The year 2010 took us on quite a ride and ultimately delivered acceptable returns in both the US stock and bond markets. Our returns were commensurate with the index, but did so without exposing our clients to what we consider the primary long term risks that exist today. The slow economic recovery in the US and the uninterrupted growth in the emerging international markets made people much more excited about bonds, commodities and BRIC-trade related companies. Simultaneously, individual and institutional investors spent most of the year closing the barn door behind all the animals which got out in 2008. By falling in love with the bond market at the lowest interest rates in thirty years, we believe these fear motivated investors are signing on for interest rate guarantees which almost assure historically poor investment performance.

Risk Number One - Bonds

We have argued all year that we are at a thirty-year inflection point in the US Treasury Bond market and other bond investments. In 1981, ten-year Treasury Bonds traded to yield 15%, but inflation was at 11% and had been soaring for the previous thirty years. Federal Reserve Board Chairman Paul Volcker tightened credit so severely that CDs hit 18% and the Prime Interest rate at major banks rose to 20%. The same year (1981), President Reagan replaced air-traffic controllers who went out on an illegal strike and psychologically broke the back of the wage spiral which had been out of control in the prior decade. These courageous acts broke the back of commodity prices and inflation, but it took amazing courage in 1981 to bet that they would succeed.

By 1984, the US economy had roared back and economists who had seen a similar scenario play out over the previous decades and assumed that inflation would rear its ugly head. Ten-year Treasury bonds rose to 14% despite an inflation rate of only 4%. This huge real return in bonds of 10% gave “wise” investors a margin of safety which insured happiness going forward. Courage in 1981 and wisdom in 1984 laid the groundwork for decades of bond investing success.

Fast forward to 2008 and place yourself into the midst of the financial crisis. Ten-year Treasury bonds traded to yield close to 2%. It took great courage to sell your “safe” Treasury bonds and take risk at that time. However, in 2010 investors and many experts advertised a “double dip” recession in the US. The Ten-year Treasury bond dropped from 4% in April to around 2.4% in the late summer. It took wisdom to sell Treasury bonds and other high-quality bond instruments in the summer and fall of 2010 while most individual investors and institutional investors poured money in. The Investment Company Institute reported that in 2009 and through the end of October 2010 investors added $622 billion and $461 billion to bond mutual funds, respectively. The only outpouring of affection in mutual funds that you can compare it to was the flow into stock funds in 1998-99. Shouldn’t that scare you? From a historical standpoint, investors haven’t been this committed to the bond market since the late 1940’s and early 1950’s when the interest rates were similar to today’s rates.

Risk Number Two - China

Groundhog’s Day is one of my all-time favorite movies. It tells the story of a weatherman (played by Bill Murray) who is forced to repeat the same day and deal with the same circumstances over and over again. He starts out by using his miserable time prison as a way to take advantage of the other people he runs into in. Eventually he allows himself to get molded into a man who seeks to help others and become the man his love interest (Andie McDowell) might want as a long-term partner.

We have been in a time prison as investors these last six years. We like to own non-cyclical premier companies which fit our strict eight criteria. We’d like to stay with the best of them for decades so that their dividends and capital gains create the kind of wealth that our investors need for retirement and income distribution needs. Unfortunately, these premium companies have been stuck in place just like Bill Murray was in the movie. The normal significant price-to-earnings (PE) premium these companies trade at has dissolved into a sizable PE discounts for the most part. The reason is simple. Most investors are completely committed to paying premiums for the companies which benefit the most from the “euphoria” surrounding strong GDP growth in the Emerging Market countries like China and India.

At Smead Capital Management, we have a framework for monitoring extremes which might identify the end of a period of “financial euphoria”. In his book, A Short History of Financial Euphoria, John Kenneth Galbraith said that speculative episodes which lead to financial euphoria are born by “something seemingly new in the field of commerce or finance”. Think carefully when someone says something like “the internet is going to change our lives” or “residential real estate always rises in Phoenix because of a constant and growing wave of warm weather-seeking retirees”. These are examples of a bill of goods that lured investors in. This time it is the idea that the Chinese economy will be able to grow uninterrupted as rural farmer and village people move to the cities to provide cheap labor. All we hear about is that there are 1.3 billion people. What could be more exciting than the seemingly new prospect of that many customers?

Unfortunately for those caught up in this episode and fortunately for us, we have a historical framework for identifying when it is late in the episodes. At the top of an episode of financial euphoria we watch the media, mergers, sentiment and IPOs. Today's rabid devotion to China's influence on worldwide capital markets makes it easy to compare the current circumstance to late 1999 and early 2000, right before the Tech Bubble burst.

The belief that the Internet was going to change our life was "new in commerce and finance". Therefore, investors felt that high prices and economic history didn't matter. The media fell in love with Silicon Valley, Time Warner merged with AOL, day-trading tech stocks became an obsession and Dotcom IPOs doubled the first day of trading.

In this episode, CNBC took an entourage of billionaires to China, and Bloomberg has organized their markets coverage around Asia. Caterpillar recently announced a deal to buy Bucyrus International (a mining equipment manufacturer) at 16 times its share price low of 2004. Speculative ownership of the commodities (Oil, Copper, Iron ore, etc.) used in China’s infrastructure build out exceeded the 2008 commodity peak last week (Dec. 8th, 2010). Here is what the Wall Street Journal reported on Dec. 8th,

“Investors are holding their biggest positions on record in the commodities markets as prices surge and debate intensifies among U.S. regulators about whether to limit the amount that any one trader can bet in markets for energy, metals and agricultural products.

Hedge funds, pension funds and mutual funds dramatically ramped up their holdings in everything from oil and natural gas to silver, corn and wheat this year. In many cases, the number of contracts held for individual commodities now far exceeds the amount outstanding in mid-2008, the last time commodity markets were soaring to records and debate raged about whether excessive speculation was driving up prices.

Contracts held by investors have risen 12% this year through October and are 17% higher than June 2008, according to data from the Commodity Futures Trading Commission, the market regulator.”

The CFTC is dealing with a more rabid speculative circumstance than it did when oil was over $140 per barrel and commodities were the most popular asset class. This should make commodity bulls very nervous. We have a saying at Smead Capital Management that says, “If there is going to be a hurricane in Miami, you don’t want to be in Palm Beach”. At this point, we believe that it is an error in judgment to own companies in the Heavy Industrial, Basic Materials and Commodity producing sectors of the US stock market. They are at the same risk investors faced back in late 1999 by owning Cisco, Microsoft, EMC and other Tech darlings. They weren’t the Dotcoms, but they were trading at inflated prices and were too close to Miami. If China gets a cold, we think that Caterpillar could get pneumonia!

Lastly on Wednesday Dec. 8th, we had the final part of the puzzle put in place by the IPOs of the You Tube of China (Youku) and the Amazon of China (Dangdang). After increasing the offering price more than expected these stock issues soared the first day (Youku more than doubled and Dangdang was up more than 80%). Youku traded at over 60 times sales on Friday, Dec. 10th (if you can believe the numbers that come out of China) and Dangdang traded at over 120 times earnings. It looks like eToys did back in 1999 when it went public at $20 per share and ended the first day of trading at $76 per share. They were liquidated in bankruptcy around March 7, 2001. Therefore, everything we would look for at the top of a speculative episode is in place with China; media affection, a huge foolish merger, over-confident sentiment and smoking hot Initial Public Offerings of untested companies.

When the Tech bubble broke back in early 2000 there was a certain amount of capital which flowed from the popular area to the more undervalued parts of the stock market. Low PE financials were the main beneficiary of that move. We believe this time it could be the Pharmaceutical companies which receive part of the money from the exodus out of the BRIC trade. They trade at among the S&P 500 Index’s lowest PE ratios and fit our other seven criteria quite well. We are over-weighted and waiting patiently for these events to unfold. Thank you for your confidence in us and your patience with the markets!