The Inevitable Correction Seems to Have Arrived

This week finds us more than a little chastened by a Market correction that seems to have arrived a bit sooner than I expected. Last week’s Musings ended with: The Market got its badly needed excuse to sell off, ... but long term investors who are attuned to the global economy should not be dismayed. By midday Friday, dismay would be a very apt way to describe my frame of mind. With the Nasdaq having already already melted some 8% over the dozen or so trading days since its January 11 (intraday) peak, it seems more likely than not that a bona fide correction, as opposed to a mere “pullback”, is upon us. This installment of Musings will explore some of the putative reasons why the prevailing bias seems to have inflected in a southerly direction.

The first thing to remember about a Market correction is that it really doesn’t need a reason. Nature’s tendency to impose regression to a mean can and does suffice. Whenever the pullbacks that were experienced along the way since the March 9 seemed like they were about to become the new norm, there were plenty of “reasons” being proffered by the hired guns of Wall Street and their media enablers. We should not be surprised to hear this chorus grow louder in the days ahead. I can remember toward the end of that swoon that ran from mid June until the day Intel’s Q2 results ignited a rally (and set the stage for the sucker’s game of trading ahead of earnings that has failed the not-so-smart-money so spectacularly these past two weeks) hearing a lot about technical breakdown and ahead of the earnings, etc. The same was true during the multi-week pullback that was seemingly precipitated by purportedly disappointing (i.e., they blew away official estimates, but analysts “expected” more, and outlooks fell short of somebody somewhere’s all-but-certainly-unguided expectations) earnings in the latter part of October. My experience has been that the “reasons” for the Market to go up or down are always there and don’t change as much as they seem to. What changes, from day to day and season to season, is what gets focused on, spotlighted if you will, by the seeming keepers of consensus. It’s as if there are a bunch of cue cards that we are all supposed to heed, and the Market shifts direction to the extent that someone somewhere decides which set of cue cards to use. (Ah, the dreaded unseen “they” who are behind the misfortunes of the conspiracy minded. Human nature is such that it is more reasonable to believe that coteries or factions will attempt to rig the system in their favor than to assume that some moral compass or fear of punishment will rule out this possibility. Just because manipulation, or any ad hoc behavior for that matter, cannot be proved or even directly observed does not mean it does not happen, any more than irrefutable assertions, a generation ago, that the Mafia “did not exist” disproved the existence of organized crime families rooted in Sicily.)

This pullback or correction that has overtaken the Market does not need a reason, some fact of life that was not in play the when the trend was the Bull’s friend, but I think a few catalytic factors have entered the mix. Much has been made of financial troubles in Greece. Substantively speaking, this should not be a big deal, as Greece is just not that much of country. Its population is only 11.3MM (up only about 340K in the last decade), which is fewer people than Texas has cows or Mongolia has sheep. Its GDP approximates the market cap of Exxon Mobil. It is less than one third the size of New Mexico and most of that (86%!) water. It is hard to think of what assets it has besides tourist venues, and its leading export seems to be people. Greece has been around longer than just about any people group presently extant, thirty centuries at least, and yet they couldn’t bring themselves to organize into a country until 1830. If the whole country were to take note of Mongolia’s very low people/sheep ratio and move there (a sort of mass "embraceable ewe" hysteria?), would the world economy notice? Hardly. I think what is in play here, besides someone somewhere with influence over what scripts get read or what “research” gets published trying to scare you into doing something stupid, is that players of all stripes are being reminded of a recent traumatic experience. The fear of imminent global collapse, so rampant only a year ago, has died down, but it left painful scars that have not healed. Visions of dominos (metaphor run amok!) jellify the knees of traders and investors. The smart money senses this and piles on, confirming the not-so-smart’s worst fears, and we get a Market correction until the path of least resistance is no longer down.

If there is a true catalyst for this apparent correction, my guess is that is that it revolves around political developments, or perhaps nondevelopment. It is a continuation of what fell into place last March. As Musings noted on March 25: “For weeks on end up until the Market’s first upward surge, we were being treated to volumes of scary-making talk of transforming our experiment in ordered liberty into an amalgamation of Chicago and Berkeley, with a sprinkling of Havana thrown in. Control of both Houses suggested that “get it all in a hurry” was going to be unstoppable. The thing is, it only seemed that way. What occurred to me as that buying stampede wore on was echoed a few days later in the WSJ by Mr. Karl Rove. He noted that every Administration starts with political capital, which they inevitably spend. It’s just a matter of time, and some spend it much more quickly than others. I can remember when Reagan had basically spent his c. 1986. It occurred to me that this time, the collective efforts of this crew had thus far been so amateurish, so evocative of Commencement Day at Clown College and so presumptuous of success as to perhaps set a land speed record for blowing one’s political wad.” It was the realization of this that launched the rally which came to denote 2009. Along the way, in thinking about what might sustain a recovery, it became plausible to suppose that we might be headed for a redux of that Clintonesque triangulation that the Market seemed to applaud fifteen years ago. The notion developed that much the way the Clintons overreached, were rebuked and then changed course in ways that facilitated relatively benign governance (from capital’s point of view, you know, things like welfare reform and NAFTA), the HopeNChange Express was on a collision course with humility and would alter their ways accordingly. This salubrious outcome was expected to be delivered in November. It came early, most recently and vividly in Massachusetts, but the drama has thus far not followed the aforementioned script. We see heightened intransigence where a shade more comity was expected. We get shrill reminders, replayed ad nauseam by the financial media, of the sort of rabid populism that degrades and ultimately destroys any economy it infects. Instead of a Clinton redux, we are left with the unsettling sense that some would move us in the direction of Chavez. (Speaking of that redux, remember that by no means is everyone who is cheering the political incapacitation of this Administration a Republican. We should not be surprised that in the back rooms and soirees were campaign fund raising takes place, it is becoming common knowledge that our Secretary of State and her husband are stepping up their heretofore low-key campaign to return to 1600 Pennsylvania. The slow drip poison accompanying that game is going to make for unsettling developments in the next couple of years.)

What is especially vexing about this downturn, and what likely caused my overly optimistic sense that the rally would stay intact for a while longer, is encapsulated in those words lifted from last week: “attuned to the global economy”. The fundamentals are not great a la what they seemed in 1999 or 2006, but who among us expected anything but a slow recovery? If anything, much of the news is far better than we were expecting even a few months ago, and certainly better than we had any right to expect at the Bottom. No one saw how strongly so much of the global Tech sector would recover. Yet here we are in the wake of the earnings season where monster blowouts by INTC, MSFT, STX and down the line culminated in Tech leading the rout. It could be argued that to the extent “Tech” is synonymous with “risk” and risk aversion just came back into style, this makes sense. This betrays an outdated notion of much of the Tech world. How many countries are better risks, better credits, than Microsoft or Intel? Which would you rather trust with your capital for the next twenty years? No, something else is afoot. What I think has happened is that the Street (those big firms who publish research and invest on their own accounts) recognizes just how great the prospects are for much of the Tech Sector over the next several years, but they didn’t figure it out fast enough to back up the truck and accumulate enough (the trouble with the greed-addled is they have no sense of “enough”.) So we get all this hokey “research” fraught with constructs like “normal peak multiple” and when the mood turns as skittish as it has been these past two weeks the owners at the margin give it the benefit of the doubt. This research is redolent with what seems to be willful ignorance. (Ponder just how much relative weight to accord to each of these terms.) I have a very large bet on certain parts of the Tech Sector (see my List), and either the companies have succeeding in bamboozling me with the steadily strengthening outlook that I have pieced together OR the Street is trying to bamboozle us with its research. The next Musings will address why I am gritting my teeth and riding through this rough patch with an outsized bet (i.e., the four largest positions constitute about a third of my investable net worth) on these Tech stocks.

The Empire Strikes Back (Volcker = Vader?)

Talk about a sudden mood change! This holiday-shortened week started out with all eyes on Massachusetts as referendum on health care reform but ended up being all about the Administration’s proposals to change up the rules for the banking industry. What seemed like applause for the swan song of Government-Issue Health Care quickly gave way to the rumble of investors heading for exits, swept along by their not surprising disdain for any such sudden thickening of atmospheric uncertainty. There has been a lot not to like about the populist trash talk that the Administration has directed at the “evil fat cats, et al” who by the way contributed so much to their political success, but I find it very encouraging that they seem to have tumbled to the understanding that was articulated in Musings few months back (Nov. 11) . That would be that something akin to the Glass Steagall Act, which separated deposit-taking banks from investment banks, needs to be re-imposed if we are going to make any sort of headway in managing down the “too big to fail” problem.

If this week’s reversal dented your net worth and dinged your sense of being on top of the ebbs and flows of Market sentiment, remember that it could be worse. You could be the Attorney General of the Bay State. One suspects that for years to come, any politician who suffers a really bad day can look in the mirror and say, “Well, at least I’m not Marcia Croakley!” Her candidacy was emblematic of corruption, the sort of decay that sets in when a “machine” is imposed and then goes for decades without an effective challenge. How else to explain the fecklessness that denoted both her campaign and career? Like an army that had been at peace for decades and no longer bothered to even drill, the gang that thought they had everything under control was no match for a no-name adversary they could not bring themselves to take seriously until it was too late. It all happened too quickly to know exactly what to make of Mr. Brown. Having been constantly reminded of the huge disparity that often exists between public persona and “what the family sees” (St. Elizabeth Edwards most recently comes to mind), it is quite premature to form much of an opinion about him, other than that he is hard working, a gifted politician and has a fetching family behind him. It struck me as bizarre when on the morning after there was speculation about him running for President, seeing as how six weeks ago almost no one outside of Wrentham, MA knew who he was. Then it occurred to me that “obscure State Senator jumped up to U.S. Senator and then commencing a successful run for the White House a few months later” has already happened. How often do you suppose he voted “Present”? He seems likely to be at least a modest net positive for the World’s Greatest Deliberative Body, but it remains to be seen whether he is even remotely qualified for the job of Chief Executive.

So the Market went from anticipating the death of Health Care-reform-as-an-exercise-in-imposing-Statism to withering under a gamut of uncertainties no one was thinking about during the three day weekend. I am skeptical about both the intentions of the Administration and the government’s collective ability to end up with something that actually does less harm than good, but I do like the essential thrust that recreates a “wall” akin to what Glass-Steagall imposed. That was a suboptimal fix as well, that had to be tweaked along the way, and not every tweak was for the good. We have a pretty good idea of its consequences, intended and otherwise. We also have viscerally memorable experience with the unintended consequences of that “wall” going away. How awful would it be if banks evolved back into boring businesses, like utilities or cereal makers or big drug store chains? Taking deposits and lending against them based on collateral that can be understood by anyone with a rudimentary knowledge of business (i.e., your typical bank examiner) might not be an exciting business, but it can be a not-bad business. Banks that want to offer insured deposits and have access to the Fed window should not be engaging in activities that even the Sage of Omaha finds incomprehensible. Investors seeking safety and relative predictability will migrate in that direction; if other investors want the kind of “excitement” that comes from the creation of “products” akin to alchemy and perpetual motion machines, we can be sure that the investment banks will provide them the opportunity.

What needs to happen is for banks to be given a window of time, five years would probably do it, to wind down or spin out their hedge fund-like activities. I would give them a year to affect either a wind down or a partial spin off, with a provision that their equity interest in such activities is permissible, but will be subjected to escalating “haircuts” re its value within regulatory capital as time goes by. My sense is that to the degree the world needs the kind of speculative activity they have been providing, it will be taken up by hedge funds, whose principals face an altogether more bracing set of risk/reward terms. We will probably end up with a bit less speculative activity, and that will be a good thing even beyond its role in rendering institutions less likely to be “too big to fail”. A moderate amount of speculative activity is a good thing, a lubricant for a vastly complex system that no one could design, but this does not mean that more such “lubricant” is necessarily a good thing. Sometimes, speculation becomes like the tail wagging the dog. It happened leading up to 2007, especially in the commodity markets, and its undue influence on commodity prices has not gone away. The really galling thing is that we all get to pay for it when excess speculation pushes commodity prices to extremes. Speculators don’t “cause” much of anything, and the world is better off with at least a few of them, but there is no doubt that speculation, egged along by perverse incentives (i.e., taxpayer funded backstops to failure) exacerbate things unto wretched excess whenever momentum becomes broadly discernible (like gasoline at $4/gallon).

One obvious roadblock to dialing down what is essentially money center banks impersonating hedge funds is that it will hinder badly needed economic recovery in the New York metroplex. That economy (down for the count, as I recall, in 1991) was given a burst of steroids by all that bonus money sloshing around for everything from shoe shines to summer places. It’s going to be a long slog back any way you slice it. (Insofar as the very idea of money center owes much to a now obsolete need for physical proximity entailed in the exchange of securities, i.e. certificates that got run across town during the day before the trade settled, recovery is not a foreordained outcome.) While the amount of speculative activity, as reckoned in the number of high earning traders, analysts, etc. will find a level in line with the need, the unwinding of the mega-casinos will ripple through a local economy that has already taken a terrible beating. Expect anyone who has a stake in the viability of that local economy to push back against reform harder than most of the rest of us are willing to push for a lasting semi-solution to “too big to fail”. Nonetheless, by acknowledging the root of this problem, that human nature is such that “bank” preceded by “investment” is the very antithesis of the safety and security that word is supposed to connote if its principals do not have copious quantities of the right kind of skin in the game, the Administration has given us the most hopeful signal we have seen in a very long time. The Market got its badly needed excuse to sell off, and rightly fears that there will be collateral damage even if the new regulations move us in a basically right direction (like the last time Mr. Volcker was calling the shots), but long term investors who are attuned to the global economy should not be dismayed.

An MLK Day Meditation on "Identity" & Slavery

This week brings us the first three day weekend of the year, and some thoughts on why this day has been set apart. While I cannot remember a time in my life when I and most of the people around me did not embrace the direction that Dr. King pointed us, I also admit to questioning the wisdom of adding yet another holiday to the calendar. That we should honor this man’s memory and his life’s work is beyond question, but at the time we first started getting the third Monday of January off from work, it spurred the question of whether this man was any more deserving of a “day” for his contributions than many others I could think of. Perhaps it was because it more or less coincided with when two holidays, Lincoln’s and Washington’s birthdays, got merged into Presidents Day. This shifting of focus from honoring individuals from whom we might learn much in the way of virtue to honoring an office was deeply troubling, un-American if you will. What would GW or AL have thought of it? It also tweaked one of the reflexes that a long life of toil has taught me, that your heroes will disappoint you. We are constantly reminded (most recently and vividly in the book Game Change:..., by Heilemann & Halperin, especially as it pertains to those human bed-lice Mr. & Mrs. Edwards) that there can be vast differences between the persona we meet and the person that has to be lived with. None of this seems to matter, though, as in just a meager few years MLK Day seems to have become as devoid of commemorative substance, and just another excuse for a three day weekend, as, say, Labor Day. Nonetheless, the good Dr. did struggle at a propitious moment to alter the course of History in a more charitable direction, and he left us with words of wisdom and inspiration. So as long as there is an MLK day, we ought to do more than just get a few more things done around the house because its a day off. We should consider the cause of justice and amity for which he gave his life, and ponder what he would make of what we have made of his legacy.

I was just shy of fourteen years old when Dr. King was struck down, and the words I most remember were the ones having to do with the dream that someday men might be judged by the content of their character rather than the color of their skin. I was just young enough absorb this without even a tinge of that cynicism that overtakes us as adults. It was possible (though not exactly easy, given the extent to which inter-racial violence was flowing in both directions in those turbulent days) to aspire to seeing this ideal come to pass in our lifetimes. Sadly, this does not seem to have been the case. A certain currency, or power, has accrued to “identity”, especially if that identity has attained the status of “oppressed”. Political advantage can be garnered by polarizing the electorate (swathed in that doublespeak that gives us “diversity”). Sensitivities seem, in some quarters anyway, as acute as ever, as a certain capacity to divine “hatred” and “insensitivity”, to take offense where none was intended and trump it up into psychological advantage, has become something of a high art form. One suspects that in his heart of hearts, this is not what Dr. King had in mind.

This issue of identity has been much on my mind since “America’s first African-American President” became tangible reality. The fact that the man who achieved this distinction is actually of mixed race stirs up the somewhat perennial question, in my fevered little mind anyway, of what makes us who we are. It’s an updated consideration of the age-old “nature versus nurture” debate. I approach this question acknowledging that a genuinely post-racial future was among the more powerful ideals in play during my formative years. Having gotten a degree in psychology and then spent the next forty or so years studying human nature, I understand this matter of identity, in this case racial, to have many components. There is genetic heredity, which determines, albeit variously among individuals, the exterior features by which everyone including strangers might identify us, as well as what we see in the mirror. This might easily trump all the others, but it need not be so. There is also what I call virtual heredity, which amounts to the people who nurture us (or fail to) in our years of early dependency, and from whom we take our earliest and perhaps most formative cues. Similarly, but perhaps not quite as powerful, would be those relational factors that are in place as we enter out into the world (go to school), as we reach that age (more or less coincident with puberty) where we attain capacity for abstract thought, and during that vulnerable time when we “leave the nest” and have a go at finding our place in the world of grown-ups (or hang out in college for the better part of a decade listening to people who never quite grew up). Many would argue that these “environmental” factors, who we take our cues from at various junctures in our formation, are more important than what our DNA would determine. A final factor, one that comes into play where the others are in any kind of conflict, would take the will into account. Individuals are free, indeed encouraged it would seem (insofar as radical autonomy seems to be one of the reigning spirits of the age), to choose identifiers for themselves if there is room for doubt.

Viewed in this light, the reader might be able to discern my thoughts on the matter of our “first African-American President”. A case could be made that he is only 50% of the way there genetically. With the “nurture” factors, the balance most decidedly tips “white”. Indeed, as far as “environment” between the ages of about ten and 25 (the age I was discharged from the Marine Corps), our “first A-A President” is whiter than I am (I certainly interacted with more black people more intimately and intensely than he did.) However, this is little more than the sort of reverie wherein gentleman once went round and round debating “nature v. nurture”. His influences may have been 100% upper-middle class, prep school, etc., but what he saw in the mirror every day and the choice he embraced trump all that. The real question is not about “authenticity” so much as to why “identity” seems so important. We can wish that we could get past all that, to move on where cultural affect lingers on and is mutually celebrated but is less important than “the content of his character”, but it seems that identity as presently defined is just too useful to those whose lives are about grasping and maintaining power.

The other thought I have nurtured respecting Dr. King’s legacy pertains to slavery. His time was about eradicating its legacy in our country, mopping up the residual stains from an age-old injustice whose banishment was a couple of centuries in the making. That era of “Civil Rights” spurred tremendous progress. Having lived in all four corners of the U.S., and for the last five here in Texas (as well as a life's work that included inquisitive visits to all but five or so States), I am convinced that while racism in the sense of our fleshly predisposition to favor those we are familiar with at the expense of “others” will never go away, its malignant, genuinely hateful version is increasingly rare. It can be found by turning over a rock in just about every single Zip Code in the country, though probably more in some of the ones that start with “1” than in most of the ones that start with “7”. In the South, where the tendency to racism mingled with the resentments of having been invaded and then economically exploited by a seemingly foreign power, it can still be found if one looks for it, but the same can be said of Brooklyn and Boston. It’s hard to believe that not so long ago, hatred was the everyday fact of life its been made out to be. Blatant bigotry is seared into memory, but I wonder if it was the rule rather than the exception, if a plurality among those living in past generations were uncomfortable with a manifestly unfair social order but at a loss as to what to do about it.

As we contemplate those who struggled against the residual injustices emanating from the aftermath of institutionalized slavery, we should be reminded that not every ideology looks at slavery as injustice. For most of the Twentieth Century, we struggled against an ideology wherein all but a privileged vanguard might be reduced to the status of slaves to a dubious “greater good”. That struggle ended, to be replaced by a flare-up of a much more enduring competition. Among the things that divide us from our adversaries in what has been an on-again, off-again 1300+ year struggle with this competing belief system is this matter of slavery. We pat ourselves on the back and honor the heros in the struggle to banish it, from William Wilberforce forward, but it has not been banished from the earth. Those whose efforts to export that belief system were halted at Vienna and Lepanto and countless other bloody dirt patches were somewhat more successful in exporting this injustice. For centuries, coastal villages as far north as Ireland were at risk of being de-peopled by raiders who would peddle their wares back home on the southern coast of the Mediterranean. The West was attuned to moral sensibility and eventually, fitfully and even bloodily rejected the grave injustice of slavery. The same cannot be said where Islam is law. Considering how the Dream of which Dr. King spoke in challenging us to a better tomorrow extended to all, we have to wonder what he would make of our apparent indifference to this lingering injustice.

Cracks In My Belwether?

This was the week that, once again, Intel humbled the collective wisdom of the sell-side analytic community, with EPS a mere 33.3% higher than the consensus estimate. What Intel had to say also strengthened my sense that what we have here is going way beyond mere recovery (Web 2.0 definitely skipped a beat early last year, but quickly got right back on track) and even the rejuvenation of Intel itself (as described in Musings on 10/17/09, The Web 2.0 Belwether). I suspect it is more like evolutionary realignment, wherein pockets of relative rationality, niches (and so opportunities for sustained seasons of outsized profitability) in a relative if not quite absolute sense, seem to be emerging in what we call the Tech Sector. If so, the collective understanding (and so equity valuation) of the profitability of well-situated participants (high intellectual and capital barriers to entry in applications where the likes of Hitachi and Samsung can only be bit players, if they play at all) falls well short of reality. This earnings release caused INTC to trade up 3%+ after hours, and yet the next day INTC and the whole Market traded off in it worst day YTD. If ever there was a case study re the disconnect between Commercial Reality and Price Reality, we’re looking at it here.

The phenomenon of “buy the rumor, sell the news” is not lost on me, but this disconnect was striking enough to “play back the tape” and try and learn something. The idea that Intel is a great belwether for the global economy remains, to my mind, above reproach. You would think that the same might hold over in the realm of Price Reality. It is big, extensively followed, proactive in its investor relations and usually among the first major companies to report each Q. Its level and trend of its results are certainly more telling than Alcoa, which traditionally is first to report, but whose results are clouded by legacy operations and grossly subsidized overcapacity around the world. It was not as if INTC was racing up all week in anticipation, as if the Market “sensed” that the consensus was way too low. There were a couple of other factors that weighed on Friday (JPM acknowledging, to no one’s surprise, that commercial lending will be a long, slow recovery; Consumer Sentiment improving, but not as much as the geniuses had guessed it would), and one suspects that the sheer ghoulishness of Haiti put a damper on things. The prospect of a three day weekend probably had traders in a “sell and go away” mode. All this said, I was sufficiently perplexed to undertake an analysis of the price action of INTC since its nadir not quite a year ago. It turns out that the fits and starts with which INTC attempted to synch up with the rate at which the apparent Commercial Reality of Intel improved since the dark days of almost a year is quite instructive.

After printing a low of $12.06 on 11/21/08 (closing at $13.11), INTC hit its ultimate low of $12.05 on 2/23/09 (data is from Yahoo Historical Prices). It would print $12.07 on Friday 3/6, but its low on 3/9, the day the Market hit bottom, was $12.30. Seven trading sessions later it would trade as high as $15.41, a 25.3% advance off of the 3/9 low. Does anyone remember anything even remotely encouraging being said during those weeks? Neither do I. The stock would then drift for a very long time with only a faint upward bias. Q1 results had almost no effect on the price, which was almost the same a week after the report as it was a week before, though volume did spike and then remain well above what looks like depressed levels in the weeks leading up to that report. We seem to recall the CEO making comments about “a bottom”, but it sure was easy to be skeptical about what CEOs had to say back then. Although the stock managed to trade as high as $16.74 just before going ex-dividend in early May, it would manage to trade under $16 as late as 7/13. In the meantime, the recovery in the world of all things digital that the CEO was alluding to was coming to pass.

Q2 earnings were released after the close on 7/14 and woke the world up to this seeming step-change in economic reality. INTC close up $1.22 the next at $18.05. It would ride the wave of Market enthusiasm which it had unleashed over the next two weeks, trading as high as $19.80 on 7/30. This level would not be surpassed until the company decided, on 8/28, to help Price Reality along by issuing an announcement that Q3 sales and earnings were on track to be higher than previously expected. This announcement gunned the stock a whopping $0.78, to $20.65. On 9/9, six months since the 3/9 nadir, INTC closed at $19.93. Notice that just how much of the $7.62, or 62%, price improvement over the course of six months took place in two short bursts: seven trading days following 3/9 (25%+) and a dozen or so days following the earnings surprise that surprised in a sense more profound than just beating consensus (18%+).

The excitement generated on 8/28 would quickly die down, and despite an unrelenting cascade of indications that the PC world was not only recovering but shaping up for boom times, INTC continued to more or less mark time. Here is an enterprise with incalculable barriers to entry, singularly well positioned to meet a need that is growing in way that, a few months earlier, was beyond anyone’s wildest imagination, and with extraordinary financial flexibility as well, but most of the time it trades along like a tired old rust bucket cyclical. It did not reach the 8/28 high ($20.65) until 10/12. Q3 earnings would follow on 10/14, and despite the pre announcement of 8/28 consensus was still way too low. Despite this powerful earnings performance and a robust outlook, the next day the stock managed to trade as much as $0.75 higher, to $21.76, before closing up only $0.34 for the day. From there, it would dribble lower against a backdrop of burgeoning prospects for the markets it serves, ultimately printing a low of $18.31 on 11/03. Thereafter, the stock would drift higher, but have a hard time breaching $20 until very late in the year, when it became apparent that the PC supply chain, which normally starts to slow down production in December, was running hard to keep up with the rejuvenated demand.

Viewed in the light cast by the Q3 experience, the underwhelming response to the Q4 results and confirmation, in my estimation, that Intel has arrived at a disposition that is more favorable than any of us can remember should not be so surprising. Even with well-known, rigorously followed and very much in control of their destiny enterprises like Intel, market “efficiency” is a curious thing. The past year does not depict a compelling case for the idea that the Market anticipates in the vein of “buy the rumor, sell the news”. Perhaps there is a technological threat that I am simply too dense to see, like phone chips actually supplanting the work that Core processors practically own, as opposed to merely sharing in the growth at the margins and so “taking share” of a burgeoning pie. If so, we will know in another year or so. More likely, the Market is just about as wrong pricing INTC at $20.75 as it was pricing it at $70+ a decade ago. (Are “these guys” any smarter than “those guys”? No wait, a lot of them are the same guys!) With a little over $2 per share in net cash (and more than they need rolling in every day) a company with Intel’s prospects ($2 EPS in 2011 is not unthinkable) should not have price that starts with a “2”. Chalk it up to that which is the nexus of investment opportunity, the persistent disconnect between Commercial Reality and Price Reality.

The High Price of Defense on the Cheap

This week we will look at how a movie featuring John Wayne taking on the Imperial Japanese Navy in a plywood boat changed my thinking about the F-22. Recall that last spring, the Administration moved to cap production on this super stealthy, fifth generation fighter aircraft. While very much in favor of having an aircraft that is so clearly superior to anything on anybody’s drawing boards, at an estimated fly-away cost of $143MM per ship set one wonders if perhaps the presently planned fleet of 187 might be sufficient. After all, the F-35 Joint Strike Fighter is coming up the development curve. Though not quite as stealthy as the F-22, it is being designed for multiple missions (and foreign participation) that are expected to require thousands of aircraft. These factors result in the F-35 having a significantly (> 40%) lower fly-away cost.

Honest and spirited disagreement can be had over the right mix of aircraft to meet our future needs, especially when the growing role of unmanned aircraft is figured in. These are very long lived programs, intended to meet or deter threats two or three decades from now. Truth be told, I found it easy to acquiesce to what seemed like a high-volume, “budget” approach (cap the F-22 but produce a whole bunch of almost-as-capable JSFs). Blame a value orientation that seeps out into many other facets of life beyond investing, as well as the fact that I enjoy a better than average understanding of what aviation suppliers stand to prosper mightily from high volume production of the JSF (They are on my List.). It’s hard to imagine anyone anywhere coming up with a credible challenge to the F-22 in my lifetime, so maybe having 187 of them waiting in the wings to do the highest priority missions, while hundreds of F-35s and UAVs do whatever dirty work comes along, is a “good enough” solution to prospective threats.

This sort of cost-efficient thinking about defense spending took a bit of hit when I watched the aforementioned movie. They Were Expendable (TWE) was John Ford’s 1945 contribution to the war effort. It was (in Hollywood’s way, loosely) based on the exploits of Motor Torpedo Squadron 3 in the Philippines at the outset of World War Two. The action centered on a couple of Naval officers, one of whom was based on Lt. John D. Bulkeley, whose actions prior to his part in evacuating Gen. MacArthur won him a Congressional Medal of Honor. The great thing about so many of the movies from back then (Hollywood’s “Golden Age”?) was that their creators were all about meeting the audience where it was. Film making may have been more technically limited than today, but one takes away a real connection with what was on the minds and hearts of that broad swath of Americans that was its intended audience. This is because the studios held to the priority of selling tickets rather than preaching or pandering (“If you want to send a message, call Western Union!”). And while some of the actors might have been just as dissolute in their private lives as today’s celebrities, they were all business on the job, rarely preening about in the manner that is all too common today. For example, one gets a clear sense of how wearing ten years of recession had been on the American psyche from watching a circa 1940 Preston Sturges film. On the surface, TWE was a lot of fast boat shoot-em-up, the requisite and somewhat stereotypical array of sailor “characters” and a bit of a love interest between John Wayne and a nurse portrayed by Donna Reed. The feeling it conveyed though was unbearable uncertainty, of dreadful and overwhelming sense of lives disrupted and perhaps devastated by unbidden war being thrust upon them. Everyone seemed to be facing up to hard choices and the cold hand of fate in ways that make so many of today’s “crises” seem lamely trivial.

It also occurred to me that those of us under the age of about 65 find it all too easy to view the outcome of that war as more or less inevitable. Viewed in hindsight through the lens which Hollywood would bankroll for the next couple of decades, it seemed that once the vast industrial might of the U.S. heartland geared up to equip the teeming masses of the English speaking world, the Soviets and what remained of Chinese fighting forces, it was just a matter of grinding the upstarts down. This film reminds us that it did not seem so inevitable at the time, even in 1945 when what we now think of as decisive battles (e.g., Leyte Gulf in 10/44) were in the rear view mirror. In 1942, it was anything but inevitable. Countless lives were being turned upside down by it or by the process of getting up and doing something about it (i.e., mobilizing to fight back against the emergent aggressors). What struck me was that considering the relative stature of the principals, as reckoned in economic potential, it seems ludicrous that the Empire of Japan should have dared to take on the U.S., and yet they did. At the safe remove of a half century plus, it seems insane, but the criminal regime that had taken control of the government (as I understand it, it was as if, say, the “outift” in Chicago had moved in and taken over WA DC. Hmm.) looked at the facts on the ground and decided that they could pull it off. They were wrong, but as depicted, explicitly as well as by inference, innumerable Americans paid all manner of prices to make it so.

This cinematic impression of lives overtaken by a war that might not have been was helped along by a couple of other inputs. One was also courtesy of Netflix, that wonderfully cost-effective source of home entertainment option for those of us who are disinclined to pay up so as to drink from the feculent fire hose of cable or satellite. We have been enjoying a series called Foyle’s War. It’s about a small town British police detective, widowed and with a son in the RAF, and does a very nice job, for a BBC production anyway, of depicting how Britain struggled to pull together as war approached and then overtook them. It is highly nuanced with the tensions and epiphanies that occur when members of a class oriented society are thrown together in common cause, though we see that not quite everybody was on board. (Of course, its BBC, so the “bad guy” in the murders he solves is invariably aristocratic, a businessman or a visiting American.) The other input was a few hours I spent last summer in a little museum in Sante Fe, NM. (It was that and go try the green chile cheeseburger voted the best in NM, or spend the whole day with my traveling companion looking at art.) The New Mexico National Guard had a very large contingent in the Philippines in 1941. Many of them were swallowed up in the Bataan Death March. A large proportion of those who managed to survive the March and then internment returned so broken in health that they only lived a short time longer. Many of these men came from towns and villages I had passed through or seen on a map for the first time just that week. This was a people’s shrine to that sacrifice, rife with photographs and letters and memorabilia dragged out of attics in the subsequent decades. It reminded me that war really is something to be deterred, perhaps by almost any means necessary.

This brings us back to the connection between the plywood boats and the F-22. (Actually, it turns out the PT boats were not made out of plywood as we know it. Like today’s cutting edge aircraft, they were made of a composite material, though not of filament and resin. A glue-infused sheet of canvas was sandwiched between 1” mahogany planks, arrayed diagonally and held together by myriad brass screws. This made for a lightweight, durable and relatively easy to repair hull, though hardly able to withstand a direct hit anywhere near the tanks that fed the twin gasoline engines.) The point of defense spending is not simply to be able to overcome existing and prospective threats. If a nation has the means, and the U.S. certainly does, it should also aim to make it unthinkable, even for corrupt gangster states like Imperial Japan or who knows what China will look like in twenty years, to even consider such an encounter. Prudent defense spending has to have an element of “Don’t even think about it”. An on-going commitment to superiority not only provides an objective “edge” in the event of actual hostilities, it should imbue a sense of futility in all but the most insane of prospective adversaries in terms of even considering trying to keep up with us. The war depicted in TWE, and that bottomless well of suffering and sacrifice that went with it, might not have happened if the U.S. defense policy had not been so “on the cheap” in the two decades leading up to it. We see no credible threat today, in the realm of air-to-air combat anyway, but just what did the threat of National Socialism and Imperial Japan look like in 1931 or even 1936? Deterrence does not have to take the form of the Mutually Assured Destruction of the Cold War era. Technology plus will power can produce a much more refined solution. The F-22 embodies the kind of technologies where if we put our minds to it, we can hold an unassailable high ground, so daunting that any party with enough intellectual resources to attempt to match it will think better of even trying. I am still not sure what the “right” number is for the F-22, or any other program for that matter, but I am sure that it is higher than what “analysis” would indicate

Of course, technology and the wealth to develop and produce superior weaponry are not enough. I did mention willpower, didn’t I? Part and parcel with the will to deter threats and so spare our people of what TWE so impressed me with is recognition of reality. Reality 2010 is that we are at war. Perhaps Imperial Japan was getting the same sort of mixed messages about our resoluteness in 1941 as the Taliban et al have been getting of late. It does not serve the cause of deterrence to act and even talk (“manmade disasters”) as if there were no war on. What must they be thinking when we give skivvie-bomber a lawyer? (Talk about wasting a golden opportunity to gather a few facts about his handlers. After flame-broiling his private parts, the guy obviously needed pain medication, which depending on how cooperative he was might have been “hard to find” later that evening. “Oh, Nurse Grabbit, it looks like you need to dress the patient’s wound again!”) I am not perturbed because the enemy almost pulled one off. We are at war, vigilance slips as time wears on, and then you get a wake-up. Wars are sloppy, messy things, often won by the side that screws up the least. From the point of view of waging a war that will not leave us alone, an uglier outcome might have been better, if only because it would have been a louder, more enduring wake-up. No, what fries me is that we have it within our grasp to implement effective and enduring deterrence of that residue of humanity that hates us and wants to kill us, or might someday succumb to dreams of global dominance the way Germany and Japan did, but we choose to pretend that stuff like that doesn’t happen anymore, and even if it did there is nothing we can do about it. This is madness, for which the great grandchildren of the people for whom They Were Expendable was made will likely have to pay.

A Way Too Interesting Decade

The New Year finds us awash in journalistic reflections upon a decade variously referred to as the Oughts or the Naughts. From an investor’s perspective it was ten way too interesting years, more or less book-ended by the bursting of two Bubbles of the sort that most decades are spared of altogether. The last couple of years have been unusually difficult for unusually large numbers of us, but the pretense bandied about of “worst decade ever” is risible indeed. Compared to the 1930s? Get real! This past week our Netflix queue happened to serve up a peek into the 1940s in John Ford’s They Were Expendable. This 1945 film starring John Wayne, Robert Montgomery and Donna Reed was more than a dramatization of the US Navy’s struggles at the outset of hostilities with the Empire of Japan. Movies in those days were great (however loosely they depicted the actual events upon which they were based) because their creators met the audience were it was. In the 1940s a massive plurality (as opposed to today’s larger than normal minority) of Americans were seeing their livelihoods and most precious personal relationships being ripped apart and subjected to fears and uncertainties that make “Great Recession” seem almost trivial by comparison. One suspects that the recency of this decade’s jaw-dropping, gut-wrenching immolation of multi-$Trillions makes it seem worse than that endless migraine that was the Seventies, but was it really?

I would submit that to the extent we want to define history by decades, the Thirties were a time of trial and testing which prepared us for the Forties, which were a time of standing up to and ultimately triumphing over a wide ranging eruption of evil. Life has taught me that tough times have an uncanny way of making us better able to rise to subsequent challenges, and I think this played out in that era. In the Fifties we were rewarded for passing that test, while the Sixties were a time of losing our way. In the Seventies we stumbled about in dazed confusion, but the Eighties saw us groping back toward the Founders’ vision of an exceptional City on a Hill. It was salubrious even if we got nowhere near the destination that had been our heading. The Nineties saw us reading the wrong message into the end of the Cold War, an “end of history” which would prove short-lived. Leadership which “felt our pain” and “tried it but didn’t inhale” attenuated our capacity for noble struggle and otherwise debauched us with temptation to narcissism. The Naughts for the most part echoed the Seventies in their dazed confusedness.

A brief cataloging of what I take to be the most defining moments of the Naughts would start with a little anecdote from its dawning weeks. We had all woken up to find that “Y2K” ended up resembling nothing more than a lame practical joke. I was writing about how the Tech Bubble was starting to lose air faster than the “pumper-uppers” could pump it up. At the end of January I attended an Analyst meeting for a company (which has since “realized value” in multiple directions) that was held at a ski resort in Utah. I remember being bombarded with images of just how flush a large slice of America’s households were with discretionary income of the sort that is needed for families to subsist in high-end resort towns at high season. It was common knowledge that demigod Naz was going to deliver 20% forever and early retirement for all who cared to partake! I clearly remember sharing a chairlift with a guy who, upon hearing about my involvement in the world of investing, asked me what he should do with his money. You should have seen the look on his face when I told him he should fold it up and keep it in his wallet. Who knew, so many years into stocks being The Only Game in Town, that this flip remark was the best possible advice your average “investor” could have received? Then on the way home, I watched a guy with one of those primeval wireless devices for day trading (Quotrek?), furtively working under the cover of a newspaper as we prepared for take-off, and not seeming to be having a good time of it.

Those were actually great years to be a value investor, when the life that had been sucked out of “everything non-BITT” (remember that?) since about 4/98 started to flow back in. It goes without saying, though, that the Great Game of buy low and sell high was rendered into trivial pursuit on 9/11/01. History had not ended after all. The silver lining was that it is always end up being a good thing when collective delusion gets swept away. Nearly a decade later, the visceral memory of that kick in the guts lingers in a plurality of Americans. I find it puzzling how after executing against the Taliban in Afghanistan with awe inspiring economy of force, but finding ourselves bogged down for years in Iraq, nearly a decade later it looks like we won in Iraq but we are still trying to “figure it out” in Afghanistan. The lesson seems to be that warfare has become quite asymetrical, that having the wrong game plan can easily undo any manner of material and technological advantage.

One consequence of the reaction to 9/11 was the apparent near demise of the aviation industry. I remember in March 2003, with the war going live in the desert and something called SARS killing a lot of chickens in China, paying something less than $500 for a pair of round trip tickets, Boston to Munich. And there were lots of empty seats on the return flight! This moment also denoted a stupendous buying opportunity in aerospace stocks, as not only was a never-ending war back on the front burner, but air travel would prove (as I wrote in June 2003 in Not Going Back to Greyhound) to be an indispensable part of how burgeoning millions of us choose to live.

The economy was seemingly pulled from the ditch by an engine that was all about real estate. By mid decade, this “asset class” was the face of a bubble that had been decades in the making and of a magnitude that was too big for any of us to see. A personal milepost in this decade would be May 15, 2005, when I took my leave from what seemed like the rapidly gentrifying hollows of Columbia County, NY and alighted in the Texas Hill Country. This transition attuned me to when the leakage quickened in the bubble that was Real Estate. It would be a couple of years before it was broadly obvious, but the media event that was Hurricane Katrina marked the beginning of the end. Let’s just say that the market for second homes in the Hudson Valley went from white hot before September to something not quite red hot shortly thereafter. The drama of Katrina broke the fever. It also was an inflection point in the political stream, a stumble from which the Administration would never recover. (It was reminiscent of how after “owning” his adversaries for years, Reagan lost the upper hand during the Iran/Contra affair and was never quite as effective thereafter.) I suspect that thrusting New Orleans into the spot light was inherently unsettling, a reminder of how much corruption and decay can lurk below a patina of frivolity and passable functionality (being below sea level doesn’t help, either!)

The next “big moment” turned out to be July 2007, when the “ix-nay on that triple A” started to emanate from the rating agencies on whose unimpeachable veracity legions of bagholders had made highly leveraged bets. This happened on more or less the same day that the SEC’s conclusion that the “uptick rule” was more trouble than it was worth took affect. A couple of similar developments at that time escape my recollection, but I remember a definite sense of sea change before that month had run its course. That peculiar Market action that defined the next few months (days with lots of stocks up >10% and down >10%) turned out to be smart hedge fund operators beating a path to the sidelines so as to start to work on the next game plan. There were so many signs, so obvious in hindsight (like, maybe, it having been 35 years since the last one?) that we were due for a once-in-a-generation purge of delusional excess, but who knew? Virtually all of us paid a heavy price, in treasure as well as self-esteem, for not recognizing what Time it really was. I for one find myself with mixed feelings about the prospect of living long enough to “go through that again”, despite having had the fortitude and buying power to take advantage of and eventually profit mightily from a situation that was a day after day, head to toe world of hurt.

If I were allowed only one more “moment”, my first choice would not be the 3/9/09 nadir of sentiment as defined by the DJIA. As Musings was wondering out loud at approximately that time, the political drift since mid-Decade in the direction of Progressivism was showing signs of being short-lived. In retrospect, I can state a little more clearly that said political movement was at high water on 1/20/09. That tide has been creeping, and then rushing, out ever since. As also noted in Musings, these enemies of liberty, who hold in low regard the rights and responsibilities of the individuals who create wealth, will do us damage, but that damage is likely to be a good bit less extensive than we were tempted to believe. The rate at which these plundering factions have discredited themselves has exceeded my most wildly optimistic expectations. Shuttered by ideology that has seeped down so deep into their souls that it is recognizable only from afar, they are insensate to the hopes and dreams of the real people they purport to govern. This nightmare will not pass without doing damage, and it will not pass without a fight, but it will pass. Circumstances may come to pass which preclude an outright recapture of the House by the opposition party ten months from now, but in any case a swelling popular reaction is putting what our forebears called “the fear of God” into quite a few of those who must stand for election. The Market recognized that this Emperor had no clothes early on this year, and I suspect will continue to applaud a popular insistence on a retreat from that retrogression that is Socialism by any other name.

The one thought as to what the dawning decade will bring that I would propose revolves around a construct that gained currency in the run up to the liberation of Iraq and then mysteriously simmered down. Remember the Arab “street”? I took this to be the millions people in those latitudes running from Morocco to Indonesia who would be so offended by our newfound assertiveness that they would sign their kids up for Suicide Bomber Summer Camp. (Recent events have indicated that the supply of competent suicide bombers might be a good bit more dried up than we had supposed.) Events gave lie to this notion. It appears that Islam is at least as susceptible to “backsliding” as Christianity, that most Moslems are as “nominal” as they can get away with, and that regime-sanctioned demonstrations are well nigh the only way one can cut loose and act out in these repressive, humorless societies. So they go for it with all the “death to America” gusto they can muster and then go home and see what’s on TV. The “street” yawned and went about its business in 2003, but in June 2009, a variation on this construct emerged in response to the craptactularly orchestrated elections in Iran. The streets turned Green, and then red with the blood of martyrs. Brutal as the response was, this movement is not likely to be denied. When Poland shook off its oppressors, we in the West did not know the names of its martyrs, like Fr. Jerzy Popieluszko, but the Poles did. This struggle in Iran is at least as far along as that one was when that priest was tortured to death by Marxist thugs. So if I have to pick one catalytic, course of history changing event, the “curve ball” which is beyond the Market’s uncanny ability to discount in advance, it would be unrest emanating out of what is now very much in play in and around Teheran.

A little shy of a hundred years ago, at a time when anarchists were running amok and “bomb thrower” was not just a figure of speech, who knew what the assassination of a Balkan Archduke would set off? Within the bounds of the proverbial “everything else being equal”, we can expect the value of equity to continue to recover from its near death experience, but there is a very good chance that what ends up surprising us most about “the Teens Decade” will be the rippling consequences of what is happening in Iran right now.