My Crystal Ball

“My Crystal Ball” is a monthly publication written by the principal and founder of Irvington Capital LLC, Michael S. Elfers. ”Mick” Elfers, an Investment Strategist with 29 years of experience,  has been writing his monthly thoughts and recommendations to clients and friends for many years. At the request of his clients, the most current monthly letter is now posted here on the Irvington website.

Enjoy the read!

Curing the Debt Disease

August 2010

Over the past two years, I have spent a lot of time talking about the global accumulation of debt. Eventually, excess debt is self -correcting, either the lenders force the borrowers to pay the debt off, or the borrowers force the lenders to write the debt off. The question is… who has the leverage? When economies are booming and assets like real estate and stocks are growing, debtors must maintain their ability to borrow or they will miss the wealth building opportunities.

But when growth rates slow, businesses cut back, borrowers’ lose their jobs and asset markets get re-priced. When a borrowers house has declined 35%, the value of a credit rating diminishes and lenders have very little leverage to force repayment.

The Cure for Inflation: 20% Interest Rates

When I started my career in 1980, the U.S. was experiencing a deep recession that was fueled by 15% inflation. Lenders maintained their control over borrowers based on rising real estate values as it was the best way for consumers to create wealth. Then Paul Volker took away the punch bowl, called the police and had everyone hauled in for a 20% interest rate sobriety test. These historically high interest rates were so suffocating that they drove the U.S. economy into a double dip recession, but slowed the inflation rate down to manageable levels. The cure for a 15% inflationary bubble was the highest interest rates ever imagined, enough to shock the American inflation psyche into a 30-year decline.

The Cure for Deflation?

Deflation is a hard thing for us to grasp. For most of our lives, asset prices like stocks and real estate have increased in value. The question about GDP growth was not “if” the economy would grow but “how much”. This is the kind of assumptive confidence that was behind our historic accumulation of debt, as long as things keep growing and creating more wealth, we will always be able to pay off what we’ve borrowed. Then U.S. stocks and real estate reached their highest valuations ever and the whole game changed.

A DifficultWealth Building Environment

As the black trend-line of GDP growth shows in the graph to the right, the Fed has lowered rates to 0%, spent trillions on stimulus and bailouts, all in an attempt to stimulate growth and job creation, yet GDP continues to slow. I asked CFO Trey Maust of Lewis & Clark Bank about the decline in consumer and business lending. Is the current slowdown in credit an overly conservative stance by banks as they have been burned in the housing market? His answer surprised me… “We want to lend money, that is our core business, our challenge is finding credit worthy lending opportunities”. Emphasis Mine

This then is the conundrum that consumers, investors and bankers are all struggling with. After 30 years of expanding debt, our credit worthiness has declined and the debt driven asset appreciation opportunities have diminished. But unlike the 20% slap in the face that stopped borrowers cold in 1981, even with 0% interest rates, you can lead borrowers and lenders to the trough of cheap money, but you can’t make them drink.

And so we emerge from the recession of 2008-09 with close to 10% unemployment and GDP growth showing signs of fatigue as evidenced by the Economic Cycle Research Institute’s Weekly Economic Growth Index. As I mentioned in last month’s letter, this forward looking index of economic growth has fallen from +30% to -10.5% since April. Since 1965 when this index began, a reading below -10% has ALWAYS signaled a recession. This time might be different but…

Time to Upgrade Your Toolbox

Where then do investors look in today’s world for reasonable investment returns when stocks are at the same levels they were at in 1998, real estate values have declined over 30% nationwide and 8 million jobs have been lost in the past 3 years? As I mentioned last month, slowing economic growth typically leads to declining Treasury yields and rising bonds prices as we have seen in Japan over the past 20 years. It may be difficult to imagine 3% mortgages and the lowest Treasury yields in history, but we thought the same thing about 20% interest rates in1981.

In addition, take a look at the list of managers that we are currently researching. As the investment climate has changed, these resourceful individuals have adapted their strategies and added new investment tools to fit this deflationary, slower growth world.To look at their returns, you wouldn’t know that it has been the most difficult decade since the 1930’s. As the saying goes, the definition of insanity is trying the same old investment strategies over and over and expecting different results. Before this stock market water torture drives you crazy, you might want to consider investment strategies that can prosper in both up and down markets.

<Irvington Manager Information Available Upon Request>

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Michael S. Elfers

Chief Investment Strategist 

melfers@irvingtoncapital.com

720 Southwest Washington, Suite 620 

Portland, Oregon 97205 

www.irvingtoncapital.com

Office 503.477.5816

Toll Free 866.724.0046

Fax 503.719.5247