Deficits without tears?
June 30, 2006
Market Summary – 2nd Quarter, 2006
American taxpayers were told recently to be of good cheer – the annual deficit – the amount by which the Federal government spends more money than it generates in revenue – is projected to be down to a mere $300 billion!!! The fact that this news triggered a celebration brings to mind a quote, attributed to Jacques Rueff (an advisor to former French leader Charles DeGaulle). He suggested that a government blessed with the luxury of printing its own money to repay what it borrowed had entered an era of “deficits without tears.”
Once gold was no longer linked to the dollar, our currency became “fiat” money (where the value of the currency is decreed by a government, and not backed by a tangible asset). If you owned our currency, the only thing you could redeem it for was more of the same. Worse yet, one institutionalized form of fiscal discipline was gone, and the spending spree was underway.
The final connection between gold and the dollar was severed in 1971. In that year, President Richard Nixon ended the gold standard that allowed foreign countries to exchange dollars for gold (part of the Bretton Woods agreement of 1944). Up until that time, DeGaulle and the French took full advantage of Bretton Woods, forcing the U.S. to exchange as many dollars into gold as the French desired. It was putting a strain on U.S. gold reserves, so Nixon unilaterally stopped U.S. compliance with Bretton Woods. In the 34 years before Nixon closed what is referred to as “the gold window,” the money supply in the U.S. doubled. 34 years after Nixon closed the window, the money supply has grown 13 times, from $800 billion in 1971 to more than $10 trillion today. With no need to mint U.S. currency in parity with our gold reserves, the presses were free to print.
The fear with fiat currency is that because the dollar is backed only by the full faith and credit of the U.S. government, its value will decline as more money is circulated. And lo and behold this is exactly what happened.
Our 4th quarter 2005 issue (titled “Who Wants to Be A Half-Millionaire”) featured the following chart. It demonstrates how the purchasing power of the dollar has declined steadily since the gold standard became a reduced factor and eventually eliminated from any link to the dollar. FDR started the process in the 1930s by prohibiting private ownership of gold and Nixon finished it by closing the gold window. Since the 1930s, the cost of living has gone up. We take it for granted now, but as you can tell by the chart, it wasn’t a given prior to the 1930s.
Unfortunately, the freedom to print money not linked to gold reserves coincided with an equally huge problem – politicians who, in our opinion, use the Federal treasury as a way to win favor with voters and assure their re-election. This is not a partisan problem, but one of incumbency. It only gets worse as politicians become more embedded in their elected posts and can’t help themselves in promising constituents more than we can afford. The fact is, the system is broke, and it has led to unfettered spending with little regard to revenues or the long-term impact on our economy.
Can anybody name a government program that pays out benefits that was either eliminated or cut in any significant way? As an example, this chart shows government payouts to individuals through various social programs has ballooned in recent decades.
These are mostly long-established programs that seem hard to kill once they are in place. The discretionary pork is flowing out of Washington as never before. In 1995, approximately $10 billion was earmarked for about 1,439 projects that could be identified as “pork barrel spending.” Ten years later, the dollar amount had risen to more than $27 billion, funding nearly 14,000 pork projects! These are pet programs that lawmakers identify in legislation for very specific purposes. The most famous (or infamous) in recent times is Alaska’s “Bridge to Nowhere,” to the tune of $231 million.
The economist/humorist/actor Ben Stein (“Bueller…Bueller”) recently wrote in The New York Times, “We are the beggars of the world, financing our lavish lifestyle by selling our family heirlooms and by enslaving our progeny with the need to service the debt.” Stein calls America a nation of “drunken sailors from the Capitol to the freeways.” In other words, as a nation, we are borrowing in order to consume.
All of which leads to a lot of concern – not that the country is going down the drain, but that some tangible investments seem highly appropriate to own in this environment. Clearly, the government is not a friend of the investor given its spending habits. So what is an investor to do? One answer, ironically, comes right back to gold.
Another value investment
We don’t stand here today predicting rampant inflation (ala Germany post-World War I) or that the dollar will soon be as worthless as confederate money after the civil war.
In fact, America is quite clearly still a strong, productive, inventive nation. Our democracy and economy are still admired around the world. We have a strong base to build on.
Yet there is a formidable, at-hand risk that many who currently recognize value in the dollar may, in years to come, see less value in holding dollars. The dollar’s inability to regain equal footing with the euro in recent years is an indication that more struggles may lie ahead. Since 2002, the dollar has lost about 14% of its value against currencies of the major U.S. trading partners.
That’s why stocks of companies involved in gold mining are still considered a good value by our standards, even though the price of gold has risen dramatically in the past year.
Something you can sink your teeth into
When seeking value, it seems sensible to look for something that you can hold and feel. That’s why we still think assets like gold and energy have a lot going for them.
These are tangible assets with obvious real value in the world in a variety of ways. You can print too much money, but you aren’t likely to dig up too much gold or strike too much oil to meet increasing global demand.
Gold soared last year and the first part of this year, and then recently retreated in price. We all know that gold can be a very volatile investment. But given the concerns we have with government spending and the state of the dollar, gold’s run is not likely to be over anytime soon.
Our investment in metals stocks began when gold was priced below $250/ounce. As you can see from the chart, it has gained a lot of ground since then. Is there room for gold to go higher? Our belief is that investments in tangible assets like gold will have more value going forward, as America deals with its debt problems and the continued decline of the dollar’s value.
While no tears have been shed yet over our nation’s debt problems, we subscribe to the old bromide, that which cannot go on forever doesn’t.
In this sense, gold continues to star in the role it was born to play, and has for hundreds of years – as a hedge against the excesses of governments and their historical track record of debasing currencies.
Energy still a find
We’ve been big investors in the energy sector since oil was at $30 a barrel. Now, the price of oil continues to edge ever closer to the $100/barrel mark. Even if it doesn’t reach that point anytime soon, there’s no reason to think the energy opportunity is behind us. The supply crunch for oil is a lifelong issue. For developed nations, oil is a critical factor in their foreign policy decisions, because it continues to play such a crucial role in their economic health. Short-term, oil prices will move up and down. More important to investors is that there remains a growing world demand for a depleting resource.
As an example of what is developing from the demand standpoint worldwide, there this from a piece in The New York Times Magazine on July 16, discussing the changing demands in China:
• China now has 23,000 highway miles, more than doubled in five years, second only to the U.S.
• The government aims to have 53,000 highway miles by 2035. By comparison, the U.S. has 46,000 miles today.
• There are 20 million cars in China today, more than triple the number in 2000
• Yet on a per capital basis, China has just 7 cars for every 1,000 people, exactly where the U.S. stood in 1915!
• It is estimated that China could have 120 million cars on the road by 2020 and close to double that by 2030.
• Chinese drive 30,000 miles per year on average, versus 10,000 to 15,000 on average for U.S. drivers
• By 2030, according to the International energy agency, China may be importing as much oil as the U.S.
Keep in mind that China’s economy grew at an annualized rate of 11% in the second quarter. It is a country on the move. And India isn’t far behind.
We aren’t foolish enough to think the current price spike will go on indefinitely, but we are convinced that energy will continue to be an attractive commodity that will increase in value over time, benefiting the energy-related stocks that we own. Long-term supply/demand will reward those who own the proper assets.
Paying the right price REALLY matters now
By at least one measure, these have been great times for American business. The stocks in the Standard & Poor’s 500 Index, on average, have enjoyed double-digit profit growth over 13 straight quarters (through the first quarter of 2006). The only other time this happened since the 1920s was between 1993 and 1996. Yet, this rising tide is not lifting all boats. While there is plenty to be cheerful about, it remains a time when a selective approach to investing is vital to generate attractive returns.
We can’t help but think that all of the problems with an overextended government budget, tapped out consumers, the dollar continuing to lose ground and higher prices for commodities add up to an important fact – the days of easy investing are behind us. The price you pay for a stock is more important than ever. Index investing is hard-pressed to succeed in today’s market.
It is important to identify companies well positioned to offer goods and services to the right markets. In an era where nothing is coming easy for the economy and pressures are mounting on a variety of fronts, only certain businesses in certain industries have an opportunity to flourish. Gold and energy are examples of two sectors that are appropriately positioned for the long run. Knowing that, we continue to keep money at work in what we see as companies with solid business prospects in those sectors.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.