Sitka Pacific Capital Management, LLC 1 September 2010
Dear Investor,The US stock market has been fluctuating higher and lower in a broad range for the past four months, afterdeclining from its high in April. In August the S&P 500 ended near the bottom of that range, and in earlySeptember it rallied toward the upper end of that range. Most global equity markets are in a similarposition; there has been a partial recovery from the declines in the second quarter, but not a full recovery.While stocks have remained range-bound, other markets have moved significantly in recent months. Goldhas continued moving higher, and silver has recently joined with a new uptrend. Grains and otheragricultural commodities have also moved significantly higher in recent months. However, despite thesepositive trends in precious metals and agriculture, energy prices have remained relatively depressed. Thishas kept the CRB Commodities Index in the negative so far in 2010.Another market that has gained recently is the Treasury bond market. The yield on the 10-year reached 4%in April, but by August it had fallen below 2.5%. The yield on the 2-year Treasury note dropped from ahigh of 1.18% in April to below 0.50% in August. While longer-date Treasuries have risen modestly fromtheir lows in recent weeks, short-term Treasuries remain at their lows of the year.With stocks off their highs, precious metals rising and Treasury yields falling, it’s clear the market haspriced in a softer economy in the immediate future. The economic data in recent months has confirmed adeceleration from the growth rates seen in the latter half of 2009 and earlier this year, and there is a distinctrisk that the economy will soften further over the next year. Exactly how much further is the center ofmuch debate.What isn’t up for debate is that we remain
in the middle
of the fallout from the bursting of the housing andcredit bubbles. Some of the effects from the ongoing structural adjustments in the economy have beenmasked (or paused) during the past year and a half by government stimulus. However, considerableimbalances remain, and some of these imbalances appear to be coming to the surface again now thatstimulus programs are fading. The markets continue to reflect this ongoing process.However, managing investments through this deleveraging process is not as complex an endeavor as itmay seem. The key is to ignore much of the short-term noise and pay close attention to how these periodshave historically resolved themselves. In the following pages we’ll take another step along that path.
September 2010
Stock Indexes August 2010 Market Indexes August 2010S&P 500 Index -4.5% -4.6% HFRX Global Hedge Fund Index +0.2% +0.2%MSCI World (ex USA) Index -3.2% -9.0% US Dollar Index +2.0% +6.7% Amex Oil Index -5.4% -13.3% CRB Commodities Index -3.7% -6.8%Gold and Silver Index +9.1% +10.0% Gold (Continuous Contract) +5.6% 13.7%
Sitka Pacific Capital Management, LLC 2 September 2010
* * *One of the more vigorous debates going on right now is the back and forth over the prospects for inflationand deflation. Underlining this debate is the growing awareness that there is a large debt problem in theUS and other developed countries around the world, and there is no easy way out of it.Unlike previous recoveries from cyclical post-WII recessions, where the economy emerged vigorous andprepared to grow out of debt incurred during the preceding downturn, it is fairly clear the US economyreached a pivot point in the first decade of the 21st century. The downturn in 2001 gave way to acomparatively weak recovery. The downturn in 2007 through 2009 saw the beginning of significantdeleveraging in the private sector, something that hasn’t happened since the Great Depression.Despite the efforts by the Federal Reserve to revive credit growth, overall credit continues to contract. Anddespite the efforts of the federal government to stimulate the economy, it appears the effects of the stimulusprograms on growth will be short-lived. As it becomes clearer that the economy will not grow itself out ofthe debt burden in the private and public sectors, there is a growing awareness that the public debtsituation is as unsustainable as the housing market was.Going forward, the inevitable resolution of this debt issue is probably the most important issue facinginvestors today. However, this is hardly a problem that has not been faced before. Societies andgovernments have taken on too much debt many times in the past, and the result, often through muchpolitical wrangling and market turmoil, has usually involved significant economic hardship or currencydebasement—or a combination of both.Many investors today seem to think that the debt problem in the US will ultimately result in high inflation,as the government attempts to lower the real cost of the debt through printing more money, therebycausing prices to rise. As prices rise, the
relative
debt burden decreases.That has certainly been the basic strategy of the Fed and the government since 1933, when PresidentRoosevelt first devalued the dollar against gold in an effort specifically intended to get prices rising again.However, while the manipulation (i.e., devaluation) of the value of money has worked to stimulate theeconomy and prices on many occasions since then, it has had much less of an effect this time around.The reason lies in the amount of credit (i.e., debt) in the economy, which has been building up for decades,and the fact that the amount of debt it is now decreasing. While the Fed has lowered interest rates to nearzero and offered vast sums to banks and other institutions, private sector lending and borrowing continueto contract.This trend of contracting credit is not solely the result of banks being unwilling to lend. Credit contractionis also a rational response of tens of millions of people and businesses faced with high amounts of debtbacked up by assets that are now worth less than they were at their peak. They are not looking to borrowmore, regardless of the interest rate. Finally, credit contraction and deleveraging is an expected response ofa demographic population bulge headed towards retirement.While the economy is currently in the grips of deflationary forces as credit continues to contract, thisprocess will not go on forever. At some point the deleveraging of the private sector will slow down, anddebt levels will stabilize. The main questions are “How far will the deleveraging process go?” and “Wherewill the cost be felt?”
Sitka Pacific Capital Management, LLC 3 September 2010
During the depression, most of this deleveraging process occurred while the dollar was fixed to gold.Prices fell dramatically as demand for goods and services plunged, and defaults soared. Rooseveltdevalued the dollar in 1933 hoping to change consumer dynamics.This time around, the cost of deleveraging is felt in the value of the dollar and the value of debt on thebalance sheets of banks and other creditors. The government’s activism in countering the recession has tosome extent blunted the impact of deleveraging by transferring some of the cost to the dollar. Other centralbanks have joined in with various stimulus packages and currency debasement processes. This is thereason gold has reached a new record high, not only as measured against the US dollar, but against manyother currencies as well.However, just because the value of the dollar has absorbed some of the cost of deleveraging and declinedagainst gold, this does not necessarily mean inflation is just around the corner. Until the private sectorstops deleveraging, there is very little chance for significant price inflation and surging treasury yields.Perhaps because we have a vivid collective memory of the 1970s, and because we have not experiencedanything close to deflation in more than 75 years, fears of inflation remain strong today. Adding to theanxiety is the perception (which, as we’ll see, is not entirely correct) that investment strategies that havedone well in past inflationary periods are almost the polar opposite of those strategies that have done wellin deflationary periods.During the late 1970s, when prices really started to rise, the value of bonds and the dollar fell precipitously,and real assets like gold went into a parabolic rise. Although they maintained their nominal price level,with the Dow Jones Industrial Average fluctuating below 1000, stocks fell dramatically on aninflation-adjusted basis. Thus, gold did quite well during the inflationary 1970s, while investors in thedollar and bonds were handed huge losses.During the Great Depression, stocks fell 90% from their peak in 1929 to 1932, and remained depressed untilthe late 1940s. Unlike the 1970s, Treasury bonds and high quality corporate bonds did quite well.What is less well known is that whenyou adjust for price changes, some ofthe key differences between assetclasses during these different bearmarkets disappear.This table to the right shows that thereal return of stocks during the 1970sbear market was actually worse thanduring the Great Depression, eventhrough nominal stock prices roseslightly. It also shows that over the past10 years, the real return of stocks hasbeen about the same as these past twobear markets.Another key piece of information shown in the table is that regardless of whether a long-term bear marketperiod is inflationary or deflationary, gold has risen versus stocks. During the deflationary period between1929 and 1948, even while its price remained controlled by the government, gold rose an annualized 5.55%a year relative to the S&P 500. Between 1966 and 1982, in the middle of which the price of gold was allowedto float freely and inflation accelerated, it rose an annualized 14.22% per year relative to stocks.
Annualized Returns of Stocks and Gold during Bear Market Periods
1929-1948 1966-1982 2000-2010(Q2)S&P 500 (nominal) -2.69% +0.98% -2.6%
S&P 500 (real)* -4.40% -5.62% -4.88%
Gold (nominal) +2.86% +15.19% +15.12%Gold (real)* +1.15% +8.59% +12.84%
Gold vs. S&P 500 +5.55% +14.22% +17.72%
*Real = Adjusted with CPI
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Sitka Pacific Capital Management September 2010 Client Letter
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