Last year David Einhorn recommended Microsoft at the Ira Sohn Investment Conference. The stock outperformed the market by 20 percentage points since then. You can read Einhorn’s presentation here. Last year we also published Bill Ackman’s speech. Bill Ackman recommended Family Dollar (FDO) and the stock outperformed the market by around 20 percentage points as well. Below, you can also read Jeff Gundlach’s Ira Sohn speech from last year:
My talk is called investment cubism. I’m talking about how investments need to be put together more than just thinking about a single investment idea.
What’s on the screen now is probably Picasso’s masterpiece, Demoiselles D’Avignon, which is the first cubist painting, George Braque, who inspired Picasso to develop cubism, [0:28] and synthetic cubism hated this painting. It was painted in 1907. I think Braque hated it because it violated stylistic unity. Picasso worked on this painting more than anything else in his career making than 100 studies and sketches. He at one time had a sealer come into the brothel, this is a painting of 5 prostitutes in Barcelona and had a medical student carrying a skull.
But Picasso worked on it and worked on it and this 8’ canvas ended up being of these 5 prostitutes. It was originally called The Brothel in Avignon. But that didn’t sell too well in 1907 to the population, so it was called Les Demoiselles D’Avignon.
The viewer, if you think about it is confrontationally being approached as the customer. Space itself is a cognitive, powerful presence in this picture, the elimination of the illusion of depth. It takes apart a one-point perspective tradition that was so important since the Renaissance where different points of view are offered up all at the same time. Matisse said that Picasso was trying to paint the fourth dimension.
The reason I bring this up in an investment context is I think we’re in a world where we need to look at investment portfolios from multiple perspectives, not just looking at one potential outcome.
Cubism ended up not have lasted very year. This is a picture by a Russian that almost no one has heard of named [2:40]. And it’s just so fantastically great I thought I’d put it up on the screen. Maybe somebody else owns it, and if you do, congratulations. The artist said that the representation without artistic transformation and deformation cannot be the subject of painting. And I would take that to an investment context and say extrapolation of recent realities towards investment themes without accounting for policy and behavioral change cannot be a worthwhile basis of an investment strategy.
This is the elephant in the kitchen, as I call it we’ve all seen this chart. This is Craig Martin’s percentage of Gross Domestic Product, and it was stable for 3 decades, from the ‘50s to the 1980s. And then somebody rang a bell and the world went crazy on this one way journey of debt. It’s been a bipartisan affair. The debt ratio went up to 353%. To extrapolate this graph forward is impossible, because this type of a debt scheme can no longer be maintained.
But we’ve been in a similar position before in terms of facing a problem with a shortfall of tax receipts. Back in 1940, you’ll notice this chart, the federal tax receipts as a percentage of debt—I like to use the net receipts—was about 10%. So the debt was 10x the receipts. I want you to think about debt, because if for some reason the interest rates were 10% across the board, all the tax receipts would go to debt service. That obviously creates a big problem. Back in those days, they thought something should be done about it. And something was done, and you’ll see that the ratio went to 2:1, a much more healthy situation, and then in 1980-somebody rang a bell, the world went crazy. We started with this debt experiment, and not surprisingly, the tax receipts as a percentage of debt filled back down. And here we are again, down to a 10:1 ratio.
The OMB projects that it’s not going to get much better. Back in 1940, how did we solve the problem? Well here it is. It’s a humongous tax increase. We went from taxes being under 5% GDP to up to 20% of the GDP, where they stayed largely constantly. Weaker during periods of economic weakness or recession until recently. So one way you think about changing this problem is through a huge tax increase.
Well here’s Ben Bernanke at the Center of the Wheel of Fortune and he’s really got these options to try to solve the debt problem. And I’m kind of thinking this is how government policy is made. And the yellow ones, you see we’ve tried these already. Just keep borrowing, QE1, which back in the day wasn’t called QE1, it was just called stimulus. Thanks to the [5:23]. Let’s nationalize the banks. Oh we did that. Foreclosure moratorium, we did that on TARP., increased spending, forgive debt, we’ve done that on mortgages. Cut taxes, believe it or not, we did that one January 1st as the payroll tax rolled back, in stark contrast to the message sent to the bellhop.
So what’s left? Well default, raise taxes, or print and pay. There’s also one other called thread the needle. This is the hope that somehow nominal GDP could grow at 6% per year and somehow we could have government foot the spending frozen and interest rates at zero. If all that happens, about 8-10 years from now, we’d be at a balanced budget. But those things are paralyzed and inconsistent, aren’t they? How are you going to 6% nominal GDP without any increase in government spending? How are we going to get 7% nominal GDP and interest rates at 0. That’s the hope.
Thread the needle, otherwise it’s print and pay pay, or raise a bunch of taxes, or default.
Now a recent NBC Wall Street Journal poll asked a question of the population. Do you support balancing the budget by putting a surtax on million-dollar incomes, and 81% said yes. You can’t get 81% of the population to agree on anything. It’s amazingly popular politically to raise taxes, as opposed to how many opposed cutting social security to balance the budget.
Now think about this in the context of the debt-ceiling debate that’s under way. 77% said do not cut social security to balance the budget. And weirdly that 76%, one guy, is against Medicare but for social security on the other side. So there’s an overwhelming political will to raise taxes but not to cut spending.
So how will it look? Let me talk a little bit about the policy market, because I’m going to get to an investment idea that relates to the housing market. This is an Andy Warhol investment picture from 1963, of car crashes, pretty gruesome stuff. It’s a metaphor for the housing market, is what Andy Warhol said in relation to these types of pictures. He said, when you see a gruesome picture over and over again, it really doesn’t have any affect. The more you look at the same exact thing, the more it goes away, and the better energy you feel.
It’s my opinion that people have just become empty and feeling better about housing ignoring the facts. Clearly housing is not doing well. We are one basis point, literally above that row since 2009. The home ownership rate that exploded thanks to subsidies largely due to government sponsored enterprises is way too high. Look at what the home ownership rate used to be. This slide is going down. So look for persistent weakness in housing. Obviously [8:02] home sales are flat on their back. Now in the sub prime world that caused all these problems, you’ll notice that the 43.7% yellow line, that’s the percentage that are not making payments today.
Oh that’s good news. It’s stable and down a bit lit lately. It’s higher than it was in March of ’09. And that white line of divide is how fast they’re selling foreclosed properties. So you have 4+ years of supply in the sub prime world. And the [8:30] world, which is that category, there’s a pick up recently in the disposition of properties. It’s 3 years. In the prime world, oh my God! You thought March of ’09 was the bottom of the world. Think about March of ’09. It was about 5% nonpayment rate. Now it’s at 11 and clearly looking higher again with last month’s pick up in dispositions stabilized temporarily.
Now the key to all of this is the recovery rate, which is the opposite of the loss of severity. This line shows how much is a loss system-wide, on a sub prime all day, and prime liquidated by the pipeline. That sub prime number is really scary. It’s going up fast. The reason that these are going up is thanks to foreclosure moratorium. The timeline that these things sit around in the pipeline rotting away are going way up, and you can see this chart is just amount of time.
The longer on the x axis is how long the house is in the pipeline and the yellow line is how much is lost when the house is disposed of. This is going higher. This is on Countrywide’s Alt-A lines. Here is Countrywide’s sub prime lines. You can see the severity is at 95%. Don’t kid yourself. This can go over 100%. What? How can you lose more than the whole loan amount? Because the servicer has cost and loan principle interest. On loan balances in sub prime, under $100K, the severity last month was near 120%–a lot of downside.
This is the liquidation timelines, which are systematically increasing. This is the percentage of the [well 10:00] that when sold more than 24 months old. Clearly this is going higher. So the severities are going higher. So somebody, a [10:10] have started to become rethought. Remember the [10:10] that caused so much problems and made some people in this room millionaires. You can see it doesn’t look like much, but look at the scale. It’s gone from 50 to 40, down 20% in the last 4 months. On my money, the way I analyze this thing, even at 40, this thing to spot rate, yields about 75 basis points, because I believe the severities are going higher.
So not surprisingly, this is the weakness in the banks, guys. This is an overlay of the triple A index to BOA stock. You’ll notice it’s basically the same chart. So BOA is basically Country Wide, which is basically a huge pile of the AVX index and it looks like it’s lower.
Now what is Investment Cubism? Investment Cubism is about putting together a mix of assets in a world that can protect you in a world where you can’t extrapolate for it and you don’t know what the future is going to bring. So I’ve put together a bunch of investment categories.
What’s with the hundred dollar bills on the screen? You’ve got to be kidding me, you want currency? Well what if the situation from the fourth quarter of ’08 were to reemerge? What if it isn’t the dollar that goes to zero, but what if it’s the concept of the contract that goes to zero? What if all the computer blips somehow had a flash crash? How much currency do you have actually have?
I heard that [11:28] told his wife to go to the ATM and take out as much as currency as she could. What if that happened again? I’m not saying it’s going to happen. But maybe the world is more likely to transact in a crisis in dollar bills than in shavings off some cube of gold, maybe. I recommend a share in US currency. As one very wealthy client of mine said recently, I like having a couple of hundred million dollars sitting around in cash. I had to laugh, right?
In the old days, we didn’t call having a couple of hundred million dollars a problem; we called it the dream. I like natural gas. It’s oil on there, but I call it natural gas. It’s cheap. All of the commodities out there, they’re up-up-up-. Natural gas at $4. I know something else is going up. Something else that hasn’t been through it. Going down. And I know the US is driving natural gas, but I know something else. The US has a little problem with dependence on Mideast oil. Natural gas can be at least a meaningful solution to that.
Now the case of gold is artificial and superficially convincing. The current quantity of financial fairness is incomprehensible. The quantity can be further expanded without physical limit. Gold cannot be conjured up. It has biblical street cred, if such a thing is possible, as certainly as money. The problem with gold is it seems to best succeed under a fantastical case in which the [fiat] money system breaks down and seamlessly converts to a gold money system.
If there’s going to be this mega-dollar collapse and some hyper-inflationary concept wins, I kind of doubt the trains are going to be running. The gold folks envision this world where nothing changes. Just go to 7-Eleven and shave off a couple shavings of gold to buy your Slurpee. I just don’t think that’s going to happen.
For real wealth preservation, portability has got to be an issue. For this gold is simply too heavy. Silver as a storehouse of value is preposterous for this reason. I advocate gemstones instead of gold. And don’t give me this liquidity argument against fine gems. This allocation would much accomplish keeping you in good stead when the system, whatever it turns out to be, makes it to other side of the crisis. Gold purports itself to be money. Gold is pretty. Fine gems have also shown themselves to money, and they’re pretty. And you can carry $25M of rubies in your shoe with your foot still in it.
Gold doesn’t have negative carry, it has can’t carry; it’s too heavy.
Also you’ve got a Warhol Marilyn out there. Someone in this room may own that too. Congratulations. You might say wait a minute. There’s no bonds out here. There is a bond out here. Investment cubism in bonds. Somebody earlier gave a nice talk about how [14:10] is kind of cheap and might do well under rising interest rates because the defaults might go down. I like that idea. But that’s not good enough. It’s too depressionary-based. I’m here. I show 6 different categories.
[GMA]’s that pay principle with huge duration. These things have a 20-year duration, [14:30]. But they pay 20% cash flow, they add a lot of interest rate to your portfolio. But that’s good, because it protects us from the depression case. [GMA] interest-only is something that works well too. It doesn’t have that much interest-rate risk. It’s paying us today 27%. You mix that together with the stuff that does well for depression and inflation [the 14:50] and you get the bottom line of 14% cash flow unleveraged, zero % capital refinancing at risk, if the whole world refinanced to a buffalo program, you don’t lose any money, or hardly at all, no depression capital at risk, risk offsets, rising interest rate duration of 6.2.
A lot of people say, I don’t like rising interest rate duration. I hate bonds. I think rates are too high. Well the problem is that if you hedge your interest rate risk, you put too much capital at risk for a depression case, 13.9. I like 100% total category. 14% cash flow unleveraged. 6.2 duration, no depression risk, no refinance risk. I leverage 20% cash flow. Not buying gold and hoping it goes up. 20% having the bank collect your money and that’s what I like to see.
So with those 6 things, we clearly have 1-2-3-4-5-6, what you end up with, you take the numbers away, is a painting by [15:57], another one of the great giants of the 20th century, and it’s all double lines. My name’s Jeffrey Gundlach. My friends [16:00]. Thanks for your time.