July 2011

Kreitler Financial:

Summer is typically dull and lazy, and not much happens. Not this summer. Events are moving so rapidly it is challenging to write a newsletter that will not be out of date by the time you receive it. We think it is best to put the daily headlines into perspective. Pimco's Bill Gross and Mohamed El’Erian talk about a "journey" we are on. We know where we came from but we still don’t know where we are going with all the financial changes. We think this analogy is good, and with this in mind, we stress less when reading the daily head-lines.

Everything we hear coming out of Washington, Hartford, or Europe are all steps in this journey. The journey will probably go on for several years. (Sorry, we can’t make it happen faster.). The change in direction is like turning the Queen Mary around. It is huge and will take time. Unfortunately it is a lot more traumatic than changing the course of a ship, changing the lives of many along the way. Our task is to attempt to prepare our clients’ portfolios and finances to deal with higher than normal levels of uncertainty.

We think the debate about extending the US debt ceiling is just one of many steps as we travel on this journey. We think it unlikely the world will end if the parties do not agree on the "right" solution by August 2. Europe has its own problems. Potential default by Italy or Greece is more serious, although this could take two years or more to play out. Investors typically price into the markets events they foresee, and this may be the case right now. If this is true, and one of the unpleasant (but expected) events happens, the market may have already assumed it and the market response may be surprisingly muted. It is that which we don’t expect that worries us.

Over the last several months we have had multiple discussions within Kreitler Financial about whether we think our clients’ portfolios are appropriately positioned for this crazy world. There is high risk, but also potential for large gains. We keep concluding in these discussions that based on what we see happening, the diversified portfolios we have created using what we call "multi-scenario investing" are the best we can suggest. This of course may change and we are continually reviewing our thinking. Our clients generally seem to be doing well considering the daily headlines. We have seen them deal with the losses of 2008 and the subsequent recovery. They seem remarkably able to deal with high levels of uncertainty that we are facing.

For those wanting more in depth reading, we are attaching a piece from GaveKal, a highly regarded Hong Kong-based research service we use. They have a unique and insightful global perspective. Please note in particular their optimism as we move to the new normal. Whether you are oriented on the left or on the right, the Queen Mary is changing course.

Some miscellaneous information...Two years ago when the Greek crisis first broke, Bob was saying "What this teaches us is that we can’t spend money we don’t have." Unfortunately, he has to eat his words as people still don’t understand this. It takes a long time for the Queen Mary to turn...Ironically, the rating agents are being condemned for possible downgrades of government debt, particularly by European authorities. Not so long ago the authorities were condemning the rating agencies for being asleep at the switch for not blowing the whistle on bad debts in the private sector.

Here at Kreitler Financial, we experienced another milestone as we welcomed Charlie’s second daughter, Gracy, in May. He’s doing well for a sleep-deprived parent. We are closing the office early on every other Friday to let our hard working staff enjoy the summer. Sorry if we miss your call. We will get back to you on Monday. We hope you are having a wonderful summer.

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Robert and Charles Kreitler and not necessarily those of RJFS or Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

GaveKal Checking the Boxes, July 14, 2011
Reproduced with permission.

These days, it is easy to feel despondent about the fate of the developed world, what with the bills rising for the bailout of the weaker EMU countries, Japan struggling under Herculean debt loads as it rebuilds from natural disaster, and now Moody's putting the US on watch for a credit downgrade as Congress and the administration haggle over a debt-ceiling deal. And unlike even just three years ago, rich-nation governments now have much less room to maneuver. They really cannot afford a new crisis: the state of public finances in most OECD countries (even in Germany) implies that another Lehman disaster could lead to a generalized government default in the OECD.

In recent trading, any sense of optimism-whether on an EMU deal or a US budget deal-has generally been rewarded with disappointment. Yet, on a longer-term view, there might be an excellent case for optimism. It is precisely because developed-world governments are in such a jam that they will have to change. This decade will witness a decisive acceleration in the reform of the welfare state (in all its forms) and of government intervention everywhere in the OECD. The inescapable laws of demographics, economics and compounded interest are marching in time. This is a simple story, yet of tantamount importance. It is now obvious to nearly all: the welfare state does not work. Current public debt levels are staggering-for the first time in modern history, OECD general government debt-to-GDP ratios are on average above 100%. And this is only the visible portion of the iceberg. The unfunded liabilities of our social security systems amount to around five times (!) this level, both in America and in Europe.

The Greek crisis of end-2009 was the first wake-up call, ending an illusory and thankfully short-lived Keynesian revival after the collapse of Lehman. As we see it, the OECD debt crisis will mark the return of "German economics", or, if we could choose a much more compelling version, a proliferation of the Swedish model of combined supply-side and welfare state reforms. Knowing (or fearing) this, more and more old-fashioned Keynesians are encouraging governments to default on their debt. But even this would not lead to any other result than that of forcing the above mentioned adjustments to take place. With or without default, access to market financing will require German-style macroeconomic policies, augmented by supply-side reforms in the most laggard economies.

What will this mean for financial markets over the next decade? It is very favorable, in fact. Money will go to the most productive sectors, both because there will be less of it (raising capital efficiency) and because governments (broke as they are) will play smaller roles in the economy. Visibility will rise as governments are forced to implement reforms (on spending, labor and pension rules, tax and regulations, etc), and higher visibility will allow for expanded PE multiples. The downside is that this will be a volatile ride: while reforms are inescapable, governments will implement them gradually, unevenly and reluctantly-financial markets will need to act as the "shepherd dog" from time to time, provoking market crises of various magnitudes, to keep reforms on track.

Summing it up, until now, the political elite has been offering the signature of the captured State to finance an unsustainable lifestyle. This is what French Kings always did: borrow heavily to prevent any rebellion in the French Nobility. Unfortunately, for Louis XVI, at some point it was not the nobility that revolted, but the people! This is where we are now in most European countries and possibly in the US as well: no more borrowing capacity and no ability left to tax a productive sector voting with its feet. The conclusion, for a Marxist, would be inescapable: we are confronting a blatant contradiction between the economic infrastructure and the political superstructure. We are thus entering Revolutionary Times! This is something to think about as our French clients celebrate Bastille Day.

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