Caution: Danger Ahead (Robert Rodriguez, First Pacific Advisors)

Speech to Institute for Private Investors

By Robert L. Rodriguez, CFA

Managing Partner and CEO

February 15, 2012

Lectura altamente recomendable de uno de los mejores gestores de las últimas décadas:

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EXHIBIT 1

Exhibit 1 above shows worldwide government Debt-to-GDP ratios from 1880 to 2009. This was a monumental undertaking by the authors, given the difficulty of gathering the data for their IMF working paper.(note 4) Among the advanced G-20 countries, the top line, debt levels are at their highest, except for WW2, at nearly 100%. Their conclusion was that fast growing countries consistently registered low debt ratios while slower growers carried the highest ratios. The research by Professors Carmen Reinhart and Kenneth Rogoff demonstrates that once public debt is greater than 90%, it begins to retard economic growth and they observed, “…government debt is far more often the unifying problem across the wide range of financial crises we examine.”(note 5) The implications of Exhibit 1 are disquieting.

EXHIBIT 2

Exhibit 2 displays a debt heat-map comparing 2009 to 1932.(note 6) It indicates that the current crisis for public debt appears to be more widespread and serious than that of 1932 but aggressive central bank monetary easing, during the last crisis, helped contain this risk thus far.

I will focus on three regions that account for 57% of global GDP which I refer to as the trio of fiscal misfits: the European Union (EU), Japan and the United States.

Exhibit 7 shows that the S&P 500’s P/E ratio, the yellow line, has declined over the past 12 years to a level not seen since the mid-1950s and is the longest sustained decline in a half century. Many consider the stock market reasonably or cheaply valued, when compared to history, so, its current valuation discounts numerous risks. The corporate earnings recovery surprised many, including me, particularly

EXHIBIT 7

with near record pre-tax profit margins, despite substandard economic growth; therefore, case closed--but not so fast. Upon closer examination, 73% of the non-financial corporate pre-tax profit margin expansion resulted from lower interest (38%) and labor (35%) costs.(note 19) Furthermore, approximately 45% of the S&P’s revenues are internationally sourced, so European and Japanese recessions pose additional risks. Contagion from Europe should not be underestimated since European banks dominate emerging market lending. I believe the market’s P/E decline reflects the growing risk of profit margin contraction, a sluggish economic growth outlook, fiscal policy mismanagement and international economic uncertainty. Increased market volatility adds to this list, as portfolio managers digest and react to news almost instantaneously. When a company’s operations are viewed as having low growth expectations, combined with peak margins and high volatility, investors typically ascribe a lower P/E valuation to the company’s stock. This portrayal describes the market and, therefore, a higher margin of safety, through a lower P/E, should be required for an aggressive equity allocation. In my opinion, low to mid single-digit returns will be the norm for the next decade and this may prove to be optimistic.

My bond market view is worse. Exhibit 8 on the next page demonstrates how much risk, and little return, there is if interest rates rise by 100 basis points in one year for the Barclays Aggregate Index. The possibility of capital loss, denoted by the negative blue bars, has been increasing and is now at a

EXHIBIT 8

record level. Though longer-term Treasury bonds were among the best performing asset categories last year, consider the risk taken. Who would be willing to buy them, at these absurdly low yields, unless they were able to sell quickly? I believe no one. It’s speculation since there is little, if any, underlying real value. Protect your capital and stay within a three-year maturity. Without a material improvement in the fiscal outlook, these low rates should prove to be unsustainable. Remember the suddenness and magnitude of the interest rate rise for Italian and Spanish ten-year sovereign bond yields this past year. Over the next decade, I expect low single-digit to negative total returns for intermediate and long-term bonds.

So how are we positioned, given this negative outlook?

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