An occasional newsletter from Sweetwater Investments 16398 NE 85th Street #201 Redmond, WA 98052 425 861-0112 info@sweetwaterinv.

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This Fortress built by Nature for Herself This royal throne of kings, this scepterd Isle, This earth of majesty, this seat of Mars, This other Eden, demi-paradise. This fortress built by Nature for herself Against infection and the hand of war, This happy breed of men, this little world This precious stone set in the silver sea, Which serves it in the office of a wall Or as a moat defensive to a house, Against the envy of less happier landsWilliam Shakespeare King Richard II, Act 2, Scene 1 Prologue It has been some time since I have taken keyboard in hand in any attempt to inform anyone of my thoughts on the world of investing. I am taking the time to write now because we are embarked on some events that are, in my humble opinion, truly historic. As these events play out the United States may not be a fortress built by nature for herself. So hang on this could get rough and as usual it will be opinionated with a different perspective. Some history for context I am now in my 39th year in the investment business and 65th year of life. For 17 of my 39 years I was a stock broker which is to say I was a salesman, for the last 23 years I have been a financial advisor and director of private wealth for a wonderful group of clients. I do not possess all the

fancy degrees, but I have completed extensive post graduate work at that revered educational institution, the school of hard knocks. During my career I have been witness to three historic uses of government power. One was a demonstration of the power of government when used properly; another showed the worst of government. We are currently engaged in another historic challenge to the role of government and whether it will be good or bad is still to be determined. Two of the historic exercises of government power occurred in the 1960's. The first was the challenge to put a man on the moon, the second LBJ's guns and butter mistake. Stay with me and I will relate this back to the financial markets of today. The Race to the Moon The period between 1929 and 1953 was one of extreme stress for the United States. Following the end of the Korean War the nation slipped into a quiet period. The Greatest Generation was eager to catch up with what they had missed in interruptions of the trauma years. In 1960 John Kennedy was elected and there seemed to be a new spirit in the nation. Those who would flock to the banner of Kennedy's Camelot where those born too late for wartime service, and after the boredom (as they saw it) of the Eisenhower years they were restive and eager for change. While the voting age in 1960 was 21 they were in many ways just like the18 year olds in 2008 who voted overwhelmingly for President Obama. Many of those Kennedy youth were to have their faith cruelly tested. I was a cranky, moody 14-year old (I know there has been little change) and even I was taken by what Kennedy was saying. Kennedy called for a rededication to the country (ask not what your country ) and was able to sell a vision of united effort to put a man on the moon by the end of the decade. Kennedy would only live three years into his vision but the national acceptance of the challenge changed everything and we are still seeing the benefits. Almost every technological wonder of today owes its parentage to the research funded by the space program. We funded research for researchs sake. We have not followed that explosion of basic hard science and we are at the end of that string of research. Instead we turned to social sciences and as one author said we are nation that spends hundreds of billions trying to find ourselves and are singularly unsuccessful. That was the good use, but also during the 1960's another set of decisions overtook the nation which created agony, wasted the birthright of the country destroying many of the ligaments and tendons which provided the skeletal strength of the nation. That decision was the parent of todays challenges. I call it the Guns and Butter decision.

Guns and Butter In macroeconomics the concept that a society has to ration its investments in the pursuit of national goals is called the Guns and Butter contradiction. The term actually dates back to the resignation of William Jennings Bryant as Secretary of State in the Wilson Administration and a dispute over the production of sodium nitrates but that is another story. The concept is that a nation cannot produce both adequate amounts of butter (consumer goods) and adequate armaments (guns), it must make choices. This places Congress and the President, popularly elected politicians, in the role of capital allocators. What could go wrong? LBJ was faced with exactly this decision. Kennedy had increased the country's military commitment to the government of South Vietnam and to our other allies. The Cold War was demonstrating its distressing habit of becoming a hot war at various times and places. Domestically the children of the greatest generation were politically active and a good portion of those 78 million were not at all happy about the possibility of giving up their sheltered, self centered lives to serve the nation in what seemed to be a thankless cause (Vietnam). One of the witty lines one heard while serving in Vietnam, repeatable in a family publication, was we are the unwilling, doing the unnecessary for the ungrateful. At the same time there was an explosion of what we called in those days the Negro1 population demanding the rights promised by the founding documents and paid for in the blood of the Civil War. It was obvious to all who saw the spectacles of Selma and Birmingham that they would not be denied. The Baby Boom generation fractured into three parts, the radical opponents of the war joined the radical elements of the civil rights movement and Los Angeles, Chicago, Detroit, Boston and other cities exploded in riots. Bill Ayers and his ilk started what amounted to an armed revolution which according to Ayers is still going on. Another segment of the generation perceived a duty to serve the nation and 58,000 died. The third segment was too young, too stoned, lucky or duplicitous enough to avoid the draft and did nothing or took advantage of the situation to launch careers. There were other movements that complicated things. There was the Roe v Wade decision, the single most divisive Supreme Court decision certainly of the 20th Century and possibly since the founding. That happened or perhaps triggered the rise of feminism. So not only did we have races fighting each other, we had generations, cultural and moral communities at war and finally the war between the sexes, none of which were going to be cold wars.
1

I do not use this word to be offensive but it is an accurate representation of language usage in the 1960s and bowdlerism is dangerous. Negro would morph to Black and then to the more inclusive African American during the next ten years. The word Negro derives from anthropological classification of humans into three races Caucasoid, Mongoloid and Negroid. This is another concept that has been correctly abandoned as inaccurate.

In international affairs the nations we had defeated, rescued, and rebuilt started to show big streaks of ingratitude and were horrors of horrors, pushing back against American hegemony. LBJ was hemmed in on all sides by all the movements and the continuing space program. It was at this point in 1965 that he made a decision, rational from a politicians point of view, (and LBJ was a consummate politician) but disastrous from an economic one. He decided that the United States could be the first nation to afford all the guns and all the butter it needed. It moved LBJs reputation to the cellar of esteem in the Presidency along with Buchanan and Fillmore (holding his dogs up by their ears didn't help either). LBJ announced the Great Society, which included Aid for Families with Dependent Children (AFDC), Food Stamps, Medicare and Medicaid and hundreds more programs aimed at ending poverty. He signed into law the Civil Rights Act of 1965 (whose greatest champions were Republican members of Congress). Good intentions but other than the Civil Rights Act they produced bad results. LBJs empire of entitlements is now threatening to engulf us. To be sure LBJ was not the first to create large social programs that is the legacy of Franklin Roosevelt. However, even FDR realized when the war started the nation had to dedicate itself to the war and not to solving social ills. As Max Hastings pointed out in his masterful history of WWII that dedication was only partly successful.2 LBJ never learned that social programs are good politics but terrible economics, worse social policy and that they never get smaller, go away or accomplish their purposes. New research by Amity Shlaes3 and well as contemporary writings4 show that the social programs started by FDR actually prolonged the Depression. In fact those programs may have turned what started out as a severe recession into a gut wrenching ten year experiment in deflation. The irony of LBJs attempts to end poverty was that it was already declining.5 From 1959 to 1965 the poverty rate in the United States dropped from 22 percent of the population to 15%. It declined a bit more after the Great Society started to about 12% but has remained there ever since with a few minor upward and downward blips. 6 It was a disaster because it was a massive misallocation of capital. In the pursuit of the war on poverty the country has collectively spent $16 trillion on personal assistance programs! That is larger than all the current Federal debt! We are still spending $700 billion a year to reduce poverty. Even after all of that we have still have 12% or so living in
2 3

Max Hastings, Inferno Amity Shlaes, The Forgotten Man: A new history of the Great Depression 4 Richard Anderson, Economics and the Public Purpose 5 Charles Murray, Losing Ground: American Social Policy 1950-1980, and D. Eric Schansberg, Poor Policy: How Government Harms the Poor. 6 Mark Perry, US Poverty Rate: 1959 to 2009, Carpe Diem ( September 20, 2010)

poverty. The defense department may be wasteful but they are amateurs compared to the social spenders. Its a truism that if a nation is increasing its debt faster than its GDP it is misallocating capital. The Guns and Butter conundrum was true, there was not enough capital to finance all the projects, wars and programs. Politicians did what they always do extend benefits, make hollow promises, come up with grandiose schemes with unattainable ends and kick the can down the road. Without sufficient capital or the courage to risk their political futures the government developed a reliance on the debt markets to fund the widening shortfall between spending and national income.

The chart above shows the growth in federal spending versus total debt and GDP indexed to 100 in 1946. As you can see the GDP has not increased anywhere as fast as spending or debt. While it stayed even with debt for awhile in the last half century it has diverged. If the debt had been productively spent GDP should have grown at least as fast as debt and in fact it should have accelerated but it did not. This is misallocation of capital on a grand scale. Now to tie all this together, while the spending on the space program was an effective use of capital as it drove innovation all across the economy the poor decision in the guns and butter case camouflaged the benefits and created long term imbalances and constituencies so ingrained that changes cant be rationally or even civilly discussed.

So now we come to the current situation. All leaders like to believe they control their own destiny, very few actually do. In the recent past the only ones who did were FDR, JFK, Ronald Reagan and perhaps the next president of the United States. I say perhaps because the next presidents destiny will be viewed from the standpoint of getting his arms around some huge trends and being able to convince people that a historic opportunity is at hand if we can act as one people rather than as tribes or that massive destruction awaits if we continue to fracture and be uncivil. The real questions in this election are not Iran, gay marriage, abortion or prayer or whatever. The real question is who can and will grapple with the tactical problems of entitlement growth, financial market reform, demographic changes, and the growing dependency ratio. Who will deal with the splintering of the American population into increasingly narrow tribes based on cultural perspective, financial power, immigration status, relationship to government? Who will deal with the growing scarcity of resources? On all of these issues the two candidates have mixed records. In the end the issues in this election are even broader, they are strategic. Does power still devolve from the people to the government or has the ability of the government to spend, regulate, tax and coerce changed Jeffersons formulation to the extent that populace is willing to cede all power to government and have the power devolve from government to the people? Do we as a people still care about equal opportunity even though it might have unequal outcomes? Does E Pluribus Unum still apply or is it vos futurus ut tribuo mihi mei (you exist to give me mine)? In these areas the candidates offer stark contrasts. Before I start to flail the financial markets I want to call you attention to two sources of information you should consider adding to your reading. The first is the work of Andy Lees of AML Macro (Andy.Lees@amlmacro.com). Andy has to be one of the smartest people on the planet and his grasp of the macro events and trends is truly extraordinary. Every time I read Andys work I feel like a student at the feet of a revered teacher. I hate it when people are smarter than me. The second source is the charting service of the ST Louis Federal Reserve Bank called Fred. Make your own charts, see trends and manipulate data to your hearts content- for free- a good use of government money. The final comment I will make is that on behalf of the clients and employees of Sweetwater we recently made a substantial donation to the Fisher House Foundation. Fisher House builds residences at VA and military hospitals for the use of the families of those wounded in combat. The housing is free to the family and each is run by retired military personnel.

Regardless of your position on the war(s) those who are wounded suffer a special hell and to have to recover without your family around is a torture too severe to contemplate. www.fisherhouse.org . The Financial Markets The next President is going to have to deal with the mess in the financial markets. I dont mean undercapitalized banks or brokers who lie to clients. I refer to the fact that in the last 40 years there has been a profound change in the nature of capitalism and this has changed the financial markets in amazing ways. During the great bear market from 1965 to 1982 something happened in the world and particularly in the United States. Perhaps it was all the money poured into the economy during the recessions. Perhaps it was the change in the flow of capital to OPEC or the effects of the spending for social programs. Whatever it was we moved from industrial capitalism to financial capitalism. Industrial capitalism refers to a system where a majority of prices are set free of regulation by market action and portions are set by regulations. The move to financial capitalism moved everything to a largely unregulated market. The financial markets stopped being source of capital for industry and increasingly became a conduit for making money with money. Since the United States was and is the leading economy and polity in the world our shift from making things to making money changed the rest of the world. Remember at the heart of Greece and Italys financial problems is the fact that someone in the financial markets convinced those governments that they could remove obligations from their balance sheets via financial manipulation. Of course all of this shell game resulted in a nice profit for the financial company who arranged it. As we saw from the AIG mess the markets for this type of product were totally unregulated. It is helpful to remember that in the past the financial markets were largely adjunctive, reactive, and coincidental with general life. In the years since, they have become integrated, proactive and leading. One of the reasons the current and maybe future president might not been able to control their fate is indicated in the chart below. Financial markets and societies go through long cycles. While the chart is in terms of the stock market that is just for convenience, it is difficult to chart social changes but they occur at the same time as the changes in the financial markets or used to.

The blue areas are secular bull markets and the red bears. Years in period 1877 to 1906 1906 to 1921 1921 to 1929 1929 to 1949 1949 to 1968 1968 to 1982 1982 to 2000 1999 to present Number of years in move 29 15 8 20 19 14 18 12

Secular bulls and bears are coincident with generational transitions and seem to occur every 17 to 20 years and last 14 to 20 years. Strangely enough 17 to 25 years are the generally accepted lengths of a human generation. If historical patterns hold up we are in the last few years of the current bear cycle. If the current cycle achieves its average length it will be over sometime in 2014- halfway through the Presidential term. These secular changes are unstoppable and they go on until they are completed regardless of who carries the hope of the nation or their shoulders. These trends destroy or create legacies. The fact that we are in this cycle means that whoever the President is he will not have the flexibility to shape policy than he would if the economy was in an upward move. I believe that we are in a secular bear market that started in 1999 but really got rolling with the .com bust in 2000. It was pre-staged by Russias default in 1998 and the collapse of Long Term Capital (LTCM). It is important to understand that past secular moves have not been caused sole-

ly by securities valuation. This one was different in that it was caused by a collapse of the financial system which destroyed the rest of the economies. In each secular bull market there were six common themes: New technologies Abundant low cost energy and resources Followed a period of sacrifice and deprivation Movement worldwide to less government regulation and to center right political ideas The rise of a new generation to power Available excess capital to invest Similarly there are several common characteristics of secular bears Overly rapid expansion of money and credit A period of sacrifice or deprivation Social changes expanding the dependency ethic Resource constraints Re prioritizing of goals, ends, and means There is one common result to both types of markets: they permanently change the world. The collapse of LTCM materialized for the world the risks of global linkage of capital markets and the enormous leverage in the financial system. At roughly the same time there was an earthquake in Taiwan that revealed the weakness of the globalization of manufacturing supply chains.7 As is typical, most people, even most investors did not have sufficient information to understand the magnitude of what LTCMs failure said about the financial system but it was prescient. The method used to ameliorate the issues with Long Term Capital harkened back to the crash of 19078 and heralded the methods to be used in the future. The reason methods of the past will not work is the normal regulators of the market action are no longer there. James Carville the advisor to President Clinton famously said that he wanted to come back as the bond market because it could scare anybody. No longer. The Treasury, municipal and mortgage markets are now fully owned subsidiaries of the Treasury or the Federal Reserve. So the mechanism used by the bond vigilantes of the past, of rising interest rates indicating an increased cost of capital and increasing risk is subverted by the willing7

See Barry Lynn End of the line for discussion of the effects the earthquake. The tsunami in Japan and the flooding in Thailand are even more recent examples of the fragility of sole source contracts from closely located suppliers. 8 The Panic of 1907, lessons learned from the Markets Perfect Storm, Robert F. Bruner and Sean D. Carr: is an excellent discussion of the last time the financial markets nearly destroyed the rest of the economy.

ness of the Fed and Treasury to print money to maintain an artificial interest rate environment. The bond markets are no longer reflective of the underlying systemic risks of the economy and that is dangerous. The longer this fiction is maintained the more likely that permanently low interest rates will become a right enshrined in law. We have seen this happen time and time again, starting with public assistance where the requirement to be looking for work was removed and income levels raised to the point that a person could have both full time employment and full public assistance support. We are seeing it now with the elimination of payroll tax on individuals as a way to help out the financially stressed. The holiday has been extended three times already does anyone out there believe that the tax holiday will not be made permanent and that either candidate is going to allow what will amount to a 6% tax increase ? For a moment imagine what will happen if and when interest rates start to rise and people who have used the current period of low rates to do stupid things( as they always do) are faced with mortgage rates of 7 or 8 %! You think there will be pressure on Congress to make low rates permanent? Those tribes I mentioned above will get together and start howling that increased interest rates are a plot by the 1% to keep people from getting a slice of the American Dream. This leaves the regulatory function of the markets to the resource markets and the stock markets. Of course no one should be fearful about that because as we all know both of those markets are free of manipulation and cant. Low interest rates and the subpar growth rates they indicate lead to three other issues the President will have to deal with. First is that peoples standard of living has not improved for the last 30 years if we adjust for the increase in debt. That has to change or the system will remain unbalanced. Second, it is starting to be too expensive to grow as the price of resources and materials will quickly turn into pressure on an economy burdened with so much unproductive debt and spending. Imagine what would happen to our income statement if we started to see synchronous growth in the world. The cost of oil and material would skyrocket as demand increased and money velocity, near zero at present, would rise and inflation would take hold quickly. While the rich nations could afford the cost of growth, the emerging world would be quickly bankrupted with resulting instability. Third, the persistent low interest rates environment is going to kill the money market industry, bond funds and perhaps a good number of banks. All of these firms make a good portion of their profits from lending and earning interest on client funds or securities on deposit. This source of profits is being eliminated by the continued low rates. This leaves the banks ( which remember are too big to fail) dependant on the steepness of the yield curve for profits ( take deposits in at .25% and buy ten year Treasury debt at 1.61% with no risk).

So once again the banksters are making a devils deal with the government, you protect us from our own stupidity and we will continue to buy Treasuries and use the profits to do what eventually will be revealed as more stupid things. Secular bear markets are hard to control because the methods used to correct the downward cycle produce different results than might be expected. Secular bears sow the seeds of the next bull market but this time the changing nature of government may indicate a whole new frontier in investment. Secular bull and bear changes have to run until the sins of the past are cleared. So the next President is going to have to come to the realization that the nation and the world have to remake the financial markets to be servants of society not the dictators. The financial markets must go back to industrial capitalism- there should never be anything too big to fail. The government should never create the moral hazard of allowing people or corporations regardless of the level of employment or political influence to believe there is a bail out for poor decisions. The rule has to be if you fail you die. The banks need to be broken up, Glass Steagle was good legislation. Federally insured deposits should never be a source of low cost financing for speculators and other lower forms of life. The criminal class running the financial world need to be held to account if not by prosecution then by sensible regulation and Dodd Frank ant it.

Best Wishes and Good Luck Dennis Gibb