Since March 2009, the Federal Reserve bought $1 trillion of Mortgage Backed Securities and $300 Billion of Treasuries. It did that by printing cash.
We are the only country that has the privilege of paying our considerable debt by printing our own money. This is a great privilege, but it must not be abused.
The 1st rule of holes is, when you are in a hole, stop digging. We got in trouble by borrowing too much, and the solution cannot be borrowing even more.
Yet the U.S. is pursuing policies that guarantee inflation and a weak dollar. The purchasing power of cash is being eroded; and fixed income does not perform well in inflationary cycles.
So where does one find shelter when paper money is constantly diminished?
I would argue large cap stocks have the best prospects to be an effective shelter. Since the March lows, the 20% of stocks with smallest market capitalizations have on average outperformed the 20% of largest stocks by 72 percentage points.
By contrast, in the first nine months of all bull markets since 1926, the average outperformance of the small-cap sector was just 21 percentage points.
Only once since 1926 have the first nine months of a bull market produced a gap greater than this year's. That was in the bull market that began in February 1933, in the middle of The Great Depression.
The reason to this phenomenon is the gigantic stimulus program. By reducing the danger of incurring risk, the government encouraged huge risk-taking, and now over levered junk is beating financially solid quality.
The opportunity today is therefore in defensive, liquid, high quality, and still cheap large cap stocks. Many large cap stocks are still flat for the year, despite the market's rally.
Wal-Mart trades at a P/E of 14. That implies a 7% earnings yield. In addition, it has organic growth of about 2%, plus it regularly raises prices with inflation. So you get a 9% yield, plus inflation, investing in a company with a strong brand and dominant industry position. That is an attractive proposition compared to the 3.6% yield on ten year government bonds, which are NOT indexed to inflation. And Wal-Mart's finances are arguably better than those of the US government. Incidentally, Wal-Mart is down 3% year to date.
Supermarket chain Safeway is another example. Although its industry is tough and ultra competitive, Safeway's stock is cheap. The company will generate $1.4 billion in free cash this year. With $8.5 billion market cap, that implies a cash yield of 16.5%. Safeway is growing, very well managed, has a strong brand and pays a 2% dividend. It also has considerable real estate: Safeway owns about 40% of its 1,739 stores. Inflation lets Safeway raise prices and simultaneously devalue its fixed cost liabilities, so the company should benefit from an inflationary environment. And the stock is down 10% year to date.
The past decade has been incredibly productive. Technological innovations from the Internet to Biotech have leapfrogged the entire world beyond what most people could even imagine only a generation ago. Just think how much less productive would your own life be without Email or Google.
Yet the past decade was also a lost decade financially. The S&P 500 has shown a negative return for the past ten years. All this innovation has not yet benefited investors.
Throughout U.S. history, a down decade was always followed by significant out-performance. I believe the coming decade will not deviate from that precedent. And large cap stocks will likely close the historic gap in valuations, outperform small caps and protect investors from the vagaries of an inflationary environment.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.