Beyond the Colossal Mess

April 4, 2012

Dear Investor:

With Euro fears already baked into prices, the quarter saw the market rise as that fear receded. The Dow was up 8%, the S&P over 12%. Europe’s crisis is far from over, with another restructuring of Greek debt likely, a Spanish reckoning along the lines of Italy – and several quarters’ more deprivation in store for the already desiccated Mediterranean countries.

But the deflationary force of European contraction is now colliding with several inflationary ones: rising labor costs in China, the tidal wave of monetary reflation pounding the fragile shore of a recovering domestic economy, and booming commodity prices, especially oil. The mix of deflation and inflation could result in an ironically stable price level – or it could lead to further global imbalances. Regardless, stocks are cheap while bonds are expensive.

Buffett quoted the legendary value investor Shelby Davis to say that Treasury bonds now represent “return-free risk” — as opposed to the risk-free return that they offered over the past 20 years. There’s no doubt that a U.S. Treasury bond is now one of the worst investments in the world. I would like to meet the people who think lending money to a heavily indebted nation for 10 years in return for a wretched 2% is a good idea.

Obviously, these bond buyers are driven by fear, not by rationale. It’s no different than sticking dollar bills under the mattress. Despite the false sense of security a mattress might bring, it’s far from safe. A house fire burns a mattress to ashes – and inflation will incinerate the value of Treasury bonds. The best value remains in large U.S. multinationals, with free-cash-flow yields over 8% — a hefty premium to bonds and most other stock sectors. The other cheap areas are European equities, homebuilders, and financials, all of which continue to be shunned by investors and remain dirt-cheap as a result.

The world is still a colossal mess, as it always is, and always will be. When traders focus on the mess, it’s called a bear market. When traders see the potential beyond the mess – like the present – it’s called a bull.