph that I put up at voiceofsandiego.org shows that going as far back as the data allows, unemployment has never begun to decline until after the recession was over.  (I even checked this for the Great Depression and got the same result).

In contrast, many of those data points that tend to be leading indicators of economic activity have rebounded strongly.  There's little question that an economic rebound of some sort is underway.  The question is how strong and enduring that rebound will be.

Back in June of 2008, we wrote that the US stock market -- then at 1,377 on the S&P 500 -- was priced for poor returns. We were talking about prospective long-term returns, but as everyone knows, the market experienced an epic crash beginning just a few months later.

In late October, after the S&P 500 had plummeted more than 38% to under 849, we posted an update arguing that the US market was now priced for good (though not great) returns.

Well, we're here to tell you that the market is priced for poor returns once again.

The following thoughts on the economic stimulus and its potential outcomes are excerpted from a letter to clients sent out on April 20, 2009.

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The Stock Rebound

You may have noticed that stocks in general have made quite a rebound over the past couple of months. As I write this, the S&P 500 has moved up nearly 35% from its early-March lows. Also beneficial to our portfolios, the dollar has dropped pretty sharply over that same period and many of the inflation-hedge themes we favor have done quite well.

Which is all very nice. But will it be sustained? Our emphasis on fundamental analysis and long-term returns mitigates the need for us to make short-term predictions. We try anyway.

As a first step in answering that question, let's have a look at: The Stimulus.

Back in March, we pointed out some important similarities between the current financial environment and that of the 1970s.

Aside from gratuitous decades-old pop culture references, the main focus of the article was on real short-term interest rates, which we approximated by subtracting the year-over-year CPI inflation rate from the Fed funds rate. At the time, real rates by this measure had just turned negative, meaning that the Fed funds rate was actually lower than the rate of CPI inflation. We thought this an important development because the real Fed funds rate provides an indication of the tightness (or lack thereof) of monetary policy.

Checking back in on those real interest rates, we see that they have proceeded further into negative territory and now rest at -3.6%.

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The following is taken from a letter to investing clients written on the evening of Tuesday, July 8. 
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The Bear Market Continues

You may recall from our last investment update that we were unconvinced by the stock rally that was then taking place. This is what we said at the time:

By early March, the stock market (as measured by the S&P 500) had declined nearly 20% from its peak. Since then, however, it has made a big comeback and is now down less than 10%. Is the downturn over?

We are skeptical.

In early 2007 we wrote an article summarizing the risks in the U.S. stock market. The article cited a study by legendary value investor Jeremy Grantham in which it was shown that, on average, long term stock market returns have corresponded quite well with valuations at the time of investment.

Here we reproduce Grantham's study with updated data and a variation or two, followed by some thoughts about where we are now in the markets and what to do about it.

Remember last year when we made fun of the financial media for raving about the completely meaningless fact that the Dow had crossed a round number? The following image was captured from the CNN homepage on April 25, 2007:

Commodities have endured a steep selloff over the past couple of weeks, a fact that has prompted vast hordes of market analysts to proclaim, with absolute certainty, that the "commodities bubble" has burst.

We find the whole situation to be a bit ridiculous. After all, the large majority of these very same analysts were entirely unable to identify the hugest housing bubble in the recorded history of the world, and before that, most of them were unable to identify the hugest stock bubble in the recorded history of the world. As a matter of fact, many of them have spent the past several years warning about an imminent collapse in commodity prices (which didn't happen) at the very same time that they were denying the aforementioned hugest-ever real estate bubble and assuring everyone that home prices would keep rising (which also didn't happen).

Have they now suddenly started getting it right?

We've believed for quite some time that the current period bears much resemblance, economically speaking, to the 1970s. Consider the following trends, all of which took place in the 1970s and are doing so again today:

• The stock market remains range-bound over the long term as inflation eats away at real stock valuations.
• Real bond yields remain very low and sometimes go negative.
• Gold, commodities, and other inflation-hedge investments are in a multi-year bull market.
• The Federal Reserve is continually behind the curve on fighting inflation.
• On weekends I wear plaid Sansabelt slacks and a mint-green polyester jacket with lapels so enormous that I am occasionally borne aloft during strong winds.

We can add another similarity to the list: the term "stagflation" is now showing up all over the news again.

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This article is adapted from a letter to investing clients originally written on January 9, 2008.
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Going into 2007, we already knew that whenever the economy slows down, the government floods the system with money in an attempt to "reflate" asset prices and economic activity. This is accomplished via monetary policy, which when all is said and done effectively entails printing money, and fiscal policy, which effectively consists of the government spending money it doesn't have. We knew this would be the policy response because that's exactly what the powers that be did during the prior downturn, and because those actions were considered to have been a huge success in keeping the prior recession mild (despite all the imbalances that the reflation efforts eventually induced).

What we didn't know was just how panicky and violent the policy response would be at the very first sign of trouble.

Global stock markets sold off hard on Sunday night (the US markets were closed on Monday so they couldn't react), and then sold off even harder last night. This morning, the Federal Reserve announced a surprise intra-meeting rate cut of .75%, bringing the Fed funds rate down to 3.5%. (Of course, this is one of the most widely anticipated "surprises" we've ever witnessed, but never mind that.)

Beyond all the dramatic headlines, there are a few very instructive details about today's move.

We have some thoughts on what may take place in 2008, but first we want to review the major predictions and observations we made in 2007.

Looking back over the articles we wrote last year (of which there were embarrassingly few -- something we intend to change in 2008!), the major themes we discussed largely turned out to be correct.

Back in March, we wrote an article in which we outlined a possible financial market roadmap -- a sequence of events that we thought the markets were likely to follow. Here is the roadmap we spelled out at the time:

We at PCA have been bearish on San Diego housing for quite some time. One of our earliest concerns was that the rampant use of risky home loans, especially "teaser rate" loans that traded a low initial monthly payment for a potentially much higher payment down the road, would lead to extensive foreclosures if the borrowers' hoped-for home price appreciation didn't materialize. The inevitable fallout from all that reckless lending was one of the cornerstones of our long-held belief that San Diego would eventually experience a housing correction that surpassed the region's early-1990s real estate downturn in severity.

When we expressed these concerns, we were almost universally informed in no uncertain terms that foreclosures could never get as bad as they did in the 1990s unless San Diego experienced widespread unemployment.

Now that illusion has been shattered.