Leithner Letter Nos. 78-80
26 June 2006 - 26 August 2006

Liberalism can never come to terms with Socialism. ... The objective of Socialism is the destruction in all its forms of the profit motive, and the standardisation of life under the control of bureaucrats in conformity with a “planned economy” socialistic in purpose. As a practical policy, Socialism and Communism are the same thing; the divergence is with respect to the tactics by which the obliteration of individualism and the transformation of men into ants can best be brought about.

John W. Dafoe
The Winnipeg Free Press (12 June 1932)

The problem with American conservatism is that it hates the left more than the state, loves the past more than liberty, feels a greater attachment to nationalism than to the idea of self-determination, believes brute force is the answer to all social problems, and thinks it is better to impose truth rather than risk losing one soul to heresy. It has never understood the idea of freedom as a self-ordering principle of society. It has never seen the state as the enemy of what conservatives purport to favour. It has always looked to presidential power as the saving grace of what is right and true about America.

Llewellyn H. Rockwell, Jr.
The Great Conservative Hoax (4 May 2006)

During the 1970s, I filmed secretly in Czechoslovakia, then a Stalinist dictatorship. The dissident novelist Zdenek Urbánek told me, “In one respect, we are more fortunate than you in the West. We believe nothing of what we read in the newspapers and watch on television, nothing of the official truth. Unlike you, we have learned to read between the lines, because real truth is always subversive.”

John Pilger
The Real First Casualty of War (20 April 2006)

In the end, denial is usually the only thing left. In my view, that’s pretty much the case today in world financial markets. Imbalances on the real side of the global economy have moved to once unfathomable extremes. And now the Federal Reserve belatedly enters the fray threatening to take away the proverbial punch bowl from a rip-roaring party. Financial markets hardly seem concerned over this impending collision. Spreads on most risky assets have fallen to razor-thin margins. Steeped in denial, investors have once again become true believers in the sure-thing syndrome.

Stephen Roach
The Sure-Thing Syndrome (10 January 2005)

Golden Era or Gilded Age?

At the National Investors’ Conference of the Australian Investors’ Association (23-26 July, Marriott Resort, Surfers Paradise, Queensland), I will give a presentation based upon a paper with the unwieldy title Golden Era or Gilded Age? Inflation and Mean Regression in Australian Stock and Bond Markets, 1965-2006 – and Some Base Rates for 2007-2011. The paper dissents vigorously from the cheery and confident consensus that has pervaded Australian financial markets during the past several years. I doubt, as one of the country’s most prominent finance journalists expressed it on 14 May, that Australians are enjoying “a golden era of prosperity.” Because it is built upon the shaky foundations of high inflation and rising debt, I wonder whether this prosperity is more superficial than genuine. As a result, I suspect that Australians have experienced – and are perhaps concluding – a gilded age.

Section 1 of the paper shows why investors should properly understand inflation, its sole cause and its various consequences. They should also incorporate the possibility of “stagflation” (the simultaneous occurrence of stagnation and recession, and rising consumer prices and interest rates) into their investment plans. Sections 2 and 3 review a cornerstone of value investing. To investors who understand “regression to the mean,” the present obsession about the prices of commodities and the rising prominence of China and India – and conjectures about the strength and duration of the mining boom – are at best distractions and at worst delusions.

Analysing data for the period 1965-2006 and using a five-year investment horizon, Section 4 shows that the yields of 5-year Commonwealth Government bonds regress towards their overall (41-year) mean. If this tendency continues, then Australians can expect bond yields to rise, perhaps significantly, during the next five years. The rate of growth of EPS of major Australian banks, mining companies and retailers also exhibits a strong mean-reverting tendency. So too do their P/E ratios and 5-year total returns. These results provide few grounds to expect that the stellar results of the past 2-3 years will continue during 2007-2011.

Further analysing this period, Section 5 shows the impact of changes in bond yields upon growth of EPS and investment returns. The good news is that during these years rising yields did not greatly crimp EPS growth; the bad news is that they did yield significantly cruel 5-year investment returns.

Applying these results, Section 6 sets out a series of “base rates” and as an illustration uses them to derive a cautious estimate of the value of BHP-Billiton shares. It also confirms another tenet of value investing: the strong long-term linkage between the achievement of superior results and the purchase of shares at price that are low relative to their earnings (i.e., at high earnings yields). Sections 7 and 8 outline the consequences of these results. Most importantly, the steadily falling, historically and I believe artificially low interest rates of the past 15 years, and the various moral hazards they have spawned, have accustomed Australians to think that “Goldilocks” conditions are normal and permanent. They have thereby eroded the memory of and respect for Grahamite principles that, since the 1930s in a range of countries, have generated decent investment returns during trying times.

Chris Leithner


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