William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

In discussions with clients and prospective clients recently, we at Smead Capital Management (SCM) have argued that the US Treasury Bond market today is the antithesis of 1984. In 1984, 10-year Treasury bonds peaked at 14% with a 4% trailing inflation rate. Back in 1981 the interest rate was higher at over 15%, but it took massive courage to believe that inflation would get tamed. It took wisdom to see in 1984 that the back of the demand-pull and cost-push inflation of the 1970’s was broken. In an editorial in the Wall Street Journal dated August 18th, 2010, Wharton Professor Jeremy Siegel reiterates our argument about why today’s 2.7% interest rate on 10-year Treasuries could be as dumb an investment as the 1984 rates were smart.

In his article titled, “Great American Bond Bubble”, Siegel points out that the fear of deflation and the lack of trust in eventual economic recovery have caused an avalanche of money to flow into bond funds and individual bond purchases.

A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites. The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.

He focused on comparing this bond bubble to the tech stock bubble of 2000. Many tech stocks were trading at 100 times earnings back then and Siegel correctly points out that if you’re buying a bond instrument paying 1%, you are effectively paying 100 times pre-tax profits to buy the bond. Are IBM, Johnson and Johnson, and McDonald’s, which sold billions of dollars of debt recently, not performing a bit of genius by borrowing money that they really don’t need. IBM paid a 1.1% interest rate for three-year bonds, while JNJ and McDonald’s issued 10-year bonds at 3.1 and 3.5%, respectively.

The negative nabobs of double-dip recession and Japanese style deflation have been jumping up and down lately as local, state and federal governments have been shedding staff to cover up the beginnings of private sector employment growth. Temporary staffing firms like Manpower are booming, which has historically been a predecessor of permanent job openings to follow. We believe the current economic consternation stems from having stared into the abyss back in late 2008, when we seriously considered a total breakdown of our economic system. We also believe that it is human nature to want the source of our prior problems (in this case excessive household debt) to get eliminated before we can feel comfortable about the future. Here is how Professor Siegel explains these attitudes.

Today the purveyors of pessimism speak of the fierce headwinds against any economic recovery, particularly the slow deleveraging of the household sector. But the leveraging data they use is the face value of the debt, particularly the mortgage debt, while the market has already devalued much of that debt to pennies on the dollar.

This suggests that if the household sector owes what the market believes that debt is worth, then effective debt ratios are much lower. On the other hand, if households do repay most of that debt, then the financial sector will be able to write-up hundreds of billions of dollars in loans and mortgages that were marked down, resulting in extraordinary returns. In either scenario, we believe U.S. economic growth is likely to accelerate.

We argue that the 2% interest rate on 10-year Treasury bonds in late 2008 was a function of not knowing whether we’d have a 1930’s style depression. We know that the TARP plan and the work the Treasury and Federal Reserve Board did back then successfully avoided the worst case scenarios. However, there is a large crowd out there that believes there are years of penance to pay for the financial sins of the last 15 years. These purveyors of painful futures don’t think the 50% decline in the stock market in 2007-2009 and the changed household behavior (some forced and much unforced) are doing the trick to cleanse the system and prepare us for long-term economic growth. The future agony they self righteously predict assumes that we can’t have a long-lasting economic recovery unless Americans borrow money like drunken sailors on leave.

We disagree and can see it in the sales and profit figures from companies we own like Starbucks, Disney, EBAY and Nordstrom. As US Households postpone car purchases, put off trading up on homes and maintain rather than remodel their homes, they keep fixed monthly payments from being added to their income statements. They are saving a good part of these outlays, paying off debt and have money left over to spend on things they want. Those things they want include coffee, movie and TV entertainment, online purchases and clothing/shoes to upgrade their appearance. None of these purchases require installment or mortgage debt.

Therefore, in our eyes, the 2.7% 10-years Treasury Bonds are foolishness. We believe everyone out there avoiding the premier US companies to own those bonds will be looking back at today in the future and asking themselves, “What was I thinking about when I could have bought those stocks back in 2010?” With huge amounts of cash earning nearly nothing in money market funds, savings accounts and a massive amount of money tied up in historically low interest rates in the bond market, we could have a market melt up if the nabobs end up being wrong. We could have a pretty good US stock market even if we avoid their worst case scenarios. We saw an 80% move up in the S&P 500 Index coming off of the 2009 lows, but the best could be yet to come.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Some of the securities identified and described in this missive are a sample of issuers being currently recommended for suitable clients as of the date of this missive and do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

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Dear Fellow Investors:

1982

The stock market bottomed in August of 1982 just below 800 on the Dow Jones Industrial Average (DJIA) during the worst recession that had occurred since the 1950’s. Unemployment exceeded 10%, smokestack industries were decimated (remember Billy Joel’s “Allentown”), housing and forest products were in a depression (foreclosures up dramatically), auto sales almost sank both Chrysler and Ford, interest rates peak at 15% on Treasury bonds and the U.S. had lost its respect around the world. The stock market had peaked in late 1972 at 1000 on the DJIA and investors could look backward and see how fruitless investing in common stocks had been for the prior decade. Business Week had called it the “Death of Equities” on a late 1979 cover.

Wise economic commentators explained in 1981 and 1982 why we could not have any meaningful economic recovery. Unemployment kept going up for months after the stock market exploded to the upside. Housing affordability was at a 38-year low. Credit needed to buy houses, cars and expand business was at such high interest rates that it seemed like nobody would want to borrow the money. Many of the home buyers and businesses who did borrow the money failed to keep up with the interest expense, damaging bank balance sheets in the process. Huge federal budget deficits were going to be exacerbated by the Reagan tax cuts. The government’s borrowing was crowding out private borrowers. Banks were competing with money market funds. The disintermediation of the banking industry forced them to pay competitive interest rates on a relatively new instrument called a Certificate of Deposit (CD). It appeared highly unlikely that a strong economy could get born in those miserable circumstances.

2009

The stock market bottomed in March of 2009 at around 6500 on the DJIA during the worst recession since 1982. Unemployment has reached 9.8%, most cyclical industries have been devastated. Auto sales dropped so low that Chrysler and General Motors went into Chapter 11 bankruptcy. Retail sales have been “reset” to markedly lower levels. The U.S. has lost its respect around the world. Homes have fallen in value more than at any time since the 1930’s. Looking back ten years, investors have suffered losses and many commentators are referring to the first decade of the 21st century as the “Lost Decade” for stocks. Numerous asset allocation experts are advising people to reduce their portfolio weightings in stocks and increase ownership in bonds. We believe this advice is being acted on. Bond mutual fund sales have run more than 20 to 1 ahead of equity fund sales since the start of the year.

Huge budget deficits exacerbated by the U.S. Treasury’s TARP program and the Federal Stimulus Bill have convinced economic experts and commentators that whatever economic recovery comes could be accompanied by much higher levels of inflation. Many economists believe that the huge debt overhang left from the prior cycle, which equals around 375% of GDP, will serve as a drag on the economy for years and mute the magnitude of an economic recovery. Banks have such large write offs from the bad loans made in 2002 to 2007 that they are pulling back from lending to even creditworthy borrowers or asking for traditional down payments and collateral levels. Compared to 2007’s levels these requests look onerous. It appears unlikely that a strong economy can get born in these miserable circumstances.

Pick Your Poison

Therefore, which is worse? An economic recovery which requires people to borrow money at ridiculously high interest rates from crippled banks, when houses are the least affordable that they’ve ever been? Or an economy where houses are the most affordable and the mortgages have the lowest rates they’ve had for 50 years from crippled banks in a society that already has seemingly unsustainable overall debt levels? Pick your poison. Did I forget to mention that the first incredibly miserable circumstance was the beginning of one of the greatest bull markets in U.S. stocks in history (1982-1999)? Did I forget to mention that the economy grew immensely and relatively consistently for 25 years? At Smead Capital Management, we don’t believe all the doomsayers out there who say, “It is different this time”. We think that a weak economy going forward is a “Well Known Fact” and is already factored into current prices.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. The securities identified and described in this missive do not represent all of the securities purchased or recommended for our clients. It should not be assumed that investing in these securities was or will be profitable. A list of all recommendations made by Smead Capital Management with in the past twelve month period is available upon request.

William Smead
Chief Executive Officer
Chief Investment Officer

Dear Clients and Prospective Clients:

There is an amazing fact in investment analysis. The longer you are right, the greater the amount of intelligence people attribute to you. Along those same lines the more money you make in business, the more intelligent people think you are. It’s like the investment world is perpetually playing the board game LIFE. In the game, if you are lucky enough to get the right roll at the beginning, you become a Doctor. The medical profession had the highest income in the game and made you more likely to win. The game was invented in the 1960′s, when Doctors were the highest paid professionals in town and were also the most educated. Since they had the highest incomes and most years in school, people asked for their opinion on a broad array of subjects under the assumption that their personal success and academic education made their opinion more valuable.
 
At extremes in markets there has usually been someone of stature who felt early on that what has happened would happen. The longer that the trend continued and the longer that the person of stature continued to predict its continuation, the more intelligence investors attached to them. A few historical examples are in order. In the very high interest days of the early 1980′s two economists, Dr. Henry Kaufman and Dr. Albert Wojinalower, correctly predicted that the Federal Reserve and its leader Paul Volcker would tighten credit and raise interest rates high enough to break the back of inflation. They were called Dr. Doom and Dr. Death because of their bearish views on the bond market and the economy. Unfortunately for them (at the time that they were considered the most intelligent form their correct predictions) they were predicting 22 to 25% Prime interest rates at the peak in 1981 and told everyone to stay out of bonds at the single best time to buy them in U.S. history !
 
Mary Meeker and Henry Blodget were technology stock analysts in the late 1990′s and rode the dot-com bubble for everything it was worth. Once again they were idolized and ascribed great intelligence until the bubble burst and they stayed bullish a long way into the crash. They crushed their fan club in the process. More recently, the oil analysts at Goldman Sach’s were riding high from predicting in 2005 that oil would climb immensely in the coming years. They predicted $90 per barrel oil and ratcheted that prediction up as oil exceeded that target in 2007 and 2008. When oil reached $145 per barrel, they were considered total geniuses and flatly predicted a run as high as $200. I haven’t heard a word about them lately as oil is below $50.
 
Today, a banking analyst at Oppenheimer by the name of Meredith Whitney and a New York University Professor by the name of Nouriel Roubini, who correctly predicted much of the difficulty experienced in the banking and financial companies the last two years, move the markets every time they appear on CNBC or Bloomberg. Their intelligence meter is through the roof and the respect the markets pay them matches it. We at SCM assume that they will be singing the same tune all the way through the bottoming process and could be scaring investors away from financial companies at the bottom the same way that Henry Kaufman and Albert Wojinalower did with bonds in 1981! Remember, the longer a trend is in place the more risky it is to bet that it will continue and all of us are human, even the experts you see and hear on television.

Best Wishes in this Holiday Season,

William Smead