Deep Knowledge is valuable.  In human relationships, its known as “understanding.” In the arts it’s known as “technique.” In sports, it’s “the fundamentals.” And, on Wall Street and with regard to investing, it’s known as having “an edge.” Only through deep knowledge can you have an intuitive understanding of something that is not commonly already known.

We admire and wonder about the seasoned fatherly man, full of wisdom and patience. The kindly aging beauty of a lady who always seems to understand us and our predicaments and know the right thing to say. We wonder (I wonder!), “How does she know? How did she get to this point of human understanding?”

We gape in awe at the performance of a Meryl Streep, or the tenacity of a Tim Tebow, the perfection of Katarina Witt, or the craft of an author like Michael Lewis. How about the perfection of a pre-scandal Tiger Woods?

Artists practice their craft. And Athletes are also artists. They practice the “fundamentals” of their craft better than others. They practice tirelessly, hour after hour, turn after turn, shot after shot. They gain and attain an understanding of their craft, which far exceeds the understanding of others. And the arts extend far beyond just the fine arts and athletic arts, they also include the professional arts.  Doctors, Lawyers, Money Managers.  It really matters when even of these folks mess up.   Who isn’t ready to suspend their disbelief when the see a surgeon perform precision work on a knee — or on a brain or on a heart? Talk about understanding the details of their craft! And they had better understand them.  The skill of professionals matter, as bad outcomes are pretty unpleasant to contemplate (injury, death, jailtime or destitution).

While some elements of mastery may be attributed to “freakish” acts of generosity by genetics and our maker, most of the mastery comes from dedication and hard work. The professional knows, either intuitively or consciously, how to do it better, say it better, show it better.

In 2000 I was hired as a Senior Analyst of a research firm focused on the PC supply chain that extended from Taiwan, through Silicon Valley tech companies, and to the end markets. I wasn’t much of an expert about anything regarding technology, so I decided to focus deeply on one area. For two months, I put together a fabrication (Fab) capacity model which demonstrated the total production (supply) of DRAM chips for the next 3 years. It was a lot of work. But when I finished my model, and then compared the supply figures to the worldwide demand figures, it showed that DRAM would be oversupplied for the next 2½ to 3 years. The implications were simple and powerful, the price of DRAM memory wasn’t going to improve for a long time, hence those companies making DRAM were not going to deliver good financial performance for a long time. My investment to understand and acquire “deep knowledge” about the DRAM industry paid off. I had created an “edge.” I knew something not widely understood. More importantly, this experience showed me the value of deep research in a practical (money making) sense.

“Teach a little and they learn a lot. Teach a lot and they learn nothing.” That is the motto of my dance teacher Mirabai Deranja. Mirabai is a professional dancer. She has a mathematical mind (which I appreciate). First, she studied astronomy, then pursued her passion for dance. Recently we were having a lousy private lesson. My brain was fried. But then, I showed her a basic walking step I had learned from another teacher lately with a lot of contra-body motion.

Suddenly Mirabai said these words: “Your back leg, the angle is wrong. Slide it on the inside, not the outside of your foot, ie., the outside of the big toe, not the outside.  “Otherwise it looks terrible.” Well, I don’t want to look terrible do I!   And suddenly, everything changed. My technique was off. That change of 20 degrees in the angle of my trailing leg made all the difference. Just like with the pitcher who needs to release the ball at a slightly different angle or the actor who needs to inflect more to show understanding or the analyst who needs to see beyond what is popular, I improved my dance technique enormously with just a small correction in technique.  The improvement came from understanding the proper angle on the trailing leg in the basic tango “walk.” Deep knowledge is understanding the fine details and the difference they can make.

I’ve always been driven by research. The understanding of the details differentiates the average from the elite. From precious metals and the unscrupulous printing of money to the coming energy crisis and rebuilding of infrastructure and biogenetics, the economy is going to grow leaps and bounds in some ways over the next decades. I think that thinking and research deeply about some of those areas is a way to develop an “edge”, an advantage, to protect client assets, and grow wealth. If you have significant thoughts about what the future portends in your area of expertise I’d be happy to engage with you in a conversation. There’s a lot of work to be done to identify the opportunities that the great recession will create. I can’t wait.

Barnes Capital LLC is a Registered Investment Advisor. We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds and high-quality companies which raise their dividend every year. We add Gold to portfolios for diversification. Call Daniel at (925) 284-3503 and visit www.barnescapital.com

Issue #37

Since 2007, Barnes Capital has made annual predictions about what will happen in the New Year.
Thinking about the future and what could happen is crucial in our role as a steward of people’s money.

2011 Predictions Recap:
We got a lot of things really right in our 2011 predictions and a few things wrong.

1) We said municipal bonds are cheap again, and we were delighted to buy them with 4% to 7% tax-free yields.  We said that Meredith Whitney’s December 2010 prediction that in 2011 there would be hundreds of billions of defaults on municipal bonds was completely wrong.  Actual 2011 municipal bond defaults were $2.1 billion.  We put our own, and our clients’ money where our mouths were.  We bought as many bonds as we could for our clients.  Medium and longer municipal bonds rallied 5-10% in the first half of the year and another 10% in the second half.  The Merrill Lynch Muni Index which includes shorter maturities gained 10.5%, bested only by 2002′s +10.73% gain.

2) We said Gold would climb to $1600 this year.  Reality is that Gold climbed past $1900 in the summer only to lose luster and pull back 20% in the last quarter to end the year at $1565.

3) We said that oil would break out to more than $100 a barrel.  Oil started around $90, ran to $110 and finished the year at $99.  With that, we hit the bull’s eye.

4) We said that real estate prices would continue going down.  That’s happening.  While some lower-priced, smaller homes in good areas are not getting cheaper; big homes, expensive homes, homes that are hard to heat and cool, and homes in less-desirable locations are still tanking.  Real estate data, however, is incredibly unreliable due to all the unresolved mortgages, foreclosures and short-sales.

5) We said stocks would perform decently.  To a point, they did.  It was a tale of two markets. Dividend stocks with global franchises did very well: McDonalds, Abbott Labs, Intel, Apple, IBM, and Chevron.  We saw great changes every week, but on the year, the SP 500 index declined from 1257.64 to 1257.60, a percentage change of 0.003% before dividends.

Other predictions which we said are less likely, but it wouldn’t surprise us if:
6) We said stocks might party like its 1999.  They didn’t. Moving into the summer 2011, stocks were up 10%, but then the fears of Europe’s implosion sent equities reeling in June, and they fell apart in August.  Stocks stayed lower for most of the fall before strengthening modestly after Thanksgiving.  The ending result: A flat year, with dividend stocks strongly outperforming the others.

7) We said states would seek cover in the courts to solve their budget problems.  This didn’t happen.  State budgets stopped the bleeding and were able to refinance their debt at ever more attractive bond rates throughout 2011.

We stated that the foreclosure problem hasn’t been solved.  One year later, that’s still the case.  We said that the 4 out of 5 economics professors who forecast 2%-7% increases in Orange County in had their plus and minus signs mixed up.  We were right; Orange County homes dropped another 4.91% through October according to the Case-Shiller Index.  Other prices around country, except for Washington D.C., were down 2%-6%.

9) We said the National Commission on Fiscal Responsibility and Reform (also known as the Simpson-Bowles Plan), would stay on life support.  It has.  It remains the most serious plan to restructure the nation’s budget and long-term liabilities.  Neither Democrats nor the Republicans are willing to compromise yet.  It will take future disasters to motivate politicians to do the right thing. We believe that stock market is be being held back by the lack of political will to restructure the deficit and the budget.  In 2011 Bond markets rallied on the perception that government will continue to kick the can down the road, which will lead to lower long-term growth as far as the eye can see (hint, that’s not very far).

10) We said Gold might enter into the third and most speculative phase of its bull market which is always the phase when the most money is made (think tech stocks in the late 1990s).  It didn’t.  Gold stocks crumpled at the end of 2011. Major mining stocks declined 16% for the year while junior mining stocks declined 38%.

Overall our 2011 predictions were on target.  We have less confidence in our 2012 outlook.

2012 Predictions
1) Bonds are now definitely expensive.  But uncertainty about slashing budgets, the situation in Europe, and interest rates remains high.  Since stocks have fallen 50% twice in the last decade, the stability of bonds is still very attractive.  Bonds are likely to deliver flat to mid-single digit total returns in 2012.

2) Gold. For the moment, Gold is out of favor as we enter 2012.  Gold will struggle in the first half of the year, but reach new highs in the second half of the year to finish at $2000/oz.  Gold’s weakness is a function of the asset being viewed as a risk asset.  The move towards new highs will be powered by the short-term memory of buyers and the uncertainty of the election and European debt problems.  Here’s a look at gold’s value over the last 13 years.
1999 –  $288
2000 — $271    -6%
2001 — $278     2%
2002 — $348   25%
2003 — $415    20%
2004 — $437     5%
2005 — $516    18%
2006 — $634    23%
2007 — $833    31%
2008 — $881    6%
2009 — $1096  24%
2010 — $1421   30%
2011 –  $1566   10%

3) Oil:  Oil prices are strong, indicating that global growth isn’t as weak as feared and that the new normal for Oil is greater than $80 a barrel. We expect Oil to remain range bound from $90 – $115.

4) European Debt: The big question mark is the issue everyone knows about, the European debt.  The Euro reaches few conclusions, weakens a bit, and all major issues including Greek default are pushed off until 2013.

5) The Euro:  The Euro will weaken to 1.20 but not break below 1.15 in 2012 versus the dollar.  For some perspective, the Euro was launched in 1999 at $1.17 per Euro.

6) Unemployment: Currently the unemployment rate has declined below 9%, but that’s only because many job seekers have STOPPED LOOKING. Unemployment will remain the Achilles Heel of the current administration and remain stubbornly around 9%.   Until our society is transformed by higher energy costs, unemployment of 8% is the new normal.  Retail (particularly among travel agents and sales clerks), low-skill manufacturing and real-estate-related jobs aren’t returning this decade, if ever.

7) GDP growth:  The Gross Domestic Product will putter along with growth that’s greater than 2% but less than 3%, solving no problems but creating few as well.

The election:  The presidential race will be a nail biter. Nobody will know the outcome until Election Night, November 6th.

9) Housing:  After 5 years of waiting for prices to return to 2007 levels, homeowners will get real.  Homeowners who want to move will start to do so. Until the mortgage, foreclosure and short sale issues are resolved, however, the real estate market data is suspect.   We expect this process to take at least another 3 to 5 years.

10) Forecasting: Barnes Capital will retire from the forecasting business, citing “impossible expectations,” “poor compensation” and “declining confidence” in our own omniscience.

In Conclusion
The Year 2012 will provide continued strong corporate earnings and government-subsidized low interest rates.  The economic resolution of Europe will make minimal progress as it continues to wait for political consensus.  Don’t hold your breath.  Stocks are priced slightly more attractively than they were one year ago.  Bonds are much less attractively priced. Therefore, we will not increase our risk exposure substantially this year, in order to achieve a Pyrrhic one-year victory.

Our clients’ primary needs are wealth preservation. We believe that real wealth preservation in inflation-adjusted terms is going to be difficult to achieve this decade.  Our investment strategy is focused on safe returns, not optimal returns. We remain believers in the solid returns of strong dividend-paying stocks, covered call writing, and municipal bonds, including California General Obligation bonds and Gold.

A cataclysmic meltdown in 2012 is unlikely.  There is simply too much money being printed by Bernanke’s Federal Reserve for things to fall apart.  Austerity, it isn’t. But, to employ an overused cliché, we’re just kicking the can down the road. Let the next Administration start the process of structural change; this one’s just muddling through.

Daniel A. Barnes, CFA
December 31, 2011

Barnes Capital LLC is a Registered Investment Advisor. We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds and high-quality companies which raise their dividend every year. We add Gold to portfolios for diversification. Call Daniel at (925) 284-3503 and visit www.barnescapital.com

What a year 2011 has been. Charles Dickens’ “A Tale of Two Cities” comes to mind: “It was the best of times, it was the worst of times.”  It really isn’t the best of times, but it’s not the worst of times, either. It is scary.

Great anxiety and uncertainty about Europe is creating a stressful environment as 2011 comes to an end.

Anxiety
I’ve spent the last few days at the Hard Assets Conference in San Francisco. I heard the end of the world proclaimed. From the price of gold and the Dow Jones Index reaching parity (they are currently at $1700 and 11,200), to predictions about the demise of the Euro, Germany leaving the EU, and other outrageous, potentially possible, prognostications, professionals are, to quote one friend, “as freaked out as I’ve ever seen.”

The current anxiety is really about the increasing trepidation that worldwide global growth will be derailed by the debt crisis across the developed world.  The reason why this would be so scary is that if global growth is derailed it’s pretty darn likely that “deflation” will ride to victory, and all assets will pretty much decline, leading to unprecedented worldwide debt defaults.

Capitalism endures
But let’s take a step back.  Is a global recession really likely?  How has the developed world fared through other crises over the last century?  I’ll tell you this, betting against global growth has historically been a bad bet.  In the last 100 years, capitalism has endured and survived the “War to End All Wars,” the Great Depression, the Nazis, fascism, communism, World War II, the Cuban missile crisis, the counter-culture movement of the ’60s, the Korean War, the Vietnam War, stagflation, high inflation, supply-side economics, George W., the tech and dot com bubbles and the profligate policies of central banks and elected officials.  Presently, it is digesting the global banking crisis, real estate deflation and the problems with the Euro.

Through all these challenges, a sustained contraction in global growth only occurred in the 1930s.  So is it reasonable or prudent to bet against that record?   It is beginning to look contrarian to believe that global growth can be sustained.

The big question, however, is really — how are we to handle this uncertainty? Is the current economic system really in danger of collapse?  For those of us in the investment field — and for those of you trying to prudently plan your future — how do we protect ourselves?  What is prudent?

Your Retirement
At Barnes Capital we believe that every retirement plan should rely on multiple pillars.  If you have worked a fair amount, you will receive one pillar in the form of Social Security.  It will likely cover your grocery bills and utilities and perhaps supplemental medical insurance in retirement.  To cover your property taxes, maintenance and/or rent, you’ll need another pillar, probably an IRA or company pension worth about $500,000.  With those two pillars, you can enjoy a basic retirement.  Medical expenses will help you live longer, but you will need a third pillar to pay the premiums, deductibles and out-of-pocket expenses.

The Debt Solution
The solution to Europe and all the debt in the developed world’s system is sustained inflation of between four and five percent for the next 30+ years.  As we work our way to fiscal solutions in Europe, volatility is likely to remain extraordinarily high. High-quality international corporations likely provide the greatest long-term security for prudent investors.

If your sizable fixed-income allocation in your portfolios have locked-in safe yields in the 6% plus range, you probably do not have to trade out of them, particularly in retirement accounts which you will not touch for 10+ years.

Finally, I believe that everyone should have 5% to 15% of their portfolio exposed to gold. This exposure to gold could even include some gold stocks, which I generally do not like. They are universally deplored, likely to become cheaper and also offer great value on an unfortunately selective basis.

Get Someone Objective in Your Corner
The bottom line is this:  You want to think through your situation with someone objective to assess the appropriateness of your current allocation.

Barnes Capital LLC is a Registered Investment Advisor.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, highest quality dividend companies and precious metals, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503.

At least in spirit, the Occupy Wall Street movement is essentially right.

It’s right in its assessment that there is something fundamentally wrong in how the pie is divided between consumers, employees, shareholders, upper management and the federal back-stopping that FDIC insurance provides.  Certainly my perspective is myopic. It’s a very large movement, and I see things from a specific, privileged vantage point.  But I do have a few degrees in political science, and I’m darned happy to see the movement of this #OWS mob.

The Relative Decline of the Blue Collar (and most of the rest of us, since 1970)
You see, I think their sensibilities are on target. We all know the numbers, or sense them, of the economic changes of the last 30 years. The blue collar worker has been in relative decline compared to the economic elite since 1970 (which was the relative high water mark of the blue-collar worker. (point to note, the “1%” so often quoted recently, comprises those households with household income above $360,000 in 2010. Finally, our blue collar has noticed enough to do something about it. OF course, its 2011, and the economic disfranchised includes not just the blue collar guy — it’s also the white collar guys , the underemployed and the unemployed,and the rest of us who have benefited less — or not at all — by the distributive mechanisms of the economic pie for several decades.

#OWS is certainly not going to roll back the “progress” of global capitalism. That heartless beast that marches on to its own secular drumbeat. But let’s point a populist gun at one of the worst offending areas; a constituency from whence many of today’s 1% made their millions: Banking.

Banking is Part of the Public Trust
Banking, due to the government backstop of deposit insurance, is not a purely private enterprise. Banking is a part of the public trust. In Latin, res publica, means loosely “public affaire”. With res being a singular noun for a substantive or concrete thing, and publica meaning of or pertaining to the public or the state. Hence the literal translation is the public thing/affair.

Banking is a public affair. Banking didn’t start out as a public affair, but it became one, when the federal government stepped in and began to insure deposits (FDIC insurance). As soon as deposit insurance was established, the banking became a public matter. And in 2008 we discovered it was actually a very public matter as the US Government needed to save the banking system from national and perhaps global collapse.

Banking should be BORING
In providing a service, lending and deposit savings, the business of banking should get back to what it used to be: “boring”. Like government service, this is an industry, that shouldn’t create any opportunity for individual contributors to make “millions”, in a year, let alone tens or even hundreds of millions. As one astute client said, the OWS# asks for the guarantee “we bailed you out, what guarantee can you give us, that you won’t blow up again?

Banking should be like Government Service including Military Service
The government is in the business of providing for the safety and well-being of the citizenry. As the politicians so clearly articulated. Banking is a required part of that safety. Banking didn’t use to enjoy the governmental guarantee. But that was in an age where their were routine banking/financial panics, and banks closed their doors — and people lost all their savings. We’ve decided long ago that that isn’t the type of society that we want. The social contract includes the underwriting of deposits, and there fore the government has right, and a duty, to regulate banking as an industry. I portend that the government abdicated that obligation, and that is the core problem in banking. As the movie “Bank Job” as well as the real life fall of Barings Bank due to “rogue traders,” showed, anytime a corporation is under shareholder (including management compensation contracts tied to bank performance), imprudent risk taking can easily prevail. It is that risk-taking that leads to the billion dollar profits and the tens of billion dollar losses.

If it weren’t for this profit pressure, banks wouldn’t be trying to levy $5 transaction costs on the customers.

The Bottom Line
Corporate practices are NEVER GOING to CHANGE, unless THEY ARE FORCED TO. The OWS# movement understands this truism intuitively. Our social contract needs to be redefined, with Banking receiving an “asterisk”, it is properly, a quasi-public/private enterprise, essential, but not fundamentally different than a public utility. Your thoughts?

I meant to pen this in August.  Then I did write it up in mid September.  By the time you read this, another month will have passed.  But the bottom line is the same: the US Dollar is still beautiful, relative to its competition. Since July, the dollar has risen 10% against the Euro and other currencies.  I believe this trend will continue.  You see, currencies are both a beauty contest and a weighing contest.  The European Union has to bail out its banking systems.  The cost of monetizing Euro debt is going to run several trillion Euros.  That makes the Euro closer to a Lira than a Deutschmark.  Result: a weaker currency.  Further, currencies reflect a region’s economic growth prospects.  The growth prospects for the Euro economy are not rosy.  With its overvalued currency, the Euro’s growth prospects dim.  The Euro needs to fall in order to improve its competitiveness and future growth prospects.  When the Euro falls, the U.S. Dollar gains.

Swiss Franc pegged to Euro
In August two events reinforced the dollar’s strengthening.  First, the Swiss Franc had been acting as one of the last “iron-clad” hard currencies, but it lost its independent status.  It is now, for all extensive purposes, tied to the Euro.  This is probably a good thing, since a cup of coffee in Geneva is rumored to cost $11 these days.

With this event, investors lost the safe haven of the Swiss Franc.  Don’t get me wrong, it’s not that the Swiss Franc was ever a legitimate reserve currency.  It never had enough “volume,” to handle petrodollars.  (The Arabian Peninsula has more than half a trillion in dollar revenues per year.)  The Saudis were never exchanging most of those dollars for Francs.  But still, as long as the Swiss Franc has been rising these last few years against the dollar and the Euro, it created the impression among some investors that there was an alternative to the dollar.

ECB finally Softens
The next shoe to drop was at the beginning of September, when the European Central Bank (ECB) gave multiple signals that it will acquiesce to monetizing its banking problem.  Yes, that’s right, they will take a page out of the playbook of the Federal Reserve and use easy money to cover the bad loans and other issues of the weak European periphery economies (the PIGS- Portugal, Italy, Greece and Spain).  But easy money = an easy currency, which is one that is not hard and not strong.

Gold
Gold is also functioning as a currency, since it is one of the only storehouses of value, which can scarcely be “monetized” or inflated away.  But the Gold market is not large enough to handle the trade flows of imports and exports.

Conclusion
There is only one true reserve currency in the world, the U.S. Dollar.  Its demise has been greatly exaggerated.  To be a reserve currency, you must have political stability, large deep markets (large enough to absorb trillions of inflows and faith in the judicial system and the sanctity of contract and property rights.  No other currency fulfills these requirements today.  The Euro is a long-term candidate to be a reserve currency.  Theoretically, so are the Japanese Yen and, someday perhaps, the Chinese Yuan.  But each of those countries has very significant issues, which cause the owners of the trillions in petrodollars to find undying solace, for better and worse, in the US Dollar.  I don’t expect that to change in the next decade.

One last point: if you live in the U.S., probably more than 90% of your future liabilities and other expenses are dollar denominated.
So whether the dollar rises or falls considerably you are unlikely to notice it most of the time.

Lafayette, California

September 20, 2011

Barnes Capital LLC is a Registered Investment Advisor.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, highest quality dividend companies and precious metals, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503.

Swiss Franc pegged to Euro
In the last month, two events have reinforced the dollar’s strengthening.  First, the Swiss Franc had been acting as one of the last “iron-clad” hard currencies, but it lost its independent status.  It is now, for all extensive purposes, tied to the Euro.  This is probably a good thing, since a cup of coffee in Geneva is rumored to cost $11 these days.

With this event, investors lost the safe haven of the Swiss Franc.  Don’t get me wrong, it’s not that the Swiss Franc was ever a legitimate reserve currency.  It never had enough “volume,” to handle petrodollars.  (The Arabian Peninsula has more than half a trillion in dollar revenues per year.)  The Saudis were never exchanging most of those dollars for Francs.  But still, as long as the Swiss Franc has been rising these last few years against the dollar and the Euro, it created the impression among some investors that there was an alternative to the dollar.

ECB finally Softens
The next shoe to drop was at the beginning of September, when the European Central Bank (ECB) gave multiple signals that it will acquiesce to monetizing its banking problem.  Yes, that’s right, they will take a page out of the playbook of the Federal Reserve and use easy money to cover the bad loans and other issues of the weak European periphery economies (the PIGS- Portugal, Italy, Greece and Spain).  But easy money = an easy currency, which is one that is not hard and not strong.

Gold
Gold is also functioning as a currency, since it is one of the only storehouses of value, which can scarcely be “monetized” or inflated away.  But the Gold market is not large enough to handle the trade flows of imports and exports.

Conclusion
There is only one true reserve currency in the world, the U.S. Dollar.  Its demise has been greatly exaggerated.  To be a reserve currency, you must have political stability, large deep markets (large enough to absorb trillions of inflows and faith in the judicial system and the sanctity of contract and property rights.  No other currency fulfills these requirements today.  The Euro is a long-term candidate to be a reserve currency.  Theoretically, so are the Japanese Yen and, someday perhaps, the Chinese Yuan.  But each of those countries has very significant issues, which cause the owners of the trillions in petrodollars to find undying solace, for better and worse, in the US Dollar.  I don’t expect that to change in the next decade.

One last point.  If you live in the U.S., probably more than 90% of your future liabilities and other expenses are dollar denominated.
So whether the dollar rises or falls considerably you are unlikely to notice it most of the time.

Daniel A Barnes, CFA                                                      September 20, 2011
Lafayette, CA

A Review of Anatole Kaletsky’s “Capitalism 4.0  The Birth of a New Economy”

I am terribly inspired.  I’m inspired by Anatole Kaletsky’s terrific book, Capitalism 4.0 (Bloomsbury 2010).  I received this book, as a gracious surprise, following the Strategic Investment Conference that I attended at the end of April.  Louis Gave, a brilliant analyst and thinker with GaveKal Research thought that I would enjoy Anatole’s book.  I’d never heard of it; but, later in May, it arrived at my office.  I spent the better part of the summer trying to get through the first meaty 100 pages.  Then, on my unexpected second trip to Europe this summer, I found time to work through the next 230 pages.

I agree with Kaletsky, that when the historians write about our time, they will say that the 21st century began in 2010 following the financial disaster of 2007-2009.  We in the investment community and you in your communities are all struggling with so many things. We’re identifying what is changing and what it means. Further, we’re thinking more about the relationship between markets and governments, the social contract and the working poor, the developing world and the developed one. And we’re pondering how we negotiate through the debt crisis and into the next energy crisis.  The challenge, too, is this: How do we do it with optimism? Who is right, the optimists or the pessimists?

One of my goals this year has been to ask better questions.  I recently posed a few questions and comments to some clients of mine.  That action set off a flood of email replies, with one fellow firmly convinced that the human race will reach a breaking point in probably the second half of this century, collapse, and then have to start over.  While the other side is more optimistic.  She sees opportunity.  And she reminded me, it starts right at home.  If we all make better individual decisions, then collectively the collapse of our civilization is by no means assured.  This brings me to why I am so excited about Kaletsky’s book: namely, I believe that Capitalism 4.0 sheds great historical and philosophical light on the questions of our time.

Kaletsky’s puts the last 30 years, the breaking point of the 2007-2009 financial crisis, and the future all in perspective.  His perspective could not be more timely.  In the next several issues of Barnes Capital’s “Insight Newsletter,” I will review and synthesize Kaletsky’s main points.  I hope you enjoy it.  It’s not terribly light reading, and it includes and requires more than a modicum of background in political philosophy and history — and some in economics, too.  I’ll do my best to distill the main points.  If I get long-winded at times, my apologies.

Anatole Kaletsky’s Background
Kaletsky was born in 1952.  His parents experienced true calamities and crisis: the Russian Revolution, two world wars, the Holocaust, and the purges of Stalin —  and they survived with joyful and indomitable spirit.  Kaletsky’s a journalist, editor at large of The Times in London, founding partner of GaveKal Capital and Dragonomics, an economic research business.  He has been NY bureau chief and Washington correspondent of the Financial Times and business writer for The Economist.

At first, I thought Kaletsky was a money manager.  I’m impressed, he’s a journalist who also completely understands money management, politics, history, theory, and economics.  A truly educated man, and one obviously embued with the indomitable spirit of his parents.  I hope that I will be able to meet up with Anatole in the next year or two.

Global Capitalism will be replaced by . . .
Kaletsky spends the first 35 pages recounting the first 3 phases of Capitalism.  His central argument is that global capitalism will be replaced by nothing other than global capitalism.  Global Capitalism died on September 15, 2008.   What fell apart the day that the U.S. Treasury allowed Lehman Brothers to fail was an entire political philosophy and economic system.  Systemic collapse of the U.S. and international banking system commenced that day and, with it, the viability of the established market philosophy of the relationship of the government to private enterprise. The status quo was over.

The traumatic events of 2007-2009 set the following in motion: On the left, it seemed that a few weeks of nihilistic capitalist collapse and chaos would bring about the disintegration of two hundred years of political economic success through revolutions, depressions and world wars. On the right, free market zealots insisted that private enterprise would be destroyed.

These are, of course, completely understandable over-reactions. It reminds me a bit of a typical conversations with my teenage daughter, where every new event brings about the end of her existing universe (for that moment, and perhaps the next one) — and that’s developmentally normal for a young teen. That the political and professional elites and idealogues overreact in exactly the same way says little for their depth of understanding of the political and socioeconomic foundation of society.

Capitalism and Democracy: evolutionary stability
A balanced assessment of the hysteria of left-wing idealogues and the right-wing hubris is necessary.  Rather than place the blame on greedy bankers, gullible homeowners, lazy money managers, incompetent regulators, or foolish Chinese bureaucrats, Kaletsky succeeds in putting the collapse in historical and ideological context of the economic and geopolitical reforms and upheavals which have characterized Capitalism’s evolution for 250 years, most recently in crossover to Capitalism 3.0 which was the Thatcher-Reagan revolution of 1979-1989.

Kaletsky’s main point, is that Capitalism has never been static. There have never been fixed rules to govern the relationship between private persons (enterprise) and government.  Rather, Capitalism has always been characterized as a complex adaptive system that fluidly changes the relationships and rules between private persons and government to the mandated politics of each unique era in time.

Kaletsky writes, “When Capitalism is seriously threatened by a systemic crisis, a new version emerges that is better suited to the changing environment and replaces the previously dominant form.”

Once we recognize capitalism as the evolutionary system that it is, instead of a static set of institutions, we can see the Global Capitalist meltdown of 2007-2009 for what it was: The catalyst for the fourth systemic transformation of capitalism, which is  comparable to the changes wrought by the crisis of the 1970s, 1930s and Napoleanic Wars.  Hence the title of Kaletsky’s book: Capitalism 4.0, Birth of a New Economy

Democratic Capitalism is a ruthlessly successful problem-solving machine.  Voters tend to reward politicians for making their lives “better and safer” rather than “worse and more dangerous.”  Democratic competition directs institutions towards solving rather than aggravating society’s problems, even if these changes bring about new problems.  Political competition is slower than market competition, playing itself out over decades and generations instead of quarters and years, but both pull in the same direction. Both are trying  to find solutions to societal and market problems.  Together, democracy and capitalism are the perfectly ruthless and successful problem-solving machine because both are mechanisms that encourage individuals to channel their creativity, efforts and competitive spirit into finding solutions for society’s material and social problems.

Kaletsky shows that in the aftermath of the Great Financial Meltdown, conventional wisdom held that governments are ridiculous because they solve the problems of too much debt, with more debt and they bail out companies that should fail.

But in Capitalist Democracy, whose raison d’être is to meet longstanding social and material demands, a problem postponed is effectively a problem solved.  To be more exact, Kaletsky shows that a problem deferred long enough is a problem that is likely to be solved in ways scarcely imaginable today.

Kaletsky quotes the ever-optimistic Mr. Micawber in Charles Dickens’ novel David Copperfield. Micawber is convinced that “something will turn up.”  However, in order for something to turn up, one condition must exist: Capitalism and democracy themselves must survive.  This is why sacrifices to protect democracy against communism, fascism, religious fundamentalism and even banking collapse are rationally and morally admirable, while sacrifices on behalf of our grandchildren’s purely economic prosperity, are not (pp21).

Karl Marx noted that Capitalism creates internal contradictions that lead to crisis, threatening its survival.  What he and his followers missed, however, was the capacity of politics, particularly, democratic politics, to resolve these contradictions and enable capitalism to survive.

A Complex System
The pre-condition to allow the flexibility that this requires, which we’ve learned from history, evolutionary biology and common sense, is that in order for a complex system to survive in an unpredictable and constantly changing world, the system itself must have internal mechanisms allowing it to undergo radical change.  Kaletsky shows convincingly that both Capitalism and Democracy have the internal adaptability to undergo radical change.  The Global Financial Crisis was the fourth time in the history of Capitalism that the system faced the challenge of comprehensive change. Here are the others:

Capitalism 1.0
Lasting from 1776 until the 1920s, Capitalism 1.0  established itself in Western Europe and North America.  This was the “golden age” of laissez-faire capitalism, complete with robber barons and industry magnates, who created the large industrial enterprises and developed interstate commerce.  Their industriousness and growth pushed the mandate of the nation state as the dominant political entity.  Under Capitalism 1.0, politics and economics were treated as two separate, unrelated spheres of human activity.  While conventional wisdom held that the two spheres be held entirely at arms length from one another, they also held that the politics and Capitalism would rise and fall together.  This internal contradiction was brought to light with the worldwide Great Depression of the 1930s, which necessitating the re-invention of capitalism, namely Capitalism 2.0.

Capitalism 2.0
In Capitalism 2.0, the separation of politics and economics ended.  With the collapse complete in 1931-1933 economics became a branch of politics in Roosevelts New Deal.  Capitalism 2.0 evolved into the militant capitalism of World War II, and then the golden age of the postwar period (complete with a quite efficient military-industrial complex). The key difference between Capitalism 1.0 and Capitalism 2.0 was the relationship of the government to the economy and the market’s (and society’s) understanding of that relationship.

The chief theorists and leaders of this forty-year period assumed that market forces were often wrong and that government’s most important function was to tame and control unstable market forces for the good of the economy. With the great period of stagflation (high unemployment and high inflation) of the 1970s this ideology disintegrated nd ushered in the Reagan-Thatcher revolution (Capitalism 3.0).

Capitalism 3.0
Reagan and Thatcher interpreted Capitalism and its role to governement with a simple 180 degree turn.  In this radical reinvention, suddenly the market instead of the government was proclaimed the superior mechanism for weighing all things.  Instead of treating economics as a branch of politics, Capitalism in 3.0 treated politics as a branch of economics.  The intellectual leaders of Capitalism 3.0 maintained that governments were usually wrong and always inefficient.  The philosophy was this: Markets should be empowered everywhere to discipline and control venal politicians.  Capitalism 3.0 culminated in the final phase of 3.3, which Kaletsky calls “market fundamentalism.”  Solutions proposed outside of market mechanisms were not approachable in 3.3.  The blinders of market fundamentalism ultimately culminated into the global meltdown of the financial system on September 15, 2008.  Since that point in time, capitalism and democracy, in order to survive, have evolved into new era, one that is fundamentally different and with it, the birth of a new economy, Capitalism 4.0.

In the Part 2 of this review, I will examine Kaletsky’s analysis of how Capitalism bends without breaking.  We will also examine why its insane for rich people to bet on Mad Max’s victory and then I’ll attempt to tie together how the most recent era of Capitalism (3.0 from 1979-2008) blinded governments, corporations and citizens to non-market based solutions.

While its easy to conclude that government is indeed often inefficient (social security being the great exception), the call for relentless experimentation also implies that inefficiently going doing the right path may be better than efficiently going down the wrong one.

Daniel Barnes, CFA
Kreuzberg, Berlin                                                                                                             September 11, 2011

Last week (8/30/2011), a strange confluence of events caused me to see some things differently.
We will start with some words I penned on July 22nd: in response to the EU discourse of the week.

Fiscal Union in the EU is coming. Many people think that the Euro is in danger. Poppycock! The problem is that politically, the people of the different countries are not ready to accept a fiscal union in the EU. Some people, even many people think that Yesterday the EU commission released the 6th plan to solve the insolvency problem in the EU. Unfortunately, the “haircut, that Greek debt holders will receive is just half of the expected “haircut” which is at least necessary in order to achieve a lasting resolution to the debt problem.”

I penned those words 35 day ago. In the past month we’ve had several ups and downs — mostly downs. The economy appears to be headed for a recession. Oil has fallen $40. And the stock market fell 1900 points. Gold rose $200 dollars an ounce; Gold fell $200 dollars, then rose back up another $120. The Libyan rebels beat Gaddafi; Hurricane Irene shut down the Big Apple.

Uncertainty reigns supreme for September 2011. Ten years ago, some things weren’t so different. The economy had slipped into a recession (but no one knew it yet). Then 9/11 hit. The U.S. responded strongly. Yet, despite the distractions of two undeclared wars and a trillion dollars of extra spending in reaction to 9/11, a housing boom and then a bust not too much changed in the last decade. It has been said that once 9/11 hit, everything was different. But, if I analyze the facts of how our economy was structured, how people led their lives, and how much things cost, 9/11 didn’t really change much, at least by my reckoning.

To recap, we headed into September 2001 without seeing a lot of uncertainty; however, we were presented with catastrophic events, which changed very little in the structural paradigm operating in that day.

Heading into 2011, we see only uncertainty. Yet this time, I think the stage is set for some real transformative change. I believe the paradigm has shifted. Political discourse is actually focusing on our real issues. How refreshing!

Paradigm Shifts
Paradigm shifts are curious things; they’re uncomfortable and yet exhilarating at the same time.
I recently had travel plans fall apart. Or at least I thought they had (perceptional differences). They were big plans and, accordingly, included significant sunk costs. But because of the travel plans seemingly going awry, I realized that I was going to get to places that had eluded me for 25 years. The sunk costs, the blown-up plans, and the terrific uncertainty of the moment all energized my mind to consider Plan B, even Plan C! John Maynard Keynes, when asked why he changed his position, once said “When the facts change, Madam, so do I. What do you do?”

Behavioral Finance
Behavioral finance discusses how people often underreact to new information.
Awareness of uncertainty puts us on edge and excites the cryptons of our gray matter. When the change happens, we are ready to think, adapt, imagine, react. We’re forced to use precisely those skills of analytical decision-making and problem-solving and adaptation. This great uncertainty opens up a whole new world of opportunities to learn, explore, adapt and exploit. That’s what’s human beings are best at!
What if today’s recognized uncertainty is exactly what’s needed to open up the minds of the electorate to the hard political compromises that are so necessary to recrafting the social contract between the young and the old, the rich and the poor.

I think that today’s uncertainty is critical as a 1st and second step to preparing the way for elective and legislative change, including forming new poltical consensuses. The European Union, the existing contract between labor and Capital, and the Asian mercantilist model are all teetering. It is precisely in this fertile environment that the political and cultural consensus will slowly (or less slowly) develop, in order to forge new agreements and frameworks, consistent with the facts of today.

I’m changing my view as the facts have changed.

Wouldn’t you?

Barnes Capital LLC is a Registered Investment Advisor. We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, highest quality dividend companies and precious metals, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503.

Recently
Today the Dow Jones Industrials fell 600 points, capping an impressive 1900 point slide over the last 20 days.  If somebody tells you they saw it coming, ask them how much money they made on their keen insight.  I’d like to say something definitive, either “this is a buying opportunity” or “a vicious circle has engulfed the developed world’s financial markets”; but I can’t.  Nothing is definitive or clear.  The perception of risk has increased.  For a more in-depth view on the questions at hand, take a look at Barnes Capital’s Insight Newsletter in the next weeks.

My Outlook
What’s my outlook?  Expect investment returns in stocks and bonds to be modest.  Own some gold bullion or the equivalent, and expect real estate returns to be negative over the ensuing decade.

The Social Contract
As we rewrite the social contract between the young and the old, the rich and the poor, in the course of the next many years, the current imbalances and joblessness will become more balanced.  The stage for a great decade of prosperity is being set.  Just don’t hope or assume this decade might still be economically great, that’s statistically virtually impossible.

What I hope, is that the politicians can act with greater courage, imagination and creativity, to develop solutions.  I’m discouraged by their lack therein.

Gaming
I have biases.  I’ll explain…I have a confession to make.  I play board games.   Always have, always will.  Other people escape to the challenge and tranquility of bass fishing; I re-fight WWII on the top of a table. A silly escape?  Perhaps.  But I’m more exhausted by a marathon 14-hour game than I am managing investment portfolios.  So while the ratings agencies were downgrading debt and European and U.S. markets were melting down, I observed these happenings within the bubble of a bunch of hobbyists at WBC (World Board Gaming Championships) in Lancaster, PA.

At WBC, I had some insights that offer me hope as to why we should not fear the challenges of this era.  Have you ever seen a bunch of serious hobbyists?  War gamers re-enact the grand conflicts of the ages, refighting the last war or the Crusades, trying to put themselves in the positions of the leaders of those days and times.  Why do they do it?  I think it’s 1) to escape, in a way that consumes the mind and spurs creative thought, 2) to have social fun and 3) to compete.

What does gaming have to do with portfolio management and wise investment counsel?  Answer: everything!  I play two types of games. One type is economic expansion games, which have few or no luck elements.  The other games I play are strategic war games. What economic business games and strategic warfare games have in common is that each are fully focused on marshaling your resources and managing risks – and those are the very same things we are doing when we handle real-life investment capital.

Recently, the investment markets have been reacting to well-known risks. In the headlines this week, this movement was manifest in the move to take risk “off the table.” This means that all “risk” assets declined.

Your investment portfolio and asset allocation is a complex business game.  How your assets are allocated constitutes many strategic decisions designed to avoid all the many risks.

The Next Generation: The Millennials
I think that this new generation is learning — through things like all-night role-playing games– practical, communicative skills that they will ultimately use to be creative, imaginative and optimistic.  They will see solutions to the great financial and economic problems of our time.  The world is getting ever richer, but ever more competitive.  Creative solutions and pragmatic approaches are mandatory. While the decline of Rome, err I mean Pax Americana may seem at hand, I’m inspired by the communicative intelligence and mental agility of the next generation.

The problems we face are the financing of health care benefits and retirement entitlements.  I know we can adjust to this reality. And I believe in the power of a billion middle-class consumers worldwide to get up every day and figure out what they need to do to make money and pay the bills.  Capitalism has been embraced worldwide.  If only politicians could employ more imagination, optimism and courage.  Maybe they should play more games in their free time?

Barnes Capital LLC is a Registered Investment Advisor.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

How do the dramatic events of this year and what the media reports affect the safety and potential returns of your own portfolio investments?

The cheeky answer is: It depends.  But let’s keep it simple.  Most people are invested in a combination of domestic equities (Dow Jones & SP500 stocks) and bonds as well as other investment products of a fixed-income nature.  The Dow, i.e. the Market, is saying that disaster does NOT lie ahead.  The average stocks could have broken to new lows in the last two months; they had every opportunity to do so, but they did not.

I have a lot of thoughts on why they didn’t and on what’s actually happening, but I don’t want my opinions to distract you from the facts that we know.  We know that the stock market averages have looked ahead and decided that stocks do not deserve to be sold down.  We know that economic growth is now expected to not pick up, that deflationary forces still seem to command the upper hand (because job growth is abysmal and labor simply can not demand pay increases in this economic environment).  The consequence of this is that that continued high corporate profits are a virtual certainty.  It also means that we must expect slow growth and low inflation in the developed world, which is why bonds have RALLIED over the last 3 months, and currently German and 10-year bonds only pay 3% annually.  Those bond rates are close to historic bottoms.  Fear about the future is reflected in the low returns of those bonds.  So, should you be worried.  Here’s my check list for you:

“I make my living off the Evening News.

Just give me somethin’, somethin’ I can use

People love it when you lose, they love dirty laundry …http://www.songlyrics.com/don-henley/dirty-laundry-lyrics/

• If you are invested in solid corporate bonds, don’t worry about the dirty laundry
• If you are invested in blue chips stock, don’t worry about the dirty laundry.
• If you are invested in gold, don’t worry about the dirty laundry.

• If you are invested in real estate – you have some real concerns
• If you are invested in running a small business – you have some real concerns.
• If you are subject to the vagaries of politics, elections and government finance — which includes having a government job, you have some real concerns.

Let’s take a look at some more “facts” that we know.

1. Oil is in ever greater demand, due to 2 billion people not driving, but wanting to.  Sooner or later, likely sooner, its price is going to rise quite high.  Driving will become more of a luxury than a right, even in America.
2. Technology is changing our lives, and it will continue to do so.  What’s more, most of the productivity gains from a wirelessly connected world will be breathtaking, once we get through the next 5-10 years.  This means that its going to be hard to predict what the 2020s look like.
3. People will find ways to “make it work.”  Right now, people in the developed world have responded radically to higher unemployment and underemployment by radically abstaining from forming new households.  Despite there being almost 20 million more people in the U.S., there are no more households than there were in 1998. This won’t continue forever, but it will continue for a while, and it’s going to keep housing prices in the dumps for some time to come.

Last week Italian and Spanish bonds collapsed several percentage points.  Italy might even consider leaving the EU.  But if they did, the higher costs for energy, imports, restructuring their currency, taxes and borrowing costs, would really hardly outweigh the benefits that they would accrue from reducing their debt burden (by devaluing the Lira 40%).  It’s not clear what’s going to happen.  But I hear you asking, how does it affect your portfolio?

Equity markets are down hard.  Does it change my mind?  Well, these new facts by themselves don’t.  However, I just read an important reminder that last week’s unemployment report is that we are in the middle of a period of high unemployment that is structural in nature, not cyclical.  That means that even if the economy strengthens into the next year, we shouldn’t expect much job creation.  That’s a real problem for growth.  So I am not excited about high allocations to equities.  For most people, 60%-75% invested in stocks is probably too high.  So if that’s what your portfolios look like, please call my office to schedule a complimentary review of your personal situation.

Barnes Capital LLC is a Registered Investment Advisor.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

Issue #33

May 2011

Apple is the success story of this generation.  From tails between their teeth, a paltry $150 million loan away from insolvency (from Microsoft no less!) in 1998, Apple rose to dominate the phone, entertainment and rich media industries.  It’s been enough to add $350 Billion in market cap, and make it the second most valuable franchise in the world.  But for all that success, Apple still gets in its own way.  Still more than 90% of the PC market is PC-based.  Although many applications are becoming “browser, web, or cloud-based,” for most corporations, their critical applications only run on Windows (or Linux) machines.  Mac users are shut out.  Or are they?  What if Apple could offer two-pound laptops (the Macbook Air 11.6 inch) that run a dually configured, Windows/Mac operating system?  Wouldn’t corporations buy those two-pound laptops?  Forget corporations — how about small businesses, which make up 85% of all businesses?  What’s stopping them from the hardware nirvana of Mac products?

A few years ago, Apple switched over to Intel chips, which do have the capability to run Windows.  But here’s the catch, YOU, gentle user, have to install Windows yourself.  Sounds like no real big deal, right?  Well, not exactly.  Let me share with you my recent experience.

A few weeks ago, I could resist no longer.  After having used IBM Thinkpad notebooks for the last 6 years, (you know, the ones with the funny red button in the middle for a mouse that functions as a mouse and which I hugely prefer to touch pads).  But a lot has changed,  and it seems that the IBM machines are about 2-2.5 times more expensive than those made by many other PC manufacturers, such as ACER.  So I bought an 11-inch Acer Timelinex.  It had a huge hard drive and a big beefy Intel CPU.  But, alas, my move cost me.  I didn’t like the keyboard.  If you don’t like the keyboard, what’s the point of having a laptop?  Also, it has a plastic case, and that seemed a little clumsy.  I did get it to run decently at home and in the office, but I discovered that a laptop with a keyboard I didn’t like was just not the device I wanted to schlep back and forth from the office.  Maybe it was my indecision about where to use the machine that frustrated me, but eventually I spilled my morning cereal on the keyboard I didn’t like.  I thought, “Great, problem solved!”  But, it kept working.  Then the charger went missing.  Is someone trying to send me a message here?

I dutifully went to back to the store, paid another $60 for a charger, and thought I’d just make due.  But then, the machine stopped charging, randomly, with the new charger.  I got it fully charged and went to give a powerpoint presentation for Rotary Club on “The Wacky World of Fantasy Baseball,” only to have the presentation completely collapse. It had functioned perfectly during setup, but at the beginning of my presentation, it died — as in would not start, would not reboot, just gave me a dead black screen. Do you begin to sense that I was getting fed up with my Acer laptop?  Surely, this was a sign to go back to Mac, right?  Besides, these machines keep getting more and more beautiful (especially the new Airbooks.)

I’m a very impatient guy when it comes to computers — or when it comes to waiting in traffic. I’ll happily drive farther rather sit and breathe the exhaust of the fellow travelers around me.  Perhaps some of the new technology can bring real-life speed back into the computer user experience.

Let’s start with discussing the advent of solid-state hard drives.  The tech industry has finally begun to retire the spinning hard drives.  Solid-state drives, similar to flash memory (like a smart phone), can enable the laptop to start instantly, rather than needing to “spin up.”  That sounds hard to beat.  So I broke down and ordered the new 11-inch Macbook Air through Apple Business sales.  It arrived less than a week later.  The beauty — ooh, ahh — of it spinning up, with gorgeous graphics!  Since the 64GB solid-state drive version cost $999, and another $100 to upgrade the RAM from 2GB to 4GB, I was in business. Or was I?  I’d foregone getting the 128 GB solid-state drive, because that extra 64GB, cost $300.  That seemed mighty pricey.  But Apple Business Sales did not ask me if I were going to install Windows.  Frankly, I can’t remember how much I emphasized that it was my intention to do so.  I’m pretty sure I mentioned it.

You see, this article is all about the business opportunity that Apple has. The company could capture a significant share of the corporate and small business laptop market share by offering Macs that are dually configured to run Windows.  Small business guys really have no interest in partitioning hard drives or installing Windows software, but that’s what Apple currently expects us to do.  This is stupid.

I’m going to take you through my step-by-step experience of trying to install Windows on my Macbook Air.

First, I went to the Apple store in Walnut Creek around 7:45 on a Wednesday night.  Here’s how the first conversation went:

DB: I need to configure this to run my financial application in Windows.

Apple Guy: Well, you’ll need Windows.  You can run it in Boot Camp Assistant.

DB: Okay, what’s Boot Camp Assistant?

Apple Guy: Boot Camp Assistant allows you to run Windows on the Mac.  Or you can use a “Windows Emulator,” Which will virtually run Windows.

DB: What’s that mean, “virtually run” Windows?

Apple Guy: It runs a program, within Mac, that emulates Windows.

So far, so good.

DB: “But does it do it cleanly, will my Windows application work just right?”

Apple Guy: “Yes, probably, but maybe not exactly like it would if it were in Windows.”

DB: “What will it cost?”

Apple Guy: “The emulator will cost $80, and you will need to buy the Superdrive for $80 to run and load the program.

DB “But it won’t work as clean as installing Windows?

Apple Guy: “Probably not”

DB: “…and I need need to spend $160 plus buy Windows…”  (I can’t remember if he said that I also have to buy Windows. But suffice it to say, it seemed to be a best practice recommendation, to buy Windows and install it, using the Boot Camp assistant.

Now I ask you, why do they call the program “Boot Camp Assistant.”  Why do I have to decide how to get the Mac to run Windows?  Imagine you are buying a TV and you have to decide whether the machine will install FAT or NTFS decoding systems.  Then you have to have a detailed conversation about that before you buy the TV.  Or better yet, you’re buying a car, and you have to have a discussion with the car engineers about what type of catalytic converter you need to use?  Is that really a conversation that you want to have?

I just wanted my Mac to run my Bank of New York trading application.  Why can’t Apple deliver me a laptop that does that?  This is business sales! Business sales is supposed to make it EASY for business owners to be customers, isn’t it?

Back to meeting #1 in the Apple Store on Wednesday night.  

So we decide, I decide, that I’ll do it the seemingly “right” way, with no complicated “emulator” software.  I’ll just go buy a copy of Windows.  Wait, buy a copy?  My powers of deduction “spin-up” (albeit slowly, like the cranky old hard-drive I’m trying to be rid of…)

DB: You mean that this is an Intel chip, but I have to BUY a copy of Windows to use it as such?

Apple Guy: Yes

DB: (thinking) Well, how much can a copy of Windows cost?  I mean, I know that Microsoft typically gets approximately $40 for their Operating system on new PC’s which PC manufacturers pre-install for customers.  So the off-the-shelf price should be, at most, double that price, right?

WRONG.  The Windows upgrade price is 3x that price — or $120 to $140.  But I don’t have a copy of Windows to upgrade because I’ve bought a Mac Machine, and it doesn’t come with Windows!  The next day, I go to the store and figure out that it’s going to cost me $200 for Windows 7.  So now, I’ve put just over $300 and about an extra three hours of time into this project.  So the fresh price of a home (not even the professional edition), of Windows 7, even at the super discount electronics store is a full $200.  And that’s before tax.

The next day, I fire up my “Boot Camp Assistant” and copy the Windows Support Software, running on the Mac, to the CD in the Superdrive.  So far so good.  Then I instruct Boot Camp Assistant to partition the hard drive.  You see, in order to run two different operating systems, you have to divide the hard drive into two.  OK, that can’t be that difficult, can it?  I select “partition.”

Nothing happens. I’m stymied.

OK, finally, I give up.  Life takes over. 

A few days later, I make it back to the Apple Store. It’s a Saturday afternoon.  I’ve got my Windows 7 in hand, and I figure, it can’t be that hard, installing it.  I must just be missing something simple…

It was a busy Saturday.  I came, armed with my new Superdrive, the Windows 7, the CD-Rom with the Windows Support Software which I had downloaded on to the CD Rom as a first step in the “Boot Camp Assistant” program.

Now it’s beyond me why its necessary to download “support software” for loading Windows, but apparently it is.  Remember, this is an “Air” machine, meaning it doesn’t even have an Ethernet cable slot.  If your WiFi isn’t working, you can’t access the Internet. Back to the logjam with installing Windows.

The hard drive refused to partition.   I had loaded some pictures and videos. (Videos, of course, take up a lot of space.)  The business salesperson who was helping me couldn’t figure out why the drive wouldn’t partition.  He went to speak with Maddie, the lead technical wiz.  I asked Maddie if she had ever gotten Windows to successfully run on a Mac.  She said she had successfully done it once for her mother.  I asked her how that went, she grimaced and said it have been very painful.  Remember, Maddie is the lead technical wiz of a store that sells $50 Million in computers and peripherals annually.  If it’s painful for her, how’s it going to be for the typical small business owner, who is expected to install Windows himself?

So Maddie didn’t have an immediate solution either.  In fact, my 64GB hard drive, that had been showing 40GB free when I had tried to do the partition myself, was now showing just 30 GB available.   A few minutes earlier, when the sales guy was trying to help me partition, the machine memory was still showing 40GB available.  But in the process of trying to get the partition to work, another 10GB “disappeared.”  Computer memory and system diagnostics can operate in strange ways that are opaque to this gentle user (and maybe most of you, too?).

By this time, I’d been in the Apple Store for more than an hour.  Biz Sales Guy was conferencing.  Maddie returned, with the Manager of Operations, Tiffany.  Tiffany was a razor-sharp, woman who has about 15 years of retail experience and manages this store that has $50+ Million in annual sales.  My impression was that she wanted to solve my problem.

While they’d been conferencing, I decided to trash all the photos and video in an effort to find enough extra disk space to successfully partition the unit.  On this 64GB drive, that produced another 20GB of space or so, somehow, the 10GB of videos, was being double counted, or something, go figure.  But still, the machine refused to partition with Boot Camp Assistance.  I suggested to Maddie that it sounds like I was going to need the full-size solid-state drive, the 128 GB version, if I am going to install and run Windows 7. Everyone agreed. The only 128GB they have is with the 1.6 microprocessor, and it costs another $100, for a total price of $1399 before extra software.  I told Maddie I’d be okay with buying that one, if she’d mark it for $1299.  She said she could make that work.  Progress.

She even remembered to add in the business discount of 5%, so my price was pretty reasonable, less than $1400 with tax.  I was, however, running out of time, so I took the new machine, and left my old one with Maddie.  She said she’d mail it back to Apple Online Sales.  You see, I couldn’t or wasn’t supposed to actually return the machine to the Apple Store because I’d bought it through online sales.  This creates what’s known as “Channel Conflict.”  Sales channels are silos.  It’s a common rule that product is not to be swapped across channel lines.  If you got your computer from Online Sales, then it needs to be returned to Online Sales.  But, I was well-pleased with the pragmatic approach and flexibility of Operation at the Walnut Store.  I was not happy about Apple’s policy of refusing to pre-configure their computers with Windows.

Unfortunately, this story goes on.

I’d run out of time that Saturday.  I took my new 1.6GHz 128GB new Apple 11.6 Air home, and figured that I could now partition it myself.  It must work, right?  About two days later, I found the energy, to attempt to do so again.  And, voila!, it partitioned successfully.  Then I loaded the Windows 7 on to the machine.  This takes nearly an hour.  That seems like a really long time, but who’s being critical?  Once Windows had finished loading, I tried to get it to run, but it wouldn’t connect to the Internet in Windows mode.  In fact, it wasn’t functioning in anything but a basic, “safe” mode of Windows. Obviously something was missing.  I went back to the Apple Store.  They couldn’t actually figure out what was wrong.  It was also too busy in the store to really get help, so I resigned myself to the idea, of calling the Apple Care online to try to finish the install.  I called them that afternoon, and we realized that it was the Windows Support Software that was missing.  There was another glitch in the installing and partitioning of the drive, too.  I can’t remember who showed me that; I believe that when I partitioned, it refused to partition the drive, under the regular options.  But Apple Care on the phone, told me to press the “advanced” button, in the Boot Care Assistant software during the partitioning phase, and Voila!  This had some feature of allowing the FAT or NTFS partition to occur.

Anyway, the other problem was that ”Windows Support Software,” which I have mentioned before, was now missing. I’d previously downloaded in Win Install 1.0, or thereabouts.  It occurred to me, that this element was missing, and somehow, with the telephone support, this got loaded onto the machine. I can’t recall if it got loaded when I was in the Windows or the Mac mode.  I think it was when I was in Windows mode.  In order to switch between the one operating system and the other, you must, upon start-up, press on the option button, which will then give you two symbols for the OS, and you have to choose which one you want.

With the install of the “Windows Support Software,” Windows got the necessary drivers to use its normal stuff, including the wireless card (so that now the machine would connect to a WiFi network, when it was in Windows mode).  I was very happy to have completed this odyssey, or so I thought.  I then loaded the other software, including the Bank of New York trading application, which was the sole reason that I was attempting to get Windows to run on this MacBook Air in the first place.

In so many ways, this is a very pleasurable computer to work on. At just 2.3 pounds, and less than 8 inches wide, the laptop has a good, full-size keyboard, yet it has a footprint smaller than a piece of paper. It’s only 1/2 inch thick.  It’s a beauty to work on, and I am typing this article on it right now.

So my Bank of New York application loaded correctly, and it began working.  Nirvana — success, at last, was mine.

Nirvana was fleeting.  Within the next days, the machine began to crash when it was in Windows mode.  I accepted the problem and made 3 Genius Bar appointments (15 minutes each) to inquire as to what to do with my crashing machine.  At the appointment, the tech guy and I agreed that a new installation of Windows was the way to go.   This took about another hour, and I think it was at this point that I realized it still wouldn’t connect to the Internet, and again had the problem of the Windows Support Software.  Anyway, I don’t quite remember the details, but I got things working again.   About a week later, I left for my mini-sabbatical in Berlin (where I’m typing now).

June

When I started using the machine with the Windows side, I started having crashing problems again.  Finally, I gave up with using Windows altogether.  I uninstalled the partition, and now I am simply using the machine in Mac OS only.  One very unpleasant residual of the affair remains however.  The machine now turns itself off, or powers into Windows mode, even though I’ve removed the partition, then it tries to boot up in Windows, but can’t find the “boot up disk,” so it fails.  I’m forced to do a hard shut down, and restart when this happens, and press the option key quick enough, so that I can have it boot in the MacOS.  Now the MacOS is the only option, but if I do not select this option fast enough, it slides into the Windows boot-up option, then dies pitifully in some loop looking for the Windows boot disk. If you want more details, schedule a meeting with Bill and Steve, the masterminds behind these to lovely evil empires.

Did I just call Apple evil?   Did I mean it?  Well, kind of.  The metaphor that currently seems to apply to Apple (and did to Microsoft as well), is that “pride cometh before the fall.”  Apple Corporation is acting pig-headed, in its asinine policy to expect customers to configure and install an operating system themselves.

Apple’s momentum is so large right now, that NOW is the time, to invade the PC notebook market, and offer preconfigured Windows operating systems on Apple laptops.  The corporate and small business user would love to buy some apple products particularly for their mobile needs which require a keyboard.  The iPad, isn’t enough.  Apple’s strategy to offer PCs on Intel chips that will run Windows is ill-conceived because it places and unacceptable burden on its customers to install operating systems on their own accord.

No wonder the business world continues to mostly ignore Apple.  Apple is ignoring the needs of business users. Most business users understand this intuitively.  I, unfortunately, have offered myself up here as a guinea pig, to use this beautiful machine as a PC; to be an early adopter of this technology.  To date, as chronicled here above, this early adoption adventure has been an abject failure.

Perhaps somebody at Apple will read this column and actually care and respond is some meaningful way.  One can hope!  A Phoenix has risen from its own ashes.  Can that Phoenix swallow its ego and serve the needs of business, to deliver beautiful products to laptop business users using Windows?  Is anybody listening?

This article is a total workout.  I’ll follow up with this story as it continues to unfold, and tie it into the enormous business opportunity that Apple seems to be squandering.  That said; the stock isn’t expensive.

Your Airbook Guinea Pig,

Daniel

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit http://www.barnescapital.com

Boy, it was great, it was mushrooms, salami and pepperchinis.  It was made fresh to order.  And it tasted even better, because it was hot, and only cost $1.70!
After pizza, I headed back home, down the street, in the same — wrong direction.  About 3 blocks later, I saw an U-bahn station… hmmm, I thought, this doesn’t look like the Istanbul Express (the nickname for the U1 in Berlin, that ends up in Eastern Kreuzberg)… It was Moritizplatz where Oranienstr. meets swank.  It dawned on me that I’d been loaping in the wrong direction.  I could admit defeat —  take a cab, — or walk back.  I thought, this is my very favorite time of the day, the birds are about to start chirping, the sky is getting lighter, I’ll just walk back.  I realized that without going in the wrong direction, I’d never have discovered Pizza Romantica.  Isn’t this a metaphor for life?

How often do we really know where we are going?
When we do — how often are we happy with our choice when we get there?
Life’s  a journey, not a destination.
And when we arrive, that’s usually when the problems start.  Aren’t there perhaps truly fewer problems along the journey than upon the destination?
Is this our nomadic past talking, or something deeper?

The sun’s going to rise soon… And I’m getting weary.  This traveler needs some rest for today’s journey (errhmm or destination) as my teenagers are now in my present.
Thanks for checking in, these are my thoughts for now.

Gruesse vom Daniel aus Friedrichshain, Berlin

June 25, 2011

Last weekend, I traveled south to La Jolla for the 8^th annual Strategic Investment conference, put on by John Mauldin.  I’ve been to this event several times as it features many of the world’s most cogent minds.  I find it crucial for me to attend so I can be the best steward of my client’s financial interests.

Paul McCulley
The stellar lineup of speakers included Paul McCulley, one of my favorites. For the last 11 years, McCulley was Central Bank Strategist and counterpart to Bill Gross at PIMCO the largest bond manager in the world.  McCulley retired in December at age 53 to a think tank and on Saturday, he appeared before us like a crazy man as our lunchtime speaker, with a big Santa Claus beard and sun-burned skin from too much fishing.

McCulley is famous for posing philosophical questions to his pet rabbit, Morgen Le Fay, who in turn elucidates  politico-economic reality.  McCulley coined the term “Shadow Banking System”, which refers to credit creation system of hedge funds, pension funds and Wall Street that supported and profited from the housing bubble as well as “debt deflation, the beast of burden that capitalism cannot bear alone.”

Saturday’s lunchtime speech focused on the current unsustainable government finances and what’s going to happen.

The Social Contract the strange marraige of capitalism and democracy
To McCulley the social contract of countries in which wealth is formed is the result of the truly odd marriage of capitalism and democracy.  Democracy starts with the socialist notion of: One person = one vote. Democracy is a struggle for justice, and the distribution of our economic pie.  It is not a struggle about the size of the pie.  This predicament finds itself in direct conflict with capitalism a simple, cumulative voting system whereby:  One Dollar = One Vote.  It is a cumulative voting system:  the more dollars you have, the more votes you get!

In order to flourish however, capitalism requires the Rule of Law, and its corollary, the sanctity of property rights.  And that is precisely the one thing that capitalism is unable to give to itself.

If capitalism were in charge of enforcing the rule of law, how would that look?  You guessed, it — the best justice money can buy.  So, capitalism needs requires the rule of law, which it cannot render unto itself.

The one thing that the socialist idea of democracy cannot give to itself is an economy.  Safeguarded by the rule of law, and the sanctity of property rights, greed (capitalist activity) provides the formation, accumulation and perpetuation of wealth, a phenomenon hereunto unknown before democracy and capitalism got hitched about 200 years ago with the successful French and American revolutions.

Capitalism’s gift to democracy is the pursuit of profit directing Adam Smith’s invisible hand with the time-proven result being the growth of our collective economic pie.

Wither Justice?
But the ethos of capitalism is at best agnostic, about whether the pie is distributed justly.  Many would aptly point out, that it is antagonistic to the idea.  McCulley says democracy and capitalism are “strange and necessary fellow travelers: visible socialist ideals dueling with the invisible enigma of greed” And this is why economics without politics is an analysis of a world that does not exist. Why do I care?  Why should you care about this uneasy marriage between democracy and capitalism?  Because the marriage is in trouble.

Marraige Counseling
Democracy and capitalism must undergo intense, expensive, and extensive marriage counseling in the next years.  This counseling will produce a rewriting of the social contract between the young and the old and the rich and the poor.

People of economic privilege must surrender some of their advantages in order to secure the viability of the fiscal corpus.  Means testing for social security and Medicare must be on the table (in other words, the rich need to forego their entitlements).  And compromises between the old and the young regarding the safety net and when it starts paying are going to have to be struck.

While this marriage counseling will be terribly expensive, it will also be successful.   The marriage between capitalism and democracy will survive this decade, and thrive in the roaring 2020s.

Call me if you’d like to discuss what this means for your portfolio.
~Daniel

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

Tune in Again Today, in a few minutes, at 11am

audio streamed live from www.barnescapital.com/radio

On this week’s radio show I’m answering every question you must ask when interviewing your prospective Investment Advisor.

• The Rising Paycheck Money Show airs every Saturday, from March 5th through July 2nd

• Day:                Saturdays

• Time:              11am – Noon

• Station:          KDIA  (live streaming at www.kdia.com) and at www.barnescapital.com/radio

• Channel:        1640 AM

Today, I discuss some of the questions I’m answering include:

• Is there an ideal type of client you are looking for?
• Tell me about your training to become an Investment Advisor
• Who will I be working with?
• What is your approach to financial planning
• Will anyone besides me benefit from your recommendations or management decisions?

and more . . .

Email me your questions at  radio@barnescapital.com

I look forward to hearing from you!

~Daniel

Call Me today between 11 and 11:45

at  510-262-9124

We’re talking about Fantasy Baseball and Risk Management today

on the Barnes Capital Rising Paycheck Money Show.

We’ll talk about your Baseball Team, or about managing the risk in your portfolio.

We’ll also discuss

• Gas Price Hedging
• How hot young players are like Stock IPOs -Too Risky!
• And how to survive the next recession and Inflation.

Can’t wait to hear from you.  Don’t be shy, call today!

Or email your Question to radio@barnescapital.com

Daniel Barnes

I’m on my annual pilgrimage to Southern California for my Rotisserie baseball drafts, and I came across the work of Marla Jo Fisher, a columnist for the Orange County Register, who goes by the nickname “Frumpy Middle-aged Mom” — with the subtitle “just can’t bring myself to browbeat my children into achievement.”

I am particularly intrigued by a hypothetical question that Fisher poses: “Is ‘browbeating our children into achievement’ a good idea?” But, rather than tackle that question, for now I’d like to think about the longer term and this question: What are the core skills that our children need to learn? i.e. which life skills are really important?

I think there are just four. Three are communicative in nature (reading, writing and speaking), and the last is computation.

Read for Comprehension
First, everyone needs to be able to read for comprehension. If you read documents, books, pamphlets, and any other ordinary documents (ballot propositions excepted) and come away befuddled, then you are going to have a hard time in life. It’s going to be difficult to hold down a job that provides a living wage in northern California. So, reading for comprehension is a core skill.

Concise Writing
Second, you’ve got to learn to express yourself in written form concisely. Learning how to do this takes some time. Schools seem to be stuck on the same format as they taught 60 years ago, namely the five-paragraph essay. I propose that perhaps a few other written forms may be of value; for example, the business memo, or its modern-day equivalent, the informative, concise email.

This isn’t an easy thing to master, as Blaise Pascal wrote:

“Je n’ai fait celle-ci plus longue parceque je n’ai pas eu le loisir de la faire plus courte”
(I have made this letter longer than usual, because I lack the time to make it short.”

Writing a concise email that communicates is a skill. Today’s “chat” and “text”-based writing isn’t quite the same thing. If you want to see where your kids are at in this skill development, I’ve got an idea. Next time they ask you for something, (the car keys, a ride into town, permission to do some complicated weekend plan, ask them to “put it in a memo.” See what you get. If your kids can not express what they want and why in a few sentences, then there’s probably some room for improvement in their writing. Even with new form of communication (voice memos, tweets, or youtube videos), concise written communication skills are non-negotiable for a every person engaged in the knowledge economy.

Articulate Speaking
Finally, articulate speaking is a core skill that is required for most jobs that pay a multiple of the minimum wage. (And making much more than minimum wage is necessary if you ever want to be able to afford to live under your own-financed roof in Northern California.) Verbal articulation, similar to written articulation, is not an easy skill to master. It involves a combination of vocabulary, mental acuity, grammar, and logical thinking, as well as personal skills of empathy, humor, and patience, as well as physical skills of projection and confidence.

Math Competence
Last, proficient arithmetic computation is critical, lest you be cheated out of your change (or sign loan documents that tie your future mortgage rate to dangerously high floating rates). A lot of people try to go through life without proficient computational skills. I believe that with better computational skills it is easier to make retirement planning and budgeting decisions. My favorite way of teaching computation skills is board and card games, but that’s just me.

How do we best support our kids to master these skills? Frumpy Mom says, “Unlike Tiger Mom’s kids, mine rarely practice their instruments.” Does browbeating our kids to do well in school help them ultimately master these four skills? I’m not sure. It’s related to the question of how much harm we’re doing as helicopter parents. But what I do know is that ultimately the core skills of reading for comprehension, writing concisely, speaking articulately, and calculating pragmatically are non-negotiable skills for life.

Let me know your thoughts on the browbeating~

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area. We manage trusts and retirement income portfolios. Financial planning is an integral part of our process.  We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

Simply click on “Radio” then on the show that you would like to listen to.

And please, if you have any questions, send your questions to radio@barnescapital.com and I will answer them on my next show.

Listen to the show LIVE at www.kdia.com, or

on your AM dial at

1640 AM at 11 AM-noon on Saturdays.

Regards,

Daniel A. Barnes, CFA

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

I’ve been thinking all week about the disaster unfolding in Japan.  The level of human suffering is mind-boggling.  In fact, I’ve wanted to write about it all week, but, frankly, I needed some time to compose my thoughts and allow the disaster to play out.  Too many unknowns.  A common and useful crutch is to use history as a guide, to frame and structure the questions and likely outcomes.  A few of the questions I’ve been pondering this week include:

Questions

What does it mean for our portfolios?  How far might equities decline?  How likely is it that significant amounts of radiation will leak at Fukushima?  Is Japan’s disaster comparable to other recent disasters (Katrina, Kobe earthquake in ’95, 9/11 and Chernobyl)? Will this disaster derail the global economic recovery?  Is the bond market susceptible?  How might Fukushima affect energy policy?  Is Fukushima or Egypt/Libya/Bahrain the bigger factor right now?  What about inflation? Will Quantitative Easing III  (QEIII) be realized?  QEIV? It’s been dizzying.

What History Says about the Economic Effects of Natural Disasters

Looking at scads of research and speaking with a few smart and knowledgeable people I learned a few things about the economic effects of natural disasters.  Historically, neither Katrina nor Kobe nor Chernobyl affected global growth rates to any meaningful extent.  All of those disasters resulted in slower quarterly followed by increased demand in the following quarter (i.e. netting out the economic effect). The highest estimate for the economic cost of the Japan disasters is $300 billion.  This is 5% of Japan’s $5.4 trillion dollar economy, but only .5% of the global GDP.

The Federal Reserve met early this week and was silent on the implications of the tragic disasters in Japan for the U.S.  Perhaps the Fed lacked information to take even a preliminary position because events are still unfolding.  Further, the Japanese as a culture are deeply imbued with Confucius’ sense of dignity, which above all is to “Save Face” and “Avoid Shame.”  Undoubtedly, the Japanese feel shame for their tragedy at the nuclear reactors in Fukushima.  Policymakers can be certain that the full extent of the damage and the intermediate consequences will not be known by us for some time to come.

This Last Week

As individuals, I think many of us have had a difficult week.  Clients have been uncertain and afraid.  Investment managers don’t know what is happening and don’t know what to say to clients because we don’t yet know the outcome at Fukushima.

I believe that there will be solutions to the tragedy at Fukushima in the coming weeks; even it means that they need to desert the plant and fill it in with sand.  My fear all week has been that the uncertainty and enormity of the situation in Japan could potentially douse the animal spirits of the current global economic recovery.

Animal Spirits & Investment Ramifications

At the moment, it seems animal spirits are alive and well.  Here is the evidence: The global stock markets managed to get through this week, despite the continuing uncertainty of the nuclear containment, with less than a 2% decline for the week. The flight to the safety of treasury bonds and gold was substantial but contained.

So the big question, do we panic and make a change?  In the last 30 years, the only time selling into a panic has been the right thing to do was when Lehman Brothers was allowed to fail in 2008.  But that disaster imposed systematic risk to the financial system.  The disaster of Japan, as horrifying as it is and as uncertain as it is, does not seem to be an event that threatens the financial system.  In homage to John Maynard Keynes, if my assessment of the facts change, then I will change my position.  But for the moment, I believe that while the human suffering and enormity of Japan’s triple disaster (earthquake, tsunami, Fukushima) is self evident, I don’t believe that Japan will significantly impact the global economic recovery.

This week, in our clients’ investment portfolios, we essentially held tight.  The stocks that we own are among the strongest companies in the world.  Most pay dividends of three to four percent.  We have a large allocation to fixed income.  Since most of our clients’ liabilities, including their monthly expenses, are denominated in dollars, we are very content to produce solid tax-free yields of four to seven percent using general obligation municipal bonds.  We sleep well at night knowing that our bonds reduce the volatility of our client’s account values.  We also hold Gold and Silver in most client portfolios.  Gold and Silver maintained their value this week.

Energy Policy

The bigger question that Japan’s nuclear calamity poses is its effect on energy policy in this country and around the world.  As big as the events in Japan are the revolutionary events in Libya, Egypt and the Middle East are probably an even bigger factor contributing the the present uncertainty.  The disaster in Japan calls into question the prudence of nuclear power as well as provides a potential turning point in our approach to energy policy.

But nothing is going to change right away.  Nuclear power is the cheapest way to produce energy.  Further, safe nuclear power seems possible.  But that is an open debate.  And its not anything that is going to be decided quickly, because nuclear energy is a huge part of the energy grids in the U.S., France, Japan, Russia, Germany, Canada and South Korea.  The following are the primary nuclear energy producers:

Nuclear Power production Worldwide*

U.S.                 105 Gigawatts              10 Gw under planning/construction

France              66 Gigawatts,                 2 Gw under planning/construction

Japan               47 Gigawatts                20 Gw under planning/construction

Russia              23 Gigawatts                17 Gw under planning/construction

Germany          21 Gigawatts,

South Korea     18 Gigawatts                8  Gw under planning/construction

Canada            15 Gigawatts

UK                  13 Gigawatts

China               9 Gigawatts                  37 Gw under planning/construction

India                 4 Gigawatts                  10 Gw under planning/construction

Brazil                2 Gigawatts.                   2 Gw under planning/construction

*Source: The Federation of Electric Power Companies of Japan & JP Morgan Research from 3/17/2011

Further, no matter what the debate elicits, it’s pretty unlikely to affect the energy policy in Sao Paolo, New Dehli or Beijing.

Infrastructure Investments

The infrastructure building and building codes of the 20th century reduced the fatalities from natural disasters, particularly earthquakes from the hundreds of thousands to the thousands.  The US policy of refusing to invest in infrastructure, including renovating buildings, traffic and city design, and repairing our bridges is crazy.   I believe that if the human tragedy of Japan and Africa is to serve any purpose it is to be a catalyst to renewed thinking about our energy policy as well as infrastructure investments.

Today

Today, March 18, the minister of Japan declared “We will rebuild.” I believe him.  The dedication of the Japanese people is likely to bring much good tomorrow and in the years to come.   If anything, the disaster in Japan reinforces the investment themes of the Bernanke printing press flooding the world with dollars to solve our ills.  That’s why this week’s calamity reinforced our investment philosophy.  My conviction in this regard is subject to change, but that’s my best estimation today.

Tomorrow

Tune in Tomorrow morning (Saturday morning) for the Rising Paycheck Money Show on KDIA AM 1640 at 11am-noon.  I’ll be talking about Japan, energy policy and what it all might mean for your savings and retirement accounts.  And I’d love to get your email with your questions to radio@barnescapital.com

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

Sometimes, you just have to take a leap of faith. Other times, you don’t have to, but you feel you “should.” The latter compelled me to sign up for my own radio show on KDIA AM 1640 last month.

I don’t know what came over me.  I mean, I like to talk, but, radio?

What I really don’t like to do, though, is to cold-call people.  I hate it.  I think in my five years in business, I haven’t even made 100 cold calls.  I just hate, it, so I’m obliged to build a business the meek-fashioned way, write a newspaper column, and hope my phone rings!

Well, maybe reality is actually a bit different than that, but you get the point: I’d rather market by teaching people some things about money than by talking about how great I am and asking for their signature.

Radio seemed like a great idea. I’d develop a new skill, talk on the air, and meet new people.

And so far, so good.  My show will be live on KDIA for the next 15 weeks (14 by the time you read this). It airs at 11 a.m. on Saturdays.  Downloadable recordings of the show from my website should be available by the time this issue arrives in your mailbox.

First Show

My first show was March 5th.  I decided to speak about gas prices, gold, real estate and retirement planning.  It started off without a hitch; or so I thought until after the show.  I asked about a copy, and it appears the first show didn’t get recorded.  Snafus happen!

Sputtering out of the gate, I welcomed my audience and shared the question: “Are rising gas prices inflationary or deflationary?”

It’s a good question, and the answer is that they are deflationary because taking money out of people’s pockets and putting it into the pump is reducing the amount of money we have to buy other things.

Hence, higher gas prices are a brake (or a wet blanket) on the economy. But alas, I sputtered with the analogies a bit.  It was, after all, my first radio show segment ever.

Boy was I thankful as we broke for a commercial!

The second segment was about gold.  Now I’m more of an expert on gold than I am on gas.  I started by asking my fabulous board operator Clifford, who has a beautiful booming baritone, what he thought an ounce of gold might have bought you in Roman times.

Alas, I think I caught fleet-speaking Clifford a bit flat-footed here, because the answer is as simple: A very fine set of clothes.  In that day, it would have been the most proper “toga.” Fast forward 2000 years, and an ounce of gold once again buys about the same thing: A set of very fine clothes from Nordstrom’s (for $11400+ bucks)

We talked about how in the last bull market in gold, gold rose from $35 to $850 an ounce, an increase of 24-fold.  The current gold bull market began with gold at $250. I do believe that gold could easily see $6,000 an ounce before this bull market is over.

Then we talked about real estate.  Real estate is difficult because it so entirely depends on a person’s situation.  While this is true of all investments, it’s especially true of investments where the roof can leak and the toilet may back up!  As an advisor, I told my radio listeners that I help clients assess whether they really want to manage properties and the recurrent maintenance and even liability issues associate with investment properties.

Finally, we talked about retirement planning.  Retirement is all about crafting a life after work, or a second career, within the constraints of living within your means.  I honestly don’t remember everything I talked about, but retirement planning is going to be something I talk about frequently on the show, as retirement planning is a major focus of our core strategy, which is to create a rising paycheck that replaces our clients’ salaries as they enter into retirement.

I think this is going to be a fun venture, this radio thing.  In any case, I’m banking on the time-tested value in taking “a leap of faith.

Tune in next week at KDIA AM 1640 on Saturdays at 11 a.m., and send me your questions to radio@barnescapital.com.

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

Saturday, March 5th

at 11 AM for our Live Radio Show

On this week’s radio show we will discuss

• Gas Prices
• Gold
• Real Estate &
• Retirement Planning

The Rising Paycheck Money Show runs LIVE every Saturday, from March 5th through July 2nd

• Day:                Saturdays

• Time:              11am – Noon

• Station:          KDIA  (live streaming at www.kdia.com)

• Channel:        1640 AM

The broadcasts will focus on a variety of topics as well as on

Your Questions

• From: Retirement Planning
• To: “Should I be more worried about inflation now that gas costs me $4 a gallon again”
• We will talk about questions like: ”Are rising oil prices inflationary or deflationary?”
• Shouldn’t I be out of stocks now that the market has gained 90% from its lows 2 from two years ago?
• How can I be safely invested in bonds if the bond market is crapping out?
• How do I choose an Advisor that’s competent and has my best interests at heart?

Email me your questions at

radio@barnescapital.com

or

Call In to the studio

at

(510) 262-9124

I look forward to hearing from you!

~Daniel

In December a Wall Street analyst with a big mouth and a business to build (The Meredith Whitney Advisory Group), declared that there would be “hundreds of billions” of dollars of municipal bond defaults in 2011.

Meredith Whitney is a bit of a media darling. She is often given credit for “predicting” the subprime mortgage crisis when she said that Citigroup should cut its dividend.

She dropped her latest bomb, which predicts hundreds of billions of municipal bond defaults, on “60 Minutes,” as well as countless network interviews.  This is a staggering sum for a $2.9 trillion market.

You’ve heard of “shoot first, ask questions later”?  Well, that is exactly what people started doing.  Investors began selling their municipal bond funds.  There were more than $25 billion in fund redemptions, which forced fund managers to sell high quality municipal bonds.

The question, of course, is this: Does her prediction have any merit?.

We ran across some impressive gathering of statistics put together by Michael Schroeder of Wasmer, Shroeder & company, that analyzes Whitney’s assertions.   There’s a problem with Whitney’s math. It seems to be off, by at least an order of magnitude.

Whitney did not specify exactly how many “hundreds of billions.”

Schroeder explains the error of magnitude this way: Whitney acknowledges that states will likely make good on their bond debt, so starting with $2.8 Trillion in outstanding muni debt, less $200 billion in pre-refunded U.S. government obligations, leaves $2.6 Trillion owed by some form of municipal government. There are about exist 91,000 such entities — in the form of cities, towns, townships, counties, school districts, housing and other state or local agencies, water and sewer and redevelopment authorities, fire districts, special taxing districts, etc.

“The states and their agencies owe 40% of the total (1 Trillion), leaving $1.6 Trillion owed by various counties and parishes, cities and towns, taxing districts, local authorities, colleges, universities, tribal governments and electric coops,”  Schroeder writes.

He continues explaining, in this way: If you assume 1/3 of these municipalities have outstanding bond debt, that’s $53 million for each of them.  Whitney says that 50-100, maybe more, will default in the next 12 months. And that’s where the number don’t add up. Schroeder uses an even higher number – 200 – to show the math error that’s going on.

He writes:

“200 issuers times $53 million equals a grand total of $10 billion of defaulted municipal bonds, or 0.6% of the $1.6 trillion of non-escrowed, not state-issued debts.”

That is a very different number, than “hundreds of billions” of municipal defaults.  In fact, it is only 1/20^th or 1/30^th of Whitney’s claim.

Schroeder goes on to acknowledge that  if you count the biggest cities, you won’t get there either. He talks about how even if the 20 biggest cities went broke, it would just be over $100 billion.

But Whitney’s prediction was dramatic, and she is credited with making dramatic predictions that have come true.

But the dramatic prediction, needless to say, led to a huge sell off in all municipal bonds, including the highest quality ones.  Sellers were terrified.  We bought tax-free yields of 5 and 6 and 7 percent all month long.

Remember the aphorism, BUY at times of maximum fear.  In the muni market, that was last month.  Remember this next time.

Oh, and buying individual municipal bonds is not easy for individual investors.  It is an area of investing where a skilled money manager really adds significant value.

In Conclusion

Never expect the crowd to act rationally.  Some investments are ill-suited to being held in mutual fund structure.  Muni’s are an example of this.

We remain believers in the solid returns of strong dividend-paying stocks, covered call writing, and municipal bonds, including California General Obligation bonds, and Gold and Silver allocations.

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area.  We manage trusts and retirement income portfolios. Financial planning is an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com.

Since 2007, we at Barnes Capital have been making predictions about what will happen in the New Year. Thinking about the future and what could happen is crucial for us in our role as a steward of people’s finances.  History has shown the importance of a diverse portfolio, particularly in times of great change.

Although we are not negative about the future, worst-case scenarios are something we think about.

We positioned all of our portfolios for the continued debasement of fiat currencies (those currencies not backed by hard assets).  We did this mainly though investing in Gold and Silver bullion and some mining stocks.

The political headwinds of what many perceive – with merit –as a bankrupt economy propelled political and fiscal policy in 2010.  We believe that the Quantitative Easing II compromise struck by Obama in late November, means that the dominant themes that we’ve believed to be most likely, including high deficits, government bailouts, higher commodity prices and the debasement of currencies, will continue into and beyond 2011.

Economic activity is made up of government spending, corporate spending and consumer spending. Consumer and corporate spending have declined dramatically since 2007.  Government spending is trying to make up for the decline with increased spending of its own.  This government spending will be financed by the existing monetary system, which enables the debt to be issued by the Treasury department and purchased by the Federal Reserve.  This system is strongly supported by the creditor nations of the world, including China, Japan, and the European Core.  Ultimately, it is an inflationary path, and we are currently overspending governmental tax receipts by between one and two trillion dollars annually.

The choice and path down this inflationary road was made long ago.  And it’s not a terrible path; at its core, debt and currency erosion is populist in nature.  In the medium- and long-term, it harms creditors and help debtors.  That means that those most willing to spend (debtors) have greater means to do so, and those most able to have the purchasing power of their assets erode (creditors), pay the price for offering of excess credit — their own profligate ways (and the country’s).

2010 Predictions Recap:
We got a lot of things really right in our 2010 predictions.

First, we predicted that Obamacare would become law, and that it would pale in comparison to the unemployment problem in 2010 and that did happen.

Real estate did have a tough year, as we predicted, but higher long-term mortgage rates didn’t materialize.  Gold did indeed mark its 10th straight year of upswings, as we predicted, but it was less volatile than we expected. It did indeed close the year strong at $1421, which is close to our $1450 prediction.  Municipal bonds performed better than we had predicted before weakening at the end of the year, and they delivered expected returns. Oil prices did indeed stay within our projected band of $65-$95.

Of our more unlikely predictions, the yield curve did become extraordinarily steep, but 30-year bonds failed to make it back to even 5%, let alone the 6% that we predicted.

The European sovereign debt crisis abated fears of a dollar meltdown, but nonetheless the dollar finished at a very low level of 79 on the U.S. $ index for the year.  A culture of thrift continued to exert itself, requiring another $600 billion in Quantitative Easing Part 2 in November as the jobless recovery continued and corporate profits continued to record the highest margins ever.

Amazon did do well, as we predicted, but Apple continued to be the beacon of fashion and success across all ages of consumers – and we predicted that that company might have problems within a culture of thrift.  That sure didn’t happen.

Democrats did lose the house as we anticipated, but Obama hasn’t got much veneer left, let alone Teflon. Finally, high uncertainty continues to reign, but risk assets, namely stocks, rallied through the last six months of the year to end at their highest levels.

The Federal Reserve continues to effectively print extra trillions of dollars each year to support the recovery. Stocks are more immune to this governmental Ponzi scheme of money printing; consequently, they are rising.

In many ways, 2010 was our Brian Downing year. Downing, a baseball player, was a career .275 hitter. On the 1979 division-winning California Angels squad, Downing hit .326  – and he never hit .300 again. We don’t expect to ever top our 2010 predictions in terms of accuracy. Nonetheless, here’s what we imagine for 2011:

2011 Predictions
1)     Municipal bonds are cheap, again.  We expect that they’ll decline in volatility and deliver solid after-tax returns for investors in the 25% tax bracket and higher. We are delighted to buy California General Obligation bonds, which deliver 4%-7% tax-free yields on coupon-bearing and zero coupon issues.  For a typical California investor in the 40% marginal tax rate, our 5% bonds are yielding an equity-like 8.33% return on an after tax basis.

2)     Gold.  Gold is real money. That’s not really anything new; we’re in the late innings of the ballgame on this one. But the biggest money in any bull market is made in the final, speculative 3rdpart of the cycle.  We may be approaching that third and final phase, which we imagine will last for 3-plus years.  Gold will climb again in 2011 and finish above $1600/oz.

The following is a list of the spot price of Gold on the last day of the year for 12 years.

1999 — $288
2000 — $271                     -6%
2001 — $278                      2%
2002 — $348                      25%
2003 — $415                      20%
2004 — $437                      5%
2005 — $516                      18%
2006 — $634                      23%
2007 — $833                      31%
2008 — $881                      6%
2009 — $1096                    24%
2010 –$1421                       30%

3)     Oil will break out to more than $100 a barrel, and this will reduce global growth as it did in 2008, stalling the economic recovery, again.

4)     Real estate will continue to bottom. Corporate real estate will fall between 5 to 10 percent and residential prices are likely to remain flat or go down as well, as low mortgage rates and higher dividend and capital gains rates support many current market prices in real estate.

5)    Stocks will actually perform decently and with less volatility than the last several years.  The current policies of Federal Reserve, however, are leading to trouble. It won’t happen this year, however. That Armageddon is destined for a Judgment Day in 2012 or perhaps during the ironic 2013 centennial of Ponzi banking system of the Federal Reserve.
Unlikely to Happen: but it wouldn’t surprise us if . . .

6)     Equities become the rage du jour, and stocks start to party like it’s 1999.  Why? Because perceived safe bonds pay paltry interest rates (10-year taxable treasury is 3.4%), whereas many blue-chips stocks are paying 3-4%, and stocks offer inflation protection, which bonds do not.  The Dow Jones delivers an 18% return to finish within shouting distance of 2007 levels.

7)     Some states seek the political cover of economic receivership due to budgetary impasse.  Without this cover, existing contracts cannot be renegotiated.  This roils the markets for a number of weeks, but like the European sovereign debt problem, it doesn’t de-rail the strong year for equities.

8)     The foreclosure problem hasn’t been solved.  Many homeowners continue to be unable to afford their homes.  Meanwhile, four out of five economics professors predict that Orange Countyhousing prices will rise 2-7% in 2011.  The fifth says it’s falling 9%.  Since housing declines tend to last a decade, and this one started in 2006, our money is with the minority forecaster.  A number of different issues could bring another 10% decline real estate in 2011.

9)     The Simpson Bowles plan manages to stay on life support throughout 2011.  This was the ambitious plan to reduce the national debt with real cuts in Medicare, Social Security, and other large entitlement programs.  This plan is currently DOA following the QE2 issuance and other Obama compromises, which affectively drove a stake through the heart of the Simpson Bowles austerity proposal.  America has no appetite for austerity.  Thrift perhaps, austerity – “Nein! Danke”

10)   Gold fever turns speculative.  Gold flirts with $2000/oz prices and gold stocks double with the Joe Public finally buying his pieces of gold.  Like any bull market, the most money is always made (and lost) during the speculative phase.  When the speculative phase in precious metals arrives, we expect it to last for multiple years, and as with the Internet, the dot-coms, and real estate, it will go on for far longer, higher and further than anybody believes possible.  QE 3 next autumn might kick off gold’s speculative phase.

In Conclusion
The year 2011 shows signs of a cyclical rebound driven by government spending, government-subsidized low interest rates, large corporate balance sheets and an increase in risk appetites.  There’s a chance that the balanced money manager (me) could be underinvested in risky assets this year. After strong performances in 2009 and 2010, we enter 2010 underweighted in risk assets and we will not be surprised if we underperform market returns in 2011.

Today’s values in stocks and bonds are not overly compelling.  We see modest returns over the next five years in the mid-single digits.  Therefore, we will not increase our risk exposure substantially this year, in order to achieve a pyrrhic one-year victory.  Our clients’ primary needs are wealth preservation.  We believe that real wealth preservation in inflation-adjusted terms is going to be difficult to achieve this decade and our investment strategy is focused on safe returns, not optimal returns.  We remain believers in the solid returns of strong dividend-paying stocks, covered call writing, and municipal bonds, including California General Obligation bonds and Gold and Silver allocations.

A cataclysmic meltdown seem unlikely this year, there is simply too much money being printed by the policies of Ben Bernanke with the Federal Reserve for things to fall apart.   Austerity, it isn’t. But, to employ an overused cliché, we’re just kicking the can down the road.  Let the next president preside over structural change; this one’s just muddling through as best he can.

Wishing you a happy and prosperous 2011.
Client year-end reports will be sent by January 18th.

Daniel A. Barnes, CFA
January 6, 2011

Barnes Capital LLC is a Registered Investment Advisor located at in downtown Lafayette in the Bay Area.  We manage trusts and retirement income portfolios. Financial planning in an integral part of our process. We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Call 925-284-3503 and visit www.barnescapital.com

By Daniel A. Barnes

What can you buy for 99 cents?  If you are in Lafayette, the answer is this: Not a lot. In my view, we owe it to our kids, to practice frugality because it is a critical life skill (and even forms the basis for wealth accumulation).  And guess what, finding bargains is fun as well!

Last week my Dad took us to the 99 Cents Only store by his house.  We had a blast. The bargains excited my perennially broke 14 year-old daughter just as much as any 4-year old in the candy store.  At the 99 Cents Only store (www.99only.com), everything is 99.999 cents or less.

Let me give you some examples: we bought a family pack of six good toothbrushes hair product stuff, sunblock, mouthwash, lint rollers, postage supplies and holiday cards and gift wrap; all just 99c.  Many of these items run from $4 to $8 at your local Safeway or Target.

A cost-conscious household should look at shopping as a hierarchy, starting at the most frugal possible venue and moving up once having confirmed that the previous level doesn’t have what you need.  To shop frugally and semi-efficiently, go to the deep value stores first, beginning with the 99 Cents Only store, then work your way up to higher end stores, which carry products not available at the deep discount stores.
In California, the hierarchy of stores looks something like this:

Ultra Frugal 99 Cents Only store
Big Lots/Grocery Outlet (formerly “Pic N Save” & “MacFrugals”)
Twice as Nice, etc
Deep Value Walmart, Costco, Trader Joe’s
Value Target
Selective Safeway, other mainstream stores
Higher End Nordstrom, Whole Foods

This isn’t a comprehensive list, but you get the idea.  A typical affluent family can certainly intelligently buy 10% of the stuff they need (groceries and sundries) at the ultra-frugal stores once every 3 or 4 months or so.

Deep Value stores, depending on your preference (personally, I’m not particularly fond of Walmart), can be frequented quarterly, bi-monthly or monthly or weekly, depending on your budget and your family size.  Value stores can fill in for items not carried by Deep Value.  Selective just means, that in general, there is no great value, just good selection and ubiquitous locations.  And higher-end stores are great because they provide some of what we really love, even though they frequently charge a huge mark-up on just about everything they carry.  Even higher-end stores can offer some value, if you are really smart about it.  For instance, I recently discovered some pants I really like that only Nordstrom carries.  I investigated and found that Nordstrom’s Winter sale starts December 18th, and the Summer sale is mid-June.  You can even select what you want, before the sale starts, and you will get the sale price (often 50%, you just have to buy it before the sale starts — within a few weeks or so).

A caveat: what if you hate to shop?  Well guess what, I hate to shop too.  So going to multiple places might sound a bit inefficient.  But it’s not too inefficient, since most people don’t need to shop at the ultra-frugal or higher end stores so often.    So while inconvenience is a major problem for those of us tucked away in the enclaves of the affluent suburbia, we do have some options. For instance, the produce markets in Pleasant Hill and Concord offer outstanding value: the produce is often just as good as what you find at Whole Foods — at a fraction of the price.

Sadly (and hypocritically) I seldom make the special trips required to get some of these deals.  That may be true for you too.  Every family needs to adjust their needs and weigh the convenience issues.  But the issue is bigger than just convenience, its an issue of modeling to our kids.

Most adults already know about lots of ultra-frugal places, but do their kids know?  My 13 and 14 year old didn’t.  And they were astounded, and delighted, to discover all they can buy for less than a one $.

Learning frugality is a critical life skill.  It is the basis of behavior which promotes wealth accumulation and it is empowering.  As our children are empowered economically, I believe they will become more independent, pay their own way sooner, and be able to contribute to society, on their own accord, in greater numbers and effect.  Life skills include smart buying.

We owe it to our kids, to teach them the skills of “ultra frugality,” the same skills perfected by our kid’s great-grandparents during the last economic tsunami, the Great Depression.

Barnes Capital LLC is a Registered Investment Advisor located at in downtown Lafayette in the Bay Area.  We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals which have protected wealth in every epoch spanning five millenia of bankruptcies, inflation and other forms of attrition. Together with our partner, RB Capital Management, Barnes Capital manages trusts and retirement income portfolios. Financial planning in an integral part of our process. Call 925-284-3503 and visit www.barnescapital.com.

Having a large army of financial advisors is one of the most profitable lines of business for Wall Street firms.  But is working with a Financial Advisor from a Bank or Brokerage the best choice for clients?

When the average person thinks about financial advisors, it’s difficult to distinguish them from stockbrokers – because their business model is the same. They sell stocks, mutual funds and other securities.

“Brokers” is a profession that inspires a wide-ranging set of emotional word associations: glamour, greed, opulence, corruption, contempt, desire.

It’s perfect stuff for Hollywood lore.  And indeed, Hollywood has embraced the greed angle in classics from Oliver Stone’s “Wall Street (1987)” with Michael Douglas and Charlie and Martin Sheen, to “Boiler Room (2000) with Ben Affleck, Vin Diesel and Giovanni Ribisi”, to the classic “Glengarry Glen Ross” (1993) from David Mamet with Alec Baldwin, Al Pacino, Jack Lemmon, Ed Harris, Alan Arkin and Kevin Spacey.

These films have brought little mottoes into the American lexicon, mottoes like “ABC – Always Be Closing.”

These films mostly get the bottom line correct:  The business of Wall Street is the business of SELLING securities to people, often insecure people.

Consider Ben Affleck in “Boiler Room”: “…There is no such thing as a no sale call. A sale is made on every call you make. Either you sell the client some stock or he sells you a reason he can’t. Either way a sale is made, the only question is who is gonna close? You or him?”

His character also says: “Anybody who tells you money is the root of all evil doesn’t f… have any.”

In “Glengarry Glen Ross,” the classic pressure case is summed up when Blake (Alec Baldwin) says to Jack Lemon’s character: “Put. That coffee. Down. 
[pause] Coffee’s for closers only.”

Now these films may not display the average conversation and pressure that Wirehouse salesmen are under, but the underlying currents are true throughout the business of financial sales.  The business is selling securities: pure and simple.

Sometimes the securities that are sold are good, appropriate securities; sometimes they are not.  In either case, the salespeople get paid.  Don’t forget, by and large, that financial advisors are very rarely bad or even greedy people; they are simply people who are doing what their employers tell them.

The “average” Merrill Lynch Broker produces $853,000 of revenue (in the industry this is known as “production”) per annum for Merrill Lynch.  That’s more than $3,500 of “production” each working day.  Suffice it to say, they are under a lot of pressure to sell.

Professional Services involve Life-critical issues,

Professional service providers, by the nature of the high value of the service that they provide  must not be beholden to the financial pressures of public ownership.  By professional service providers, I am talking about doctors, lawyers and, yes, financial advisors.

A conflict of interest exists when the professional must choose between serving the client and serving the corporation and its shareholders.  This conflict is manifest in our understanding of the highest calls to duty: In public service, the duty is to serve the people; in medicine, doctors follow the Hippocratic oath; in law and finance, it’s the fiduciary obligation,  the legal obligation to act in the best interests of clients.

The advisor’s fiduciary obligation to his clients clashes with his obligation to the corporation.  Professionals are serving clients on life-critical issues their money, their health, and their rights under the law.  This is different from public companies who sell us products. We don’t mind Procter & Gamble maximizing its profits selling us toothpaste.  But no one wants his or her doctor to be focus on their bottom lines.

In health, you want your doctor to do whatever is in your best interests. You do NOT want him to maximize his firm’s profits.  Similarly, you do not want your lawyer to be focused on maximizing his profits for his firm.  What you want is for him to save you money and to keep you out of jail.

The problem for professionals who are employed by public companies arises from the nature of the obligations of a public corporation.  Public corporations are mandated to maximize shareholder value.

That means they have incentives to grow the business, ideally 10% every year, even if this means that clients get an increasingly profitable and efficient service that is focused less on the clients’ well-being than on getting more profit, either by adding more and more clients or on selling additional services or products.

Wirehouses are now mostly public owned

One of Wall Streets biggest problems, and it’s a problem for you, the client, if you happen to be a client of one of these firms, is that the largest wirehouse brokerages are publicly owned corporations (Merrill Lynch is now owned by Bank of America, Smith Barney, formerly owned by Citigroup, is now owned by Morgan Stanley, Ameriprise is owned by American Express.)

As a shareholder in public companies I fully understand the mandate under which public companies operate.  However, I do not believe that professionals who provide a high-skill service, which engenders the well-being of clients, should be employed by publicly owned corporations.

The reason is simple: The interests of the shareholders and the interests of the client are not aligned.

Advisors who work for publicly traded companies, including most of the large wirehouse brokers, feel this obligation rubbing them against their clients’ interests and well being.

It’s quite a dilemma: Is their ultimate allegiance a fiduciary obligation to his client (in which case he should seek to minimize fees and commissions), or to the corporation (in which case he is aiming to maximize revenue per client)?  At a minimum, the broker feels the imperative to sustain the high production quotas to which the shareholders of the publicly traded company are accustomed.

The bottom line: These brokers do not serve you best.

Wall Street’s Scale: Number of Clients served

In order to pay for those shiny NYC buildings and in the interest of profitability, Wall Street advisors bring scale to the business of financial advisors. A typical broker will service and sell to five, 10,  or even 20 times the number of clients that an independent advisor would be willing to serve..

Excellent boutique money managers and registered investment advisors limit the number of client families that each investment professional is responsible for to 50 or fewer families per advisor.  Wall Street brokers, on the other hand, maintain books of business with hundreds, sometimes even a thousand client families for a broker.  There is an obvious qualitative difference in service and customization between the two.

So how does an average wirehouse broker serve most clients?

Most are adequately served with products that pay large commissions upon sale.  Some clients don’t pay fees, but the brokers make 2+ pts (that’s industry parlance for 2%) when they sell a bond at 102 that they bought for 100.

Every year thousands of people switch advisors.  They usually choose to work with the largest, most well-known brokerages, such as Paine Webber, Smith Barney, Merrill Lynch, Prudential, Axa, Ameriprise, and Chase.

This is a mistake because the largest brokerages are made up of ordinary advisors who are “working for the man.”

If you are seeking a new advisor, search for one who is beholden to no one but his clients and his own reputation.

Annuities Undressed:

Wall Street brokerages sell a lot of insurance and annuities.  Insurance and annuities sales can often be among the worst deals for clients.  A front-end loaded annuity pays a commission of anywhere from 3% to 7% for the broker.

When you buy $300,000 of an annuity, your “broker” just produced between $9,000 and $20,000 of revenue from you for his firm.  It’s even worse than all that.  Total fees can easily equal a third of the total return of the product over its lifetime.  And if you want to change your mind and get rid of the annuity policy, you’re probably looking at a loss unless you’ve been invested for a decade or longer.  When you open up the insides of what securities comprise your annuity, guess what you will find?  Stocks and bonds!

Annuities are simply a big expensive boxes that package plain vanilla stocks and bonds, then stick an ultra-permanent bow on them, and hand the broker a big paycheck for his work in selling you.

You are safe.  But you just lost, and the broker won.  He’s supposed to be your guy, but his product sale has only guaranteed his livelihood, not yours.  Above all, you’ve sacrificed liquidity.  If your life changes and you need the money, you’ll likely wind up losing a lot of your investment due to “surrender charges”.

Now, if that annuity were the very best set of securities for you and you never needed something different, then maybe the deal wasn’t so bad.  But lives change.  Your annuity won’t change with you.  And as your life changes and the product is no longer well-suited to you, will you hear regularly from the guy who sold you the annuity?  Probably not.

You see, the problem with product sales is that there is almost NO incentive for the broker to continue servicing you.  Until you invest more money with him or sell the annuity, he won’t receive any more revenues from you.  When the business model is entirely based on a one-time sale, there is less accountability and no fiduciary standard to speak of.

The Good Guys: Fee-only Registered Investment Advisors

The annuity and mutual fund product sales model is very different than what fee-only advisors, who receive a fee from managing your money, provide.  Good independent advisors eschew product.  They cut your investment expenses in a dozen different places, such as by building a custom municipal bond portfolio for you and by shopping around for the best price.  Above all, good advisors are working for their fees by providing service and an ear to you and your family whenever the need arises.  Unlike with an attorney, there’s no clock ticking, either.

Benefits of an Independent Advisor

Top investment advisors provide soup-to-nuts service, so that you will never need to call in to deal with large financial organizations again. There is no more tolerating:

1. Automated phone support,
2. Waiting for an operator
3. Or being told you have the wrong department.

Your investment advisor can handle this all for you.  Many clients find this to be a tremendous benefit, particularly as they get older, or if they’re very busy.

My Dream

It is my dream that independent investment advisors continue to grow their market share of the financial services business.  Neither wirehouse brokers, who are well qualified, nor other financial representatives at banks, insurance or brokerage companies are financially incentivized to minimize your fees.   I encourage you to check out independent fee-only advisors who are motivated to minimize your overall fee cost, while providing you great individualized service.

If you would like to know more about the types of financial advisors and the business models under which they work, read our white paper “Choosing an Advisor”

Barnes Capital LLC is a Registered Investment Advisor located in downtown Lafayette in the Bay Area.  We protect client capital using municipal bonds, high-quality dividend-increasing companies and precious metals, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition. Together with our partner, RB Capital Management, Barnes Capital manages trusts and retirement income portfolios. Financial planning is an integral part of our process. Call 925-284-3503 and visit www.barnescapital.com.

Today the Dow Jones rose 2% to 11,434 and Gold hit $1390 an ounce, up 6% in just over 24 hours.

What happened?

What happened was that the Fed announced it will throw (err, I mean print, or, uh, I mean buy) $850 to $900 billion of treasuries and other assets between now and June 2011.   The idea behind the Fed’s announcement is to try to stimulate the economy by keeping interest rates low.  The Fed is led by Ben Bernanke.  As Chairman of the Federal Reserve he also has other names: Dr. Bernanke, Professor Bernanke, and — my favorite — “Helicopter Ben.”

In 2002, Helicopter Ben said that deflation wouldn’t happen here. “The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost,” he said.  He also referred to a statement made by Milton Friedman about using a “helicopter drop” of money into the economy to fight deflation.

I just like to refer to him  as ‘Helicopter Ben’.

Helicopter Ben is an expert on the Great Depression.  When he was speaking in 2002, he said that if he were in charge he’d drop buckets of money out of helicopters before letting deflation take hold in this country again.  Yesterday, Helicopter Ben continued to make good on his word.

I value consistency in other people.  Well, Bernanke is being consistent.  In a Boston speech on October 15^th Bernanke said that additional monetary stimulus is warranted because inflation is too low and unemployment is too high.  The jobless rate has been above 9.5% nationwide for the last 14 months. The idea behind this newest Trillion dollars in stimulus is to support the fledgling economic recovery by keeping interest rates low.

I ask you, what happens when you throw a Trillion dollars at a problem?  What happens is that the value of each dollar declines.

Today, the US Dollar continued its decline against other currencies, against Gold, against oil, and against stocks (it takes more dollars now to buy the same stocks).  This should come as no surprise.  When I was a kid, we had a national debt of 1 Trillion dollars.  Today it’s nearly 14 Trillion.

It will likely be $20 Trillion in four years.

So let’s see, debt has increased 14x.  What have other prices done?  In 1977 Gold was $147 an ounce.  Today, it’s nearly $1400 an ounce.  So while the debt level has gone up 14x, the price of gold has gone up 9x.  Let’s remember a few other prices.  A postage stamp cost 13 cents in 1977.  I used to buy candy bars for about 20 cents.  They are between 75 cents and $1.50 today.

It’s safe to deduce that if we “print money”, and throw it out of helicopters (or buy treasuries (it’s the same thing in our ‘sophisticated economy’), then the prices of many things (oil, stocks, gold, food, and most everything else), will go up.

What’s it mean?

Don’t listen to me, just heed what markets the direction of the money.   Today the markets spoke loudly.  Stocks are rising and so are other durable assets including commodities, rare collectibles and hard currencies (of which there are only three:  Gold, Silver and perhaps the Swiss Franc).

Here’s my final thought for the day:

Why is it, that when we predict something, and it comes true, it’s still surprising?  I’ve been predicting the long-term rise in gold for 8 years.  Last December, in my annual forecast I predicted a $1450 gold price by the end of this year. Now that this is turning true, why do I feel so surprised?

I suppose it’s because it’s so breathtaking.  Like a true-believer fan, who had faith that the Giants could win, continued to say that they would win, but can’t believe it — now that they have actually won!

These new price changes are just the beginning.  Some day we will “remember” when gas “only” cost $3/gallon, and Gold was “only $1400”…

Daniel A. Barnes, CFA

November 4, 2010

The other day, I sat down to vote with my absentee ballot.  I laid out the pamphlets, voter instructions and ballot.  Then I got my father on the phone (who is a political junkie), and we discussed the propositions and candidates.

Now it’s not that I’m not familiar with the political process.  With two degrees in political science and all 156 episodes of “The West Wing” under my belt, you’d think I could read a proposition and figure out if I were for or against it.

Well, um, no, I couldn’t!

You see, you aren’t the only one’s confounded by the double negative speak of the propositions.  It was Proposition 24 in particular that tied me up.

So, here I was, trying to figure out if I were for — or against — the proposition. But first, I needed to figure out what the proposition was going to do, what it actually meant.

Proposition 24 is a repeal of some fancy new provisions that were put into place in 2008 and 2009 to allow businesses to carry current losses back to previously filed tax years.  It also allows companies to more easily shift their taxes losses among affiliated companies.  A “Yes” vote, is a vote to rescind those new laws.  A “no” vote, is a vote to leave those tax advantages as they stand.  (I’m not an expert enough on them to call them a loophole or not).

I tried to get a better sense of the proposition by reading the direct-mail pieces, but that didn’t help, because the direct-mail pieces speak in partial truths.  Those partial truths are not much help at all in understanding the issue.

At first I thought that I was against Proposition 24, so I voted no, and duly marked in the “no” oval with black ink.  But then I re-explained it to my dad, and in doing so, realized, that a “no” vote was a “yes” vote for the existing carryback tax provisions, which would allow and enable businesses to go back several years and amend their tax returns to get money back for taxes they’d paid in past years.  I realized that I am against those laws passed in 2008, and if I am against those, then I am FOR the proposition.

My “no” vote was an error.  I’d voted for what I didn’t want!  I can’t help but wonder, if I’ve misinterpreted these “double-negative” phrased propositions, I’m probably not alone.

I needed to change my ballot to “yes.” So my natural reaction was to cross out my “no” vote and change it to “yes.”  So I did it.

About 30 seconds later, it occurred to me, “What if by crossing out an answer, I just invalidated my entire ballot?”  I started thinking of the whole “chad” issues from the Florida recount 10 years ago that decided the Gore-Bush election.

I had just spent almost an hour figuring out my votes.  What if I just screwed the pooch with my cross-out?

The next day, I decided I would call the county election office in Martinez.  After about 6 or 8 minutes of listening to music, I got a real mensch on the line.  She informed me that my messed up answer on Prop. 24, would not invalidate my entire ballot.  “Whew,” I thought.

To correct it, however, is not so easy.  She told me that neither using Wite-Out nor crossing things out is permissible, but “correction tape” is.  I have Wite-Out, but not correction tape at my office, so I had to go to our neighbors and ask them for some, and thankfully, one of them did have it.  I took the correction tape and made several passes over the incorrect “oval marking.”  I don’t know if I did it correctly, but let’s hope so.

In addition to my focus on the elections, I recently read a scathing expose’ of Ameriquest, one of the worst predatory subprime lenders.  It reads like the story of business in the 3rd World, not the 1st.  Given the recent questions regarding the resolution of the foreclosure debacle and the impending Stimulus 2 plan, I think we are stuck in the “resetting” period of which I’ve written previously about.  Individually, I think we can cast our votes, hopefully as we intend, while focusing on living within our means and getting back to business basics, living basics and a more sustainable way of living.

Meanwhile, at my shop, Barnes Capital, we continue to protect client capital with municipal bonds, high-quality dividend-increasing companies and gold and silver, which have protected wealth in every epoch spanning five millennia of bankruptcies, inflation and other forms of attrition.

Barnes Capital is a Registered Investment Advisor located at in downtown Lafayette. With RB Capital Management, Barnes Capital develops custom tailored portfolios for its clients. Specialized in retirement income portfolios, financial planning in an integral part of our process. Call 925-284-3503 and visit www.barnescapital.com.

Faith and Reason are each essential components in parenting and investment decision-making.

Theologians and philosophers have debated the role of each in justifying man’s existence and the existence of God or the necessity of religion. Those are questions beyond the scope of my column, though.

Let’s look at issues closer to home. Faith and reason are essential components of parenting teenagers and of protecting and growing your wealth.

Managing investment portfolios is more than a little bit like parenting teenagers: Some things will work out well; some will work out okay — and there are going to be a few disasters along the way. Just as we can not control the weather, nor control the forces and events that will play out in adolescents’ lives, we similarly cannot control market forces, nor the relative successes and failures of the companies that we own. At the same time, there are things we can do to make adolescence — and investing — go more smoothly.

When you’re parenting a teenager, you can tell ‘em what to do, but you can’t control what happens. As a portfolio manager it’s the same. I can purchase securities at fair prices, but I cannot (over the near-term) control the prices at which those securities trade. Just as good parental role-modeling tends to produce good kids and productive members for civil society, however, good portfolio decisions will invariably produce portfolios that will in time, grow in value, meet client goals and allow both clients and their advisor to sleep well each night.

As an investor, people say to me that investing is just a crapshoot. That it’s gambling; that we have little control over the stock market. This point of view is correct in some ways. But only at first glance. As a student of markets and business, the randomness, is actually much less than random over longer periods of time. (Think of the massively successful investor Warren Buffett, who says in the short run the market is a voting (popularity) machine, but in the long run it’s a weighing machine.) And just as in parenting, it’s possible to reduce the randomness just as we reduce the probability of poor paths that our children may take, when we parent (and invest) with sound strategy.

But let’s go back to the role of “faith” in investment markets. An element of “faith” underscores all investment markets. It, however, is so much more than that. Faith is the essential ingredient of a wealth-building society. Faith in the sanctity of property rights is the first and primary ingredient of financial transactions. Without that faith, the accumulation of assets doesn’t exist in anything but the crudest form (stuffing it under the mattress).

Just as in parenting, you at some point have to place some faith that God will watch over ‘em. As an advisor and portfolio manager I place faith that the securities that provide “security” (no coincidence in that name) and sense of well-being will in time grow with inflation and perform as well as the valuations at which we bought them warrant.

The key is in the “values.” If we buy at fair values and consciously avoid buying at high values, we will, like your teenagers, see in the fullness of time, well-maturing nest eggs and retirement portfolios.

What’s difficult in this time is to refrain from buying at poor values. That is what has made the last several months very difficult from the perspective of an advisor. Value in stocks and bonds and gold have become less compelling. Right now even “sitting on our hands” is a tough requirement. Markets are wiser than all the gurus combined. And markets today — as Gold hits $1340/oz and the Dow approaches 11,000 again — are speaking loud and with a clear voice. They are predicting that the U.S. government is going to print its way out of our current collective fiscal straights. Accordingly, I have faith, that they will succeed. Which is why reason dictates that gold and stocks will increase in value coincident to fiscal policy and the chosen path of printing our way to fiscal solvency. In real (inflation-adjusted, including dollar-denominated) terms, we may only break-even. But breaking even is so much better than the alternative.

So how shall an advisor protect client capital today? Recently, I was accosted by a family member who pointed out that the total sum of liabilities in the U.S. is 220 Trillion. Which means it’s bankrupt, right?

Please take note of the question mark at the end of that last sentence. It’s a question: Are we bankrupt? The answer is a resounding, “No.” Parts of the system, however, are indeed bankrupt. So, let’s just sit back here and analyze, let’s assume the system is bankrupt, and that for the next seven long years we will be working out our nation’s collective Chapter 11.

Chapter 11 is an orderly restructuring of a company during which some of the equity stakeholders may lose some or all of their investment value. The remaining creditors of the company are typically not affected at all. The purpose of chapter 11 (Chapter 13 if you are an individual) is to maintain the organization and to recapitalize the company in order to continue on a viable financial basis.

Chapter 7, on the other hand, is another name for “going out of business.” Chapter 7 is the point where creditors force a company to sell all of their assets in order to pay off the creditors.

The U.S. economy is not in danger of going Chapter 7.

The U.S. economy, however, can arguably be said to be in the midst of Chapter 11 bankruptcy. Remember, in Chapter 11, equity investors stand to lose their entire amount of invested capital.

The implosion of the housing markets is an example of this. Equity stakeholders (home owners), lost their invested capital in real estate when the properties they purchased declined in value more than the amount of equity that they have invested.

The real estate investor who is caught with zero or negative equity investment has lost the value of his investment. However, as long as he can maintain the standing with the mortgage, he has not gone chapter 11. However, when he know longer can pay the mortgage, then the losses must be realized. The equity investor loses his invested dollars, and probably his credit score is significantly affected.

That investor, however, remains an economic participant in the U.S. economy. He may continue to draw a salary, start a new business, or buy a new property. Bankruptcy implies a cessation of economic activity. Reorganization and the realization of investment losses doesn’t have the same long-term effects as going out of business.

The real estate market has suffered the equivalent of what Warren Buffet refers to as being caught “swimming naked.” Just like investors in failed dot.com companies or California restaurants, real estate investors lose their equity invested and then move on.

On a grander scale, neither the implosion of the real estate market nor the stock market is going to destroy Company USA. What the losses do is rebalance the playing field. Those who have lost have hopefully learned. Those who have lost have hopefully not been bailed out by the U.S. Government. At the moment, the big losers will be the purchasers of U.S. Treasury bonds. Long-term government bonds will only triple your money, including reinvestment of income, over the next 30 years. Eventually yields on treasury bonds will increase to accommodate the fact that only the re-inflation of our economy will facilitate the management of Company USA’s obligations. In fact, annualized 4% inflation will cut the debt in half in 18 years, and by 70% in 30 years. You can bet that the natural depreciation of the currency through inflation is going to exceed the current yield of 2.5% on the 10-year Treasury bond.

At Barnes Capital, we continue to protect client capital with municipal bonds, high-quality dividend-paying stocks, which continually raise their dividend — and gold and silver, which have protected wealth in every epoch spanning five millennia of bankruptcies, war and attrition.

So since this is an investment column, what does this era of “resetting” mean for your retirement account? I think it means that its time to settle in for a period of extended low returns. In a period of low returns, there is not going to be a lot of “wealth creation”; certainly not in real (inflation-adjusted) terms. But these fallow times, can bear the seeds/swell of the future energy waves.

I do think that the next “good times” will be driven by the looming energy crisis. It will take a while for this crisis to materialize, but when it does, we are going to experience a giant build-out, required for the transformation from an oil-based energy infrastructure, to a more diversified energy economy.

And that more diversified energy economy isn’t as far away as we think. Today, we utilized electricity and a hybrid taxi, to make our way to SFO. We’re sitting here on BART going to the airport. It’s quite an easy, one hour ride to cover the 32 miles or so. The economics are okay. There are three of us, and the taxi to the Bart was $9, and the Bart tickets were $27, so we get to the Bart for $36, versus $91 for a taxi ride including the Bridge toll. More importantly, I think it is important that we model, to the best of our reasonable ability, alternatives to a 2-3 even vehicle households. Now don’t get me wrong, I enjoy my comfortable car and the independence it provides me as much as anyone, but alternatives to our car dependent lives do exist, (such as taxi-barting it to the airport), and when they do, I’d like to embrace them more often, so that my kids can see the other ways of doing things. The 5 years I spent in Munich without an automobile were among the best.

Resetting is seeing the same things, but differently. Did you happen to see Vantage Point? It was a movie showing an event for 6 different people’s perspectives. As we share, commiserate, bemoan today’s mandate of austerity, perhaps may we also rejoice in the promise that this change can bring forth in our collective future.

That promise of growth and change will in time with it bring unconscionable opportunities including investment opportunities. Asset values, which are scarcely compelling these days, will appear between now and then. As a father, and friend, I’m trying to actively observe the metamorphosis of our new-found austerity. But it’s hard to see. As an investment manager, I’m looking at asset values in stocks and bonds and commodities, and reminded of the sage maxim, “Don’t do anything, just sit there!”

If you’re wondering if you are sitting in the right place, just give me a call. I’d be happy to discuss that with you this Fall.

Berlin is like no other European City.  It is the big Apple of Europe.  Every
nationality is represented; it’s a 24-hour city, and there is opportunity for growth
around every corner.  I still don’t know of another European city with more
open land in the middle of the city.  And Berliners just aren’t’ the same as other
Germans.  There’s a hearty laugh, which seems out of place in the country I
know quite well.

Berlin rose in power in the 19th century. With a population of 200,000 at the
turn of the century, Berlin became a metropolis of nearly 3 Million people by the
turn of the century.  It was greatly strengthened by the advent of the railroads,
as it was the chief city tying together Silesia, Pommern and East Prussia.
John Mauldin’s weekly column (www.frontlinethoughts.com) analyzes the
growth potential of geographies in more precision than this one, but my singular
takeaway from my recent time in Berlin last month, is that the European
Union needs more integration, not less.  The tremendous stability of life in
Western and Central Europe is impressive.  Economic stability, even in the
midst of eroding fundamentals and a decline in the standard of living, is still
stability.  Stable environments rarely fall apart.  As my Google friend Bjoern
who’s relocated back to his native Berlin (having cycled from Dublin home),
and does video-conferencing with his colleagues in Mountain View every day
remarked, “there’s a crowd of fans for every world cup game, because they all
live here (in Berlin on the Bergmannstrasse).

Down this one street over a few hundred yards there are: Mexican, Argentine,
Brazilian, Italian, Spanish, American, French, Thai, Vietnamese, Turkish, Greek
and maybe German food.  A cheer always went up from when a World Cup team scored.
Berlin and Budapest are the former capitals of the German and Austro-Hungarian
Empires.  I’m intrigued by what the energy and change of these cities means for
the future of Europe.

A few more observations: we are in a transition period. The new economy
and new century is emerging. The cold war is over, the War on Drugs is
dying, the War on Terrorism is becoming less shrill, global connectivity is
empowering business models and Brussels is trying to support a new class
of entrepreneurs. 

Speaking of which, Prague and Budapest now have a cost of living that’s approaching western levels (or at least the prices in Mississippi and other low-cost western areas. Case in point, The Rudas Turkish Bath in Budapest used to cost 30 Forints when I visited it in 1990; today the entrance price was 2800 Forints. See, it doesn’t take all that long for people to adapt to capitalism and let market forces work they’re way through the system.

And did you know, (as I just learned from my friend Steve Carlson in Budapest,
that the EU is funding Eight VC start-ups to fund Entrepreneurs in Hungary?
There is a lot of new things going on, and I don’t think that the US media is
picking up on the underlying currents or changing tides.

My takeaway is the great retrenching of the western economies is here. As
we emerge into the 2020s, the industrial society of our youth as the East-West
conflict will be an artifact in the history books as well as the catacombs of our
own memories.  A new society and set of values is developing, and we over 30
are not even aware of it.  I’ll follow up on this thought in a new blog or article
soon.

Oh, and forget about worrying about the Russians. We used to worry that the
Russians are coming, but according to my travel buddy Igor, the Russians are
already here, in the Bay Area and everywhere we went in Europe be it Munich,
Berlin, Stockholm or Stenungsbaden.

In investments as in life, the challenges of tomorrow will usually be the things
we haven’t thought of yet. There’s nothing like gaining a bit of perspective
by viewing things from different angles. My recent strolls through Berlin and
Budapest did just that.

Hungary: I caught up with Bob Cohen, a cultural anthropologian and musician from NYC fluent in 15 languages, in Prague where his Klezmer band (www.dinayekapelye.com) was performing. A resident in Budapest since 1987, Bob says the Hungarian government has returned to authoritarian style rule.

Steve Carlson, a southern Californian, in Budapest since ‘88 and editor of Budapest Weekly sees the Hungarian political culture as soft authoritarian, with public life highly politicized. For example, as school teacher, it matters what party you support. Everyone cheats on there taxes while the tax authorities and customs office have the right to simply grab money from your bank account.

Suffice it to say, Hungary has fallen short in embracing the progressive tax policies embraced by Estonia, Poland and even Slovakia (which now uses the Euro).  These examples are really text-book cases of how market’s work.

If there is any one reason I believe that the United States will maintain some of its “safe haven status” over the next 25 years, it’s because of our justice system’s maintenance of the inviolability of property rights.

Germany in the meanwhile benefits massively from the Euro common currency according to my friend Michael in Munich.  I was a bit surprised.  I’d figured that with the EU and IMF bailouts of Greece and impending disasters in Spain and elsewhere that Germans would be much less enthusiastic about the EU.  But German exports continue to achieve new all-time high, and the 20% decline in the Euro since it hit $1.59 in two years ago, is helping the German exports continue to prosper.

Berlin: the Euro is enabling global business activity. My friend Bjoern, who works for Google, is video conferencing with Mountain View headquarters almost daily after relocating back to his native Berlin.

Sweden: Remember that Scandinavian used to be known as prohibitively expensive? The Swedish Krona fell 15% against the Euro and that hiccup has put their economy and competitiveness back in line with the EU.  As a traveler, however, you barely can tell how well Sweden is doing, because it was the Summer Solstice and everyone’s in such a good mood; it was hard to get much of a read.

Prague: David, who works in the Czech Spirits industry, said he could see the Euro being replaced with a new currency — after tossing out the laggards: Greece, Spain, Italy, Portugal, and Ireland. I’m skeptical of his view. I see the current turmoil as the natural and to-be-expected process of growing pains for the new currency.  Good change rarely can coexist without the presence of crisis.

There’s no turning back on the Euro. The Euro was launched in 1999 as an experiment in monetary union sans fiscal unity. That experiment has now ended, as its economically strong members are forced to subsidize the weaker members (see McCulley’s article at www.pimco.com).

Europe is economically stabile. Economic stability, even in the midst of eroding fundamentals and a decline in the standard of living, is still stability and stable systems rarely fall apart. Meanwhile global connectivity is empowering business (teleconferencing in Berlin) and venture capital attention as the EU (Bruxelles) this summer granted money to eight different venture capital firms to invest in start-ups in Hungary.

Speaking of which, Prague and Budapest now have a cost of living equivalent to the low-cost areas of the West.  The Rudas Turkish Baths in Budapest which cost 30 Forints in 1990 today the price is 2800 Forints (about $14-well worth it!). See, it doesn’t take all that long for people to adapt to capitalism and let market forces work they’re way through the system.

The bottom line: the Euros’ not going away. As Michael in Munich said, it’s more difficult to undue it, than to fix it.

When we emerge into the 2020s, the industrial society of our youth and the East-West conflict will be an artifact in the history books as well as the catacombs of our own memories.  As David in Prague wrote me this week; “In five years the world will look much different than it does now”. I concur.

I hate graduations.

It’s that time of year. Chances are that recently many of you have gone through some pomp and circumstance rituals to celebrate for yourself, your kids, nieces, or someone else who means a great deal to you.

Now, why do I hate them? Do I really hate them? Well, no, but this is a short snappy finance column. I need to say something to get your attention, don’t I?

In actuality, it’s the backward-looking focus of graduation events that annoys me. “They” tell you it’s about what you have done. Don’t believe it.

That’s not it. And the requiems for the halcyon days just passed and alleged “best days of your life” just make me want to throw up. And not one in ten of us remember the speeches (though we may recall how we felt at the time).

My knee-jerk reaction aside and upon a modicum of reflection, I do believe graduations have a purpose. Graduations are a celebration to you, the graduate! Not of your past, but of your future.

Graduations ought to be our celebration with you, about what you have learned about yourself and what you will do in your future. Your journey of self-discovery is what we celebrate with you. Not for what you have done, but to what you will do.

Graduates, feel proud if you have applied yourself — or not, but in the process come to know yourself a bit better. For productive achievement is the output of a life well-learned, well-examined, and even well-failed. Graduations, of course, are also for those of us not graduating.

They spur our own reflection for what we have done and what we will or ought to do. Why the fuss then? It’s an excuse for a party and a justification for the tuition and other expenses. The party is for your elders and friends to share with you. Just don’t confuse the needs of your parents with the celebration of what you’ve learned for yourself.

Graduates, in your future no one is going to care about how you performed in the past, what grades you got in algebra, not even what honors you’ve achieved. They will care about how you are as a person, who you are as a person. So today, graduates, we honor you and your journey ahead.

A few years back there was a very neat movie called “Once,” which highlighted the album “The Swell Season” by Glen Hansard and Marketa Orglova.

“The Swell Season” and the movie “Once” were about heartbreak, love and redemption. Universal themes of conflict and betrayal, rebirth and reawakening were interlaced. As I sit here today and contemplate what portfolio changes could be made in the wake of Southern Europe’s (I mean Greece’s), impending default, I am reminded that spring rains will bring forth a summer bursting with flowers and fellowship.

Sovereign debt (debt issued from governments) has defaulted in the past and will default again in the future. Just because your neighbor goes bankrupt doesn’t mean he’s not fun to hang out with, just because your sister goes through divorce doesn’t mean she means any less to you, and just because the global markets and governments can’t balance their books or pay their debts doesn’t mean that we shouldn’t carry on with our lives.

Just as I don’t trust marriage as a “sure” lifetime “thing,” I don’t trust sovereign currencies either, and neither should you. Just as there’s no way to know if your daughter is dating or marrying the right guy, there’s no way to position your savings and investments in a foolproof way either. But, in investing, we’ve got an advantage over the nuptials: At least we can diversify our bets.

As some sage said, “May you live in interesting times.” I think we are living in interesting times, and I can tell you that any bet in just stocks, or just bonds, or just dollars, or just yen or renminbi, or just gold, or just oil, is a fool’s bet. But bets in all of them just might get you through the spring swells and lead to the survival of some of your net wealth in the summers ahead.

To engage more in lively discussion about life, money, nuptials or dreams, call me at 925-284-3503.

Looking forward to the summer season, Daniel A Barnes, CFA

It’s baseball season. I’m at Buckeye Field. It’s the second inning: no score, no outs, man on first and second. My son is at the plate, and he’s ahead in the count: 3 balls and 1 strike. The coach yells, “Don’t give him anything!” I smile. The good thing about being ahead with a 3-1 count is that the pitcher must throw you a strike. If he doesn’t, the batter takes a base. Being forced to throw a strike, the pitcher has to throw the ball in a spot that is a lot easier to hit. Unless his “stuff” is really good, the odds are that the ball he throws will be a “fat” pitch, a pitch that’s easy to hit. Well, here comes the pitch, and it’s right down the middle. Jonathan slams it over second base for an RBI single, igniting a seven-run inning for the Cubs.

Just as batters need to exercise patience and wait for the pitch when the odds are in their favor, money managers should exercise similar patience when choosing investments for their clients.

Money managers must wait for the pitch (investment) when the odds (count) is in their favor. That means they shouldn’t buy risk investments (equities), when prices are not very attractive.

Sometimes prices in an asset class are low. When they are, pessimism abounds (think the 1970s). At other times, such as in the second half of the 1990s, a feeling of “good times” prevails. In those times, it’s probably not a great time to make risky investments. You see, the primary determinant of the performance of an asset class (stocks, bonds, real estate) is the price you pay for it. Today, with stocks up 60 percent from a year ago, prices are less attractive than they were only recently.

Money managers look to certain measures to tell the overall health of the market. Standard & Poor’s 500 Index (SP500) is one of them. It’s an index of 500 of the most widely held common stocks on the New York Stock Exchange (NYSE).

The SP500 is now 1165. Do you know where it closed at the end of 1998? 1232. In other words, SP500 stocks are down five percent over the last 12 years. While the dividends have made you about two percent annually, you would have made more if you were in cash instead stocks over the last 12 years — despite stocks’ 60 percent rise since last year.

Investing in the buoyant Clinton era yielded a negative return. Why? Because the price you paid was too high.

At Barnes Capital, we endeavor to never forget that good pitches yield better returns, so we remain vigilant in exercising patience while we stand at the plate, with other people’s money, and wait for pitches where the odds are in our (and your) favor.

To talk more about baseball analogies, your portfolio or your dreams, call me at 925-284-3503.

Looking forward to baseball season,
Daniel A Barnes, CFA

I changed my life last month, I got rid of half of my “stuff.”

How does it feel?

“It feels great!”

I feel lighter. Sheepishly I must admit, I’d become quite a pack rat or in my mind, a collector of quality or utilitarian “stuff” including a library.

My decision to purge began with the search for a new home. I wanted to force myself into a more European style of existence, to have everything thing I need and nothing I don’t.

Perhaps I’d had pretty good reasons for keeping some stuff, at least at one-time there were. But how much was that still the case? I wanted room in my life to let in new things. But there wasn’t any room for anything new amidst “my” clutter.

I needed to move, and I wanted to shed my “archival” past of academia for more minimalism. I sought a home with room enough and nothing extra. And I found it! But it was 40% smaller than my old home. There was no way that everything would fit.

So I pledged to let 40% of my “stuff” go.

I found that purging stuff is really hard work. But it’s worth it, because clearing your “clutter” allows you to apply how you’ve changed to a new physical existence. Just keep what you love, and “shed” the rest.

I was inspired by Karen Kingston’s book Clear your Clutter with Feng Shui. Adopting Kingston’s approach, I tried to shed everything that I didn’t “love,” or that was no longer “very important” to me.

So how did I start? I started with clothes, and I got rid of every item I no longer liked (or never liked), I managed to reduce my clothes by 40-50%.

If you start in the kitchen, give away all the dull knives, pots and pans, and duplicate items. See how much better you’ll like your kitchen. I probably managed a 40% reduction of my kitchen stuff.

If you start in the backyard, toss the broken, weathered, and unwanted debris (This is much easier to do if you are moving).

If it’s your garage, God help you! My garage was the vessel of my books, games, academic and dot com archives, and sports equipment. I think I managed a 40% reduction.

After uncounted trips to the donation center and many Craigslist sales, I successfully shed, “camping gear, stoves, sleds, dining room tables, old desks, broken lamps, ugly lamp…”

It was time to let it all go, and I did.

In portfolio management, clearing clutter also applies. Portfolios are rebalanced and new portfolios are constructed from the best securities at that moment in time for the given situation. Selecting securities anew allows me to account for changes in values and in clients’ lives and construct the portfolios accordingly.

Last month I shared some of the “nuggets of wisdom” I’d received from my Grandma Barbara. Well, she didn’t pass down only nuggets; she also passed down some dirt clods, clods that I found clogging up my garage and my life.

For me, this was about shedding a “Depression Era” mentality. That’s right, Depression Era! When I pass down my values to my kids which I got from my parents, who got them from their parents, I’m passing down the values of my kids’ great grandparents! Have you ever done the same? And we wonder why our kids say we’re “clueless”!

Some of the Depression Era values are needed again today, but most are not. In a world of overcapacity and overproduction, the value in hoarding has been eclipsed by the value of minimalism.

Remember the saying “Your body is a temple?” Well it’s from biblical times. Back then the Temple was the center of people’s social, public, and sometimes spiritual lives. A friend of mine, who is a pastor, recently shared with me that today it’s as if your life is in your garage, and God is the car, “Is there room for the car in your garage?”

Happily de-cluttered, Daniel A Barnes, CFA

I lost my Grandma Barbara this last week. Grandma Barbara was the last member of the World War II generation in my family. I was blessed to develop meaningful relationships with all four of my grandparents. With them, I received nuggets of wisdom to absorb and take in, and this wisdom was oftentimes much easier to digest than that which came from my parents.

Grandma Barbara taught me to play canasta when I was 7. We spent hours and hours playing. My grandma, who was a little itsy-bitsy thing, just 4’10”, had an excruciatingly difficult childhood. She was born to an educated mother and an alcoholic father. Her father’s alcoholism trumped her mother’s family status and education. She was born in 1920 in Detroit and raised in a boarding house from age 7 to 17. She ended her childhood quite early when she met my Papa Jack when she was 15 and married two years later.

My grandma never tired of sharing with me about the times that followed. It was 1937. The Depression was still everywhere you looked. My Papa Jack went to engineering night school and worked during the day as a draftsman. My Grandma managed the household on the $15 a week that they brought home. For work, she’d pack a brown bag lunch for him and give him six cents to ride the streetcar to work.

Hard times remained for the next five years, until the U.S. was thrust into World War II. Then there was a new set of worries, but the economy picked up then as America built ships and planes to fight the Axis Powers. In that same year (1942), my Papa Jack landed his dream job, an engineering position with North American Aviation (later McDonnell Douglas). North American moved Papa Jack and Grandma Barbara out of snowy Detroit to California that summer. Then that fall my grandparents sold their car to buy a house, and for the next several years, Papa Jack took the streetcar to work again.

Those were hard times. Yet the nation thrived. Today we’re in the midst of a soggy economy and problems galore. Crushing debt burdens us, and other issues seem overwhelming. No one has any answers. And no politician can implement change over the special interest groups, not even a popular president with control of Congress.

Meanwhile, the outlook for investments is as soggy as I can remember. So this week, I’ve been spending a lot of time thinking, “What would Grandma Barbara say?” And what I’ve decided that she would say something like this: “What are we complaining about? Let’s just put our nose down and get to work.” That was the spirit of this generation, which we are now losing. While few of us have the opportunity to ride streetcars to work, today’s economic challenges will turn into tomorrow’s opportunities.

Seventy years ago the world had no idea that the Axis would control the European continent just six months later. But with time and effort, the tragedies of that era turned into triumphs, as the industrial democracies vanquished the fascist dictatorships.

Today I’m thinking: It’s not the problems and dilemmas of today that matter, but the attitudes that we bring to them, that ultimately make all the difference. In the November 2009 column, I spoke of today’s kids and young adults; they are Generation Y, also known as the “Millennials” (born 1982-1999). My kids are a part of this group and they are just coming of age as we lose the last members of the World War II Generation.

I believe the Millennials are special. They acknowledge that they are inheriting a screwed up set of problems, and they accept it. Right now, they are perhaps not so “work-inclined” at the moment, either because of immaturity or a lack of opportunity. But let’s give them some time, and imbue them with our faith.

I believe the emerging hard economic times will do wonders to develop a sense of purpose and work ethic in the Millennials, who are coming of age in a time and place that is not so fundamentally different in nature than the era of my Grandma Barbara and Papa Jack. Perhaps I’m waxing optimistically, but for all my Grandma Barbara’s flaws, she passed on a few nuggets of gold:

1. She accepted me for who I was
2. She believed in me.

Her faith in me made a very big difference in my life. I have faith that the wisdom and cynicism of Generation X and the collegiality and team-building skills of Generation Y can be a terrific combination to tackle the challenges our society faces today. These kids inherit the spirit of what Tom Brokaw labeled “the Greatest Generation.”

I believe that if we don’t have the answers, we can inspire our kids and our leaders with a trust and faith that I learned from my Grandma Barbara: Accept the current situation and believe that we have the power to transform it.

Don’t you?

Well, the year 2009 has come and gone. Few would claim it was the best of times. But perhaps, it was far from the worst of times as well. It was a momentous year, a year of building on last year, where nothing was at the end as it began. The year began with a nation aghast at Bernie Madoff and his “crime of the century,” a 20-year Ponzi scheme that caused billions in losses for savvy and simple investors alike.

I think the real story of 2009, however, is the rebirth of thrift. Americans tend to reject the idea of sacrifice. President Carter’s 1979 “malaise” speech, where he urged people to save energy by lowering their thermostats, did not go over well, and it ushered in Reagan’s presidency. But consumer household debt fell in 2008 for the first time since the level of household debt had been measured (1952), and in 2009 consumer household debt has continued to decline.

This is significant. It remains to be seen, however, if this is a permanent shift. If it is, it bodes well for the long-term productivity of the nation, as more dollars will become available for investment in long-term capital projects and other efficient utilizations of capital. Sadly, national economic policy is much more complicated, and the actual benefits of thrift could be largely unfelt for years, or decades.

Nevertheless, all great change begins with a successful turning point and 2009 qualifies as one. In my company newsletter, Barnes Capital Insight, I traditionally provide predictions on the coming year, as well as a review of the preceding years’ predictions. If you would like to review predictions form 2007-2009, go look at our website, www.barnescapital.com and sign up for the newsletter’s if you would like to receive our quarterly letter in the future. Because of the space limitations of this column, I’ll share two of my five “likely to happen” predictions and two of
my five “unlikely to happen, but I wouldn’t be surprised if…” musings.

With no further ado:

Likely to Happen

1) Changes in health care become law. But with the deepening recession, this milestone event pales next to the growing unemployment problems. The actual implementation of health care reform is less clear and remains unrealized in 2010.

2) In real estate, the selling season begins strong in late February as hope springs anew. Then the Alt-A mortgage resets kick-off and massive amounts of suppressed inventory flood the markets. By June, oversupply and higher long-term mortgage rates sends multiple regional markets into tailspins. Deals fall out of escrow and sellers begin to face the music. But it’s too late for big changes to happen in 2010, and inventory quietly gets taken off the market as buyers in waiting and sellers in denial put off getting real and moving real estate for another year.

Unlikely to Happen: but it wouldn’t surprise us if . . .

1) Longer-term interest rates keep rising, right through levels believed to be insurmountable in the near term (6%), leaving the yield curve at its steepest ever.

2) Bond market investors begin viewing the monstrous mountains of debt and the revolving ponzi scheme of government financing as unsustainable, and they don’t quit their buyers’ strike until late fall when the 30-year bond flirts with 6%.

In Conclusion
The coming year portends potentially a lot more change. Mid-term elections, health care, real estate imbalances and higher unemployment could combine into a combustible brew. If new mayhem ensues, I’ll be keeping my eyes open for opportunity. However, in stewarding client’s accumulated savings, I’m focusing more on income and capital preservation than growth right now.

For a complete list of 2010 predictions, sign up for the Barnes Capital Insight newsletter at www.barnescapital.com/insight.

Since 2007, we at Barnes Capital have been making predictions in this newsletter about what will happen in the New Year. Thinking about the future and what could possibly happen is crucial for us in our role as a steward of people’s finances. History has shown the importance of a diverse portfolio, particularly in times of great change.

Although we at Barnes Capital are not negative about the future, worst-case scenarios are something we think about. It can sound pessimistic, but the reality is that there are scenarios, albeit very unlikely scenarios, that can dramatically affect personal finances. There were business owners in Germany before World War II who lost everything when their businesses were seized by the government. If the owners could have gotten out while keeping some of their capital, it would have made huge differences in their futures. So, although we don’t expect cataclysmic events to happen in the political or economic life of this country, they are possible. Barnes Capital attempts to structure portfolios that can survive unimaginable events and that also work well during normal times, if there actually is any time that could be considered normal.

In 2009, our predictions had some degree of accuracy. In the sports world, the Yankees did make the World Series, although we predicted they would lose. Here are some things we missed on: Nuclear power did not have resurgence in the U.S., although the Europeans have continued to embrace it. There was no Republican Tax Cut, and President Obama did not restart the Depression-era Works Progress Administration (WPA).

At the same time, we did predict that President Obama would enjoy some of President Reagan’s Teflon, and he has. Although he did not resurrect the WPA, he did succeed in getting his measures for changes to the health-care system passed. Gold continued to rise, although it rose even more than we predicted to end the year right around the $1100 mark.

The big story of 2009 was our nation’s collective return to a thriftier lifestyle. The decline in consumer household debt that began in 2008 continued in 2009. Household debt had not declined since the statistic had begun to be measured – in 1952. It’s hard to say how long that trend will last as well as what it will mean in the long-term. Of course, the fact that it’s hard to predict the future with any degree of accuracy has never stopped us from making an attempt.

Here are our predictions for 2009:

Likely to Happen

Prediction 1:
Changes in the health care system become law. But with the deepening recession, this milestone event pales next to the growing unemployment problems. The actual implementation of health care reform is less clear and remains unrealized in 2010.

Prediction 2:
In real estate, the selling season begins strong in late February as hope springs anew. Then the Alt-A mortgage resets kick-off and massive amounts of suppressed inventory flood the markets. By June, oversupply and higher long-term mortgage rates sends multiple regional markets into tailspins. Deals fall out of escrow and sellers begin to face the music. But it’s too late for big changes to happen in 2010, and inventory quietly gets taken off the market as buyers in waiting and sellers in denial put off getting real and moving real estate for another year.

Prediction 3:
Gold finishes 2010 on an upswing notching — the 10th straight year of a rising gold price. During the year, the ancient relic pulls back its price more than 15% twice without breaking a sweat and it closes the year strong with a close above $1450.

The following is a list of the spot price of Gold on the last day of the year for 10 years.
2000 — $273
2001 — $279 2%
2002 — $348 25%
2003 — $416 20%
2004 — $438 5%
2005 — $518 18%
2006 — $638 23%
2007 — $838 31%
2008 — $889 6%
2009 — $1109 24%

As we continue to say: Gold is real money. The world is gradually rediscovering this. There is little reason to think that will change. Here’s one final thought – a rhetorical question on the subject: If you were going to leave an asset to a great~grandchild in the year 3000, what would your bequest be?

Municipal bonds repeat their tumultuous ride of 2009 rallying strong in the face of higher demand, while falling hard during increased issuance months. Returns remain positive for the year in single digits.

Prediction 5:
Ever-expanding world population growth in the developed world creates a floor in oil prices above $65. Continued global recovery despite the global bear market in real estate pushes oil into stabile $65 – $95 trading range.

Unlikely to Happen: but it wouldn’t surprise us if . . .

Prediction 6:
The Longer term interest rates keep rising, right through levels believed to be insurmountable in the near term (6%), leaving the yield curve at its steepest ever.
The bond market investors are viewing the monstrous mountains of debt and the revolving Ponzi scheme of government financing as unsustainable, and they don’t quit their buyers’ strike until late fall when the 30-year bond flirts with 6%.

Prediction 7:
Rising longer-term interest rates and global uncertainties cause other sovereign wealth funds to acquire more dollar-denominated assets. Fears about dollar collapse subside.

Prediction 8:
Amid the chaos of a continuing credit crunch, thrift catches on. The ongoing turmoil in real estate (with the resets of alt-mortgages) causes middle- and upper-class people to spend less and save more. The Job recovery is stalled, and bank deposits climb, eventually leading lenders to begin to loosen their lending fast (as in famine) in the fourth quarter. The new culture of thrift continues to cripple retailers, including Apple but not Amazon.

Prediction 9:
The Democrats lose the House in mid-term elections. Political ennui and high joblessness (euroschlerosis) result in more hate for Congress and toss-the-bums out attitude. Obama’s Teflon holds, despite an increasing number of bare spots.

Prediction 10:
Risk Assets climb in the first half of 2010 as the global liquidity tide continues to lift boats. But, as summer approaches, rising long-term interest rates increase dollar demand, and risk assets suffer a twenty percent decline. Municipal bonds rally with short treasury notes and the dollar. Gold also rallies. Uncertainty rises and the chant of the unknown becomes louder to the drumbeat of a nervous economy. Risk assets give up many of the 2009 gains, but stabilize in the late fall. Higher inflation and lower returns reinforce the feeling of a permanent “Euro-type” recession. The culture of thrift strengthens modestly. High uncertainty reigns heading into 2011.

In Conclusion
This will be a year where the dominant feeling is uncertainty and certain skittishness about the future. Sometimes, there’s an unjustifiable euphoria over expected economic or political conditions. Right now, there’s no trace of overconfidence.

There’s a legendary curse, oftentimes erroneously attributed to the Chinese: “May you live in interesting times.” Right now, for better or worse, our world is pretty interesting.

I don’t watch TV much. I don’t keep up with what’s going on in the media or commercials. My favorite shows of the last five decades were: “The Bionic Woman,” “Eight is Enough,” “Hill Street Blues,” “The Paper Chase” and “The West Wing.” (“Mad Men” might make my elite list if it gets through more seasons.) I like the tried-and-true, both in television and investments.
Because of this, I have not even taken much notice of media fervor on Gold fever. However, recently, several people–knowing I’ve advocated Gold for investment portfolios for a long time (since 2002) – asked me whether I still like Gold?

The answer is simple: Yes–because Gold is a classic long-term instrument for capital preservation. Let me pose a rhetorical question: “What backs the dollar?” Answer: faith in the political stability of the nation and the work ethic of the American people. In the 1930s the dollar was known “as good as gold” Is it still? Well if it were, then $35 would still buy an ounce of Gold. But $35 dollars doesn’t even by a gram of Gold anymore. Why not? It’s not because the dollar isn’t as good as gold, government policies of overspending have led to a 95 percent decline in the value of the dollar since World War II.

Given the errant pirates in charge of the printing press and the underinvestment in Gold reserves by China and Russia, at Barnes Capital we believe that demand for the pretty metal will continue to increase for years to come. Jefferson understood the danger of banks 210 years ago when he said “If the American people ever allow private banks to control the issue of their money, first by inflation then by deflation, the banks and corporations that will grow up around them, will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered.”

His point is well taken: Banks manipulate money issues for their own benefit, not the benefit of the rest of us. We’ve clearly seen that with how they’ve handled the bailout money and $700 billion in TARP funds. Looking ahead, I believe that we haven’t even begun to see the great unraveling of some of the inequities that currently persist. And it’s unclear how much reform is really going to take place in under the “Obama revolution.”

But it’s clear to me that more rocky shoals lay ahead. How are things going to end? Probably with a swerving U.S. supertanker caroming off fiscal shoals. ($7,000 Gold anyone?) But betting on a crash is imprudent. It’s far more likely that radical changes will be thrust upon us, like a supertanker doing a 90-degree turn. These changes will happen so fast that they will avert the calamity, but because of the velocity and magnitude of the change, no one will be able to reposition their assets fast enough to respond to the unfolding of events.

This scenario could play itself out any time in the next twenty years. The bottom line is that we may have to swerve the U.S. supertanker, in order to avoid economic calamity. On the way to that seminal event, Gold might just keep climbing longer and higher than most anyone imagines. Will it? I don’t know, but I still know very few people outside of my clients and a few friends who are actually are invested in Gold. Do a survey yourself; just ask ten friends whether “more than two percent of their money is in Gold or Gold stocks?” I bet you the answer is still “No.”

Our firm shares offices with Creekside Partners, an excellent investment firm. Creekside recently made a compelling case for holding natural resource and commodity stocks rather than Gold. We agree, and we use similar assets in our client portfolios. But we also view Gold as an asset class for capital preservation. If we are wrong about Gold moving steadily higher in its powerful bull market, then our client portfolios will prosper via their diversification in other assets, particularly stocks and bonds.

In Conclusion

We don’t know what Gold or stocks will do in the near or intermediate term. That’s why we focus on making sure a client portfolio is intelligently diversified. The genius of diversification is that we don’t have to know exactly what will happen in the future, we just have to get the mix of assets right for each and every unique client family.

If you are unsure whether your portfolio is sufficiently diversified, give us a call and ask about our “Second-Look Service.”

Sometimes I don’t like the term Financial Advisor. It’s seems as though there are about half million financial advisors, and they’re not a cut from the same cloth. But at the end of the day, they do pretty much all have the same mandate: To protect the hard-won accumulation of people’s net wealth. And protection is all about stewardship, the concept of responsibility to care for something owned by someone else.

As an Advisor to clients’ accumulated saving, I understand my mandate as steward of that savings. And, I don’t like risky assets today. We are at the crossroads of change, and in times like these there are often great successes – but also great failures. We want to focus more on investments where we are confident that we will receive our principal back. We want to focus less on investments where the principal is at a greater risk.

That means we want portfolios to be less weighted with investments in which we own assets with operation and risks, specifically stocks and real estate. Great fortunes are made by the founders of innovative companies that create value in the midst of times of big change.

Companies like that include Microsoft in the computer maelstrom of the 1980s, Cisco in networking in the 1990s, and Google in search and advertising this decade. But great fortunes are accompanied by great losses, and there are plenty of other companies that suffered significant losses. As minority shareholders, we are not founders, and hence, we care more about the return of our money than the return on our money. That’s why we are so happy now. Risk assets continue to be priced at what we think is full value.

Be Happy

For those heavily weighted in risk assets like stocks, now’s your chance. If your time frame is less than 7 years, don’t worry too much about the future, be happy you’ve been given a chance now to reduce your risk exposure, and sell ownership assets at reasonable prices.

We don’t know exactly which direction the winds of this alleged recovery will blow. A rapid recovery has been anticipated, but we’re skeptical. A wet blanket recovery is also very possible.
In either case, the assets that we think will not perform as well are the assets that represent ownership, and stocks are included in that category. We call these “risk” assets and we suspect that many people own more of them than is healthy for their financial well being and the prudent stewardship of their accumulated savings.

Real Estate and General Volatility

Markets are difficult. Sometimes ownership interests are priced too cheaply, and sometimes they are price too expensively, relative to debt instruments and other investments such as real assets (commodities). That’s why there is market volatility. It is also why this period of time is so difficult; it is at present not clear whether the values of existing assets are too high or too low.

Real Estate also represents ownership. While Real Estate tends to carry with it less operational risk, it still entails a lot of risk. Real Estate also goes in twenty-year cycles, one decade good, the next decade bad. We are in year five of the bad decade, so we are not optimistic about real estate values today.

In Conclusion

Today as steward of our client’s finances, we don’t like risk assets in this market.

Great fortunes can be lost in periods of heightened creative destruction. We don’t know who the next Google will be and finding the next Google isn’t my mandate, stewarding client wealth is. Earlier this year, most participants agreed that risk assets were too cheap, particularly stocks. So on this basis; the stock market rallied 50% from its darkest days in March 2009. But we recognize that risk assets are particularly risky right now, and we’d generally prefer to be a lender instead of an owner, while we wait for the dust to clear.

If you are unsure whether your portfolio has too much risk in it, give us a call and ask about our “Second-Look Service.”

Bond Intelligence

The economy is likely headed for tough sledding. Stocks haven’t been saying so, but given the jobs situation (there aren’t many), it’s not a good outlook. Bonds are confirming this. Bonds often perform well during a recession because other investments become less profitable, thereby increasing demand for bonds.

Since the alleged recovery began, bond yields have fallen. In a true recovery, they are supposed to rise. Treasury investors are willing to accept a 3.2% annual return for a government bond for the next ten years; twelve months ago, they would accept only a 4% interest rate. This signals to me that the recession will go on much longer than the stock market has been predicting. In the tug of war between stocks and bonds, as smart as the “stock market” is, the “bond market” is the smarter of the two.

Blocking and Tackling

The Bond Market’s signaling a long road ahead for the elusive economic recovery. Most assets seem to be at either fair or full value. Bonds which sold at very compelling prices earlier this year have since gained ten, twenty, even thirty percent. But now, value is conspicuously absent among most asset classes.

In this value void, I recommend you go back to the fundamentals, investment blocking and tackling. Have you recently check your diversification?

In the journey to achieving your life goals, diversification is the only “free lunch.” While it is unclear how creating two trillion dollars of new currency each year will affect the economy, stocks, bonds, gold, oil, or other currencies. And while we can know these outcomes in advance, we can rely on investing fundamentals to navigate these rocky shoals in dense fog. In the land of the blind the one-eyed man is King and true diversification is the optic which illuminates.

Diversification

If your portfolio is missing stocks, bonds, gold, oil, or cash, it may be poorly positioned to capture the upside and avoid the downside of whatever the next few years bring.

Not all diversification strategies are created equally. Your advisor may say you are diversified; to him, you are. Your advisor’s understanding of what constitutes diversification, however, may be antiquated. Maybe he or she works for a big brokerage firm or bank and simply passes on conventional ideas born of the bull market of 1982-2007.

I encourage you to review your current strategy. A lot has changed in the last few years, and I garner many people are not well-positioned to navigate and thrive on the tricky road which lies ahead.

“Second Look” Service

If you are not sure about what your strategy is, and whether it is appropriate for your unique situation today, you may want to consider a second look. I offer a “Second Look” service. This is a complimentary review of your existing portfolio allocation with no cost, obligation or pressure. If you are concerned about your making the best choices to achieve your life goals in a safe way, call me at 925-284-3503 to schedule a 30-minute “Second-Look” review meeting.

Stocks

Stocks are speculations. The safest stocks are, however, very safe speculations. A stock is a speculation because when you own a stock you have no claim to income from that investment, nor a do you have a claim to a return of your principal. As a stockholder, you are a minority owner in a company. It is your hope that the company will prosper, becoming more valuable over time, which will ensure that someone else would be willing to pay as much or more for what you paid for this piece of ownership. This is quite unlike a bond, which is a financial obligation on the part of a company to pay back the amount of the loan (bond).

Yet no one would invest in companies if there wasn’t a prospect of the return of capital — a return on capital which exceed the risks being taken.

When I buy stocks for clients, I buy the least speculative stocks. Most of our portfolio companies have a record of paying a dividend for at least ten years. Furthermore, most of them have increased the size of their dividend every year. When a company increases the size of its dividend every year, it is demonstrating that its business is out of the ordinary. Additionally, the increase in the dividend payouts over time increase the value of the stock.

Bonds

At Barnes Capital, we prefer to purchase individual bonds, as opposed to bond funds, for most investors’ accounts. The two inherent qualities of fixedincome investments — a guaranteed coupon (interest rate), and the return of principal upon maturity — are absent when a client invests in a bond fund. A bond fund has neither a fixed yield, nor a contractual obligation to return their principal to. Furthermore, bond funds have no maturity date. The average maturity and, therefore, risk profile of a bond fund is constantly changing at the whim of fund managers, who frequently trade their positions.

Bond funds aren’t efficient either. Bond managers cannot avoid harvesting losses in periods of rising interest rates. They inevitably trade a certain portion of their portfolio for a variety of reasons, many of which are beyond their control, such as share redemptions from fund shareholders. As such, bond fund managers are forced to liquidate their bonds in frequently
unpleasant market conditions.

At Barnes Capital we prefer to invest client assets in individual bonds because we know exactly what we are buying on your behalf, and when you will be paid your interest and when you will receive your principal back.

The Bottom Line

Stocks are speculations, so in the wealth preservation game, it only pays to buy the “safest” speculations. Bonds are contractual obligations, and investors can sleep well at night, knowing that unless Armageddon occurs, they will get a return on their money — and the return of their money.

New Address

Barnes Capital’s new Address is 985 Moraga Road, Ste 205, above Mangia’s in La Fiesta Square. Call for an appointment for a complimentary assessment of your current investment portfolios.

Unemployment is 11%, there is no pricing pressure, credit isn’t available, and the savings rate has skyrocketed, from negative to over 7% within two years. People are spending a lot less money, almost 10% less, than they were just two years ago. Rising unemployment will continue to keep downward pressure on assets, wages, and the inflation rate.

Last month I talked about Inflation. I believe that Inflation is a serious future problem; however, Deflation is a serious current problem.

Deflation is when the prices of things get cheaper. We are used to a certain amount of deflation in some industries like electronics or computers, but deflation is not otherwise a common modern event. Deflation is abnormal because governments tend to overspend–then print more money in order to more easily amortize accumulated debt. But sometimes, exogenous events occur that reverse the virtuous cycle of rising prices. When this happens, wealth and credit are destroyed and a vicious spiral of asset deflation ensues.

The US economy has been teetering at the edge of deflation for nearly two years. By one estimate, the government has printed $2 Trillion dollars but the recession has destroyed $15 Trillion in credit and other assets. The destruction of asset value is a deflationary event, because it literally means there is less money in the system.

Deflation is a problem today because of the decline in real estate and financial markets, as well as the weak position of employees. Worker compensation comprises 70% of the total economy. With 2,146,000 unemployed Californians (11.6%) employees are hesitant to ask and unlikely to receive raises. Further, employee’s inclination to leave their jobs for other opportunities, is at its lowest level since the Bureau of Labor Statistics began tracking this data point fifty years ago.

Why should you care? I’ll tell you, its because if workers can’t get raises, it’s very difficult for inflation to rise. Without inflation, deflation occurs. Deflation reduces cash flow (income) and creates a very difficult situation for anyone carrying debt because debt needs to be amortized from cash flow. If cash flow (including income from wages or other sources) is falling, then it is hard to keep up with debt payments (think mortgages and foreclosures and other bankruptcies).
Last month I made the case that inflation is going to become a problem. And I still believe that over the next three decades, it will be higher than in the last twenty years. But what the future portends, does not necessarily apply today, tomorrow, or even this decade!

The Bottom Line

But don’t despair: there is reason for hope over the long-term. The current high savings rate indicates an opportunity for higher economic growth; particularly once that savings is invested productively to educate our children, overhaul our infrastructure and transportation systems, and support the development of new growth industries like clean-tech and alternative energy sources.

In the short-term, it’s Deflation that we must worry about. Expect the federal government to continue massive deficit spending in order to move us from the edge of the deflationary abyss.

With California crying wolf saying “it’s bankrupt”, and the federal government printing trillions of dollars to stimulate the economy, it doesn’t take an economics degree to figure that all those extra dollars chasing the same or fewer goods, will eventually create higher inflation.

The critical benefit of inflation is its power as a force of structural change. There’s no smoother mechanism for redistributing wealth or rebalancing budgets. The current budget crisis is the result of the decisions of politicians who for 40 years increased benefits in good times while failing to reserve for down periods. This has resulted in lower skilled workers enjoying semi-skilled wages, semi-skilled earning higher skilled compensation, and so on. Many public union contracts are iron-clad. So since those contracts cannot be effectively renegotiated, the only mechanism available to rebalance future budgets is inflation.

Over the next thirty years or so, it’s a virtual certainty that inflation will rise more than the cost of living increases written into union contracts. Eventually, the imbalanced cost structures of government budgets will come back into balance.

Some critics claim that deflation is the near-term risk, because the deflationary forces are very strong. This is true, and will remain so for some time. But the critics neglect one key fact: the government controls the printing press. Some hark that the printing press won’t work so well when the dollar loses its status as the global reserve currency. Don’t believe it. Despite enormous fiscal pressure, there is presently, and for the foreseeable distant future no reasonable alternative to the dollar. No other currency is as immune from political and geo-political risks as the dollar. The dollar is and will remain the reserve global currency for decades to come.

The specter of a rising inflationary cycle raises a few questions. First, how will the eventual return of higher inflation affect you? Inflation helps debtors and hurts creditors. It hurts people with conservative investments (creditors), because if inflation is going up 5% annually, and you are making 3% on a CD, but only 2% after paying income and state taxes, then your purchasing power is declining 3% each year, in an inflationary environment. It helps debtors, because if you owe $100,000 in student loans, and inflation averages 7% for a decade, then the real burden of those student loans is cut in half. This principle applies equally to pension obligations and the national debt. So the simple answer to the question of whether inflation will help or hurt you is whether you expect to primarily be a creditor or debtor over the next decades.

Inflation is ultimately, the most populist and egalitarian market force that exists. While inflation will erode the value of many existing assets, and this will exacerbate the challenge of producing real returns for wealth management clients, inflation will ultimately rebalance budgets and repair structural economic imbalances, benefiting society and future generations.

The Bottom Line
Inflation averaged 2.5% per annum in the 1950s and 1960s and 1990s and 2000s. But in the 1940s, 1970s and 1980s it averaged 5.7%, 6.8% and 4.9% (Crestmont Research). I expect a return to the average changes in later set, with inflation averaging 4%-5% over the next few decades.

Looking ahead, the Sandwich Generation is most at risk. Families in their peak spending years (40s and 50s) caring for parents while funding college costs and dealing with other economic dislocations are most vulnerable in the coming inflationary wave. We’ll pick up there in next month’s column.

June 2009

Many changes are coming to our society, and they are likely to have significant effects on capital allocation, risk and returns. I believe that over the next ten years investment returns will be modest in nominal terms and low in real (inflation-adjusted) terms. Demographic and generational change will dominate the directions and responses to events.

As an investor, I’m responsible for protecting private wealth; that’s always my focus. Lately, I have become very interested in some work from historian and social demographer, Neil Howe. Howe’s research on generations describes how the common experiences of each generation’s unique time and place in history create and determine a shared outlook.

Generational Archetypes
Howe describes four archetypes of generations, which are repeating in eighty-year cycles. Each archetype develops in the time and place in history during which that generation comes of age. Further, when one archetype generation is passing on, the new generation follows the collective patterns and character traits of the generation it is replacing, refilling that archetypes’ societal role.

Howe posits that the Millennials (born 1982-2002); share the archetype of the GI Generation (born 1901-1924), which Tom Brokaw dubbed “The Greatest Generation” in his 1998 book who fought not for fame or recognition, but because it was the “right thing to do.” Like the GI Generation, Howe expects the Millennials to be the force of change for our society in the coming decades “because they intuitively see what the right thing to do (Sic.)” is. Compared to the last few generations, they are civic-minded, political engaged and progressive. If these characterizations are accurate, they portend potential massive institutional change and structural.

Recently, that possibility has captured my attention.

Immigrant Roots
Like the GI Generation, the Millennials have a huge number immigrant roots. Forty percent of the Millennials generation is non-white or Latino. Twenty percent of them have at least one immigrant parent, ten percent have at least one parent who is not a U.S. citizen. Similarly, the GI generation’s parents were a part of the massive immigrations to the U.S. in the 1880s to 1910s from central, southern and Eastern Europe.

The pendulum of the social fabric is swinging. I am taking notice that the momentous changes that Howe predicts may have profound consequences on investment decisions. But before getting to some of the ways that we are preparing client portfolios to weather the oncoming storm of change, let’s jump into some of these issues of “Great Change” – and the beginning of the end of the world as we know it.

Great Change

We enter the next decade on the cusp of a magnificent tidal wave. And it feels to me like it’s beginning to crest. As the wave gathers strength, coming to envelop the wave riders, the only question that counts is “how skillful are they at surfing?”

Will they be able to ride the tidal wave without going over the falls?

I grew up in what was once a sleepy beach city in South Orange County. One of the scariest things for an adolescent beach kid is learning to ride the bigger waves without “going over the falls.” Literally, this means riding the wave – without simply being tossed from the top of the wave, face first into the sand, as often happens if you are poorly positioned when the wave breaks. Think of the fishing trawler with George Clooney at the helm in “Perfect Storm.” That boat was fine as long as it either rode the waves or went through them, but if it gets to the top, and goes over the falls or capsizes, it’s game over.

As wealth managers, we’ve got to navigate these awesome swells of societal transformation with skill in order to avoid “going over the falls.” Asset allocation is the name of the game. We need to decide how to invest money for something more than a government bond fixed return. We just experienced a rebound this year in stock and bond values. But that’s yesterday’s news. What concerns me is what the future looks like? How will this affect you, your parents, your kids?

How is will this wave break? How will it affect stock, bond and real estate values? While we can predict some of the issues that will provide the catalysts to social upheaval and institutional change (health care, pension changes, energy, global warming, war) we cannot predict the eventual outcomes.

Predicting Historical Outcomes

Think back historically. Nobody knew that when they dumped the tea into Boston Harbor it would lead to the founding of a new nation, one which ultimately would become a transcontinental hegomonial state.

No one imagined during the debates of the 1850s that the bloodiest of wars ever on this continent was about to break out, and that it would divide and then forge together a nation that would ascend past all others in the succeeding century.

No one imagined that the surviving kids of the depression era were about to take on the world. In the 1930s, America was an isolationist nation.

Consider the Obama election

Obama captured the energy and power of this emerging generation with a masterfully designed social networking campaign that he orchestrated while Boomers and Gen-Xers were still trying to figure out what social networking was.

Catalysts to Great Change

Howe believes the Millennial kids bring a community spirit, teamwork skills and a sense of “doing what’s right” that can and will empower change in the way we do things. He predicts changes in institutional structures on a global scale. If he’s right, then the investing game will become even more dicey and dynamic indeed. If the social and institutional structural order really is about to undergo transformational change, then we in the wealth preservation game ain’t seen nothing yet.

What type of generation has the will to take on the entire structure of health care, Social Security, energy and pension reform? Howe says it will be the pragmatic, hard-nosed Gen-X generation.  For Howe, Gen X is most characterized by their value of liberty, survival and honor. Gen-X is just now moving into positions of leadership and authority. But already, it has had its greatest impact by the innovative strong individuals who have distinguished themselves entrepreneurially and at a younger age, than previous generations. Examples of Generation include Jeff Bozos (Amazon.com), Michael Dell, Tim Geithner and Barack Obama (A Gen-Xer at heart, who was born in the last cusp of the Boomer Generation).

Generation X is filled with impatient, pragmatic, ruthless problem-solvers, and we (I was born in 1968, which puts me in among early Gen Xers) will be the generation in the leadership positions during the coming transformational era.  Perhaps the simplest way of thinking about the character differences between Generation X and the Millennials is their influence on the development of the Internet. Generation X made Google, which is brutally all about finding what you need and finding it fast. The Millennials are Facebook, which is gabby; and all about creating communities and socializing.

Generation X and Millennials – A One-Two Punch
Extrapolating from Howe’s ideas, I can imagine that the hard-nosed practicality of the leadership generation today, which Obama embodies, paired with the iron will of community-focused, do-the-right-thing, Millennials, all 95 million of them, may be a one-two punch that can change our society faster than we suspect possible.

The Millennials won’t be in positions of leadership anytime soon, but they will be the dynamic force of the equation, the body politic. Howe believes they have the political will to take on pretty much any issue. As dictators know, you can only do what the army supports. The Millennials are the army, which is why Obama has been empowered to take on the biggest issues like healthcare.

My prediction: We will probably bear witness to more structural change in the next 20 years, than we have seen in the last 50 years.

This is a big and scary thought for money managers. What does it mean to bond allocations? What does it mean for the stock market? What about alternative assets? Here are some of our assumptions and the investment conclusions that we draw from them on managing client wealth and creating investment policy.

1. The energy crisis will be massive. We will invest tens of trillions globally in energy solutions over the next few decades. We want to overweight our exposure to energy companies.
2. The dollar will decline gradually. We want some investments, which are not directly dollar sensitive.
3. Multinational companies will continue to be profitable, and have less dollar exposure than other investments. We want a significant percentage of our equity holdings invested in multinational companies.
4. Taxes will go up. We want to buy municipal bonds when they sell at good values.
5. Inflation will go up. We want exposure to assets that will appreciate with inflation
6. Deficits will go up for quite awhile. We want to avoid an over allocation to growth investments because most classical “growth” investments will not turn out to be “growth investments due to transformational institutional change.
7. Scientific breakthroughs will improve the economics of different businesses. We don’t know when they will occur so we avoid non-dividend paying emerging businesses due to their low returns on capital.
8. Opportunities will appear.  Liquidity is important. We are less interested in hedge funds, and other investments that tie up or commit capital for a long period of time.
9. The standard of living will be a struggle maintain. We are wary of consumer discretionary companies.
10. Volatility and fear will dominate the investment climate. We want to convert capital gains into income streams, when possible.

Concluding Thoughts
In the midst of the social discourse of a rapidly changing society, stock, bond, real estate and other asset prices are unlikely to be stable (i.e. they will be volatile). We want to remain opportunistic. We prefer capital preservation and income strategies to growth strategies. As soon as the economic global recovery picks up steam the next Energy Crisis will be upon us. The transformation to non-carbon based energy economy will likely take at least 50 years, similar to the transition from a wood-based energy society to a coal-based one in the 19th century and the coal to petroleum transformation of the 20th century.

The western world can only compete in the new information economy if it relies on its strategic advantage in services and its creative innovation in new technologies and industries. Production-focused education curricula must be transformed into an environment supportive of creative and critical thought. The social debate that will ensue, commencing in the next decade will be massive. The Millennial Generation, with their penchant for teamwork and their belief in building a new and better world may demand that education move from preparing children for an industrial economy, to preparing them for a knowledge-based economy.

So that’s some food for thought today and this quarter. Our business has flourished in 2009 as our investments in gold, municipal and corporate bonds have led our portfolios to better than market returns with much lower overall risk. Our income-focused capital preservation strategies are designed for retirees and affluent investors seeking to protect their accumulated assets through the commencing Great Changes.

“Second-Look” Service
We offer a “Second Look” service. This is a complimentary review of your existing portfolio allocation with no cost, obligation or pressure. If you are concerned about making the best choices to achieve your life goals in a safe way, call us to schedule a 30-minute “Second-Look” review meeting at our new office location in La Fiesta Square.

Publishing Foci for Barnes Capital Insight
Going forward, BCI will be produced quarterly. The January issue will continue as the Review & Forecast Issue. The July issue will be a mid-year update to the Review and Forecast Issue. The Spring and Fall issues will highlight whatever I am really interested in at that moment. My best English teachers used to tell me to write about what I know and am passionate about. BCI will follow that advice.

Incidentally, you may want to take a look at our newly designed website, and our articles in Lafayette Today. In March I began writing a column in this local monthly paper with a circulation of 11,000. These articles are short and snappy.

Guilt is more effective at guiding positive economic behavior in comparison to the decisions made in “Shame” focused cultures. Guilt motivates conscious actions for forgiveness, resolution and redemption. This is a cycle based on problem-recognition, decision-making and solution-focused action. It’s an economically healthy cycle, and one which fully embraces of the art and mystery of “creative destruction” a process vital for persistent economic growth.

The guilt system works because it rewards action for admitting fault (confession of guilt), forgiveness (for acknowledging errant ways), redemption (the hope and action – for a better tomorrow, and opportunity (to pursue that future including debt forgiveness, bail-outs, et al.) Guilt, by the cleansing action of acknowledgment and its by-product, action, more often than not, produces economically healthy, future-focused, decision-making. Perhaps not in all cases (think General Motors)–but usually.

Confucian culture suffers from decision delay and the tribal ideal of “saving face”. Positive action is obfuscated. With little incentive to admit fault, the system fails to correct, mature and advance.

Consider the rhetoric of the late 1980s. Japan was going to take over the world. The Japanese had mastered production and quality control in many industries. But long-term economic strength is not founded on the basis of several industries; it is founded on values and work ethic. No number of industries can sustain a nation over time, because industries, by definition, are mortal. They expire. (Think of the buggy whip, the carriage wagon, the PC industry.) All lines of business must transform themselves over the generations, simply to continue to exist. Transformation requires an admittance of difficulty, fault, blame and corrective, strategic action to adopt–or die. As Andy Grove stated “only the paranoid survive”.

The Japanese production dominance of the 1980s was similar to the German war-making dominance in WW2. But mastery in several industries, was not sustainable over time, because technological innovation and creative destruction, rendered certain industries and technology, insufficient. Case in point, the H-bomb made the perfection of the blitzkrieg and the surprise attack, mute.

The Christian response to economic calamity and asset bubbles particularly, is much different than the Japanese response in the 1990s. I bring this up because I’m coming to believe that the predicted demise and doom saying, so widespread, prevalent and gloating, is an increasingly myopic vantage point. China has a fatal banking problem. This may be one of the reasons that China makes surprisingly little headway developing a consumer economy.

Bottom-line: The predicted demise of the American economy is wrong. Southeast Asia has a radically different ethic that does not support long-term growth, due to the absence of self-correcting mechanisms.

Fast forward two months. Its June now, and the market is telling whomever will listen, that things are better than they were in the dark days of November or early March.

I’m not convinced yet, but what I do know, is that for all the abrasively transparent faults of the U.S.’s profligate ways, the American economy enjoys powerful long-term economic advantages, one of which is our self-effacing cultural value of forgiveness over denial and mea culpa over hari kari.

Daniel A. Barnes, CFA

June 2, 2009

Gold is timeless money. For five millennia gold has represented wealth, and maintained its purchasing power over time. I believe we are in about the 5th inning of a bullish gold cycle.

If you’ve read my article, google “Tangible vs Financial Assets”, then you know that I believe that tangible and financial assets oscillate in 20 year cycles of outperformance and underperformance. Tangible assets are real estate, commodities, precious metals, gems and collectibles. Financial assets are IOU’s: either debt (bonds) or ownership interests (equity).

In 2006 I believed that bonds and equities would deliver below average returns over the next 5-10 years while gold and other tangible assets represented attractive assets. Since 2006 much has changed, but the fundamental reasons behind including gold in your portfolio have not changed. If anything, the case for gold has become even stronger.

Why Buy Gold?

1. Diversification: The theory of diversification is that you always want some of your assets moving in the opposite direction of your other assets. Historically, Gold is inversely correlated to the dollar, and it is not correlated to stocks, or bonds. As such, it’s pretty likely to do well, when stocks and bonds have modest or negative returns.
2. Supply: The bear market in Gold lasted 16 years, from 1984 until 2002. Funds for exploration of existing and new mines evaporated and very little exploration occurred. At the same time reinvestment in existing plant, equipment, and exploration was nominal. As a consequence of 20 years of under-investment, annual gold production has been in decline for the last 4 years. Current mines have not been able to replace their reserves. It takes 7 to 10 years to bring a new gold mine into production, so any new discoveries today are many years away from fulfilling new demand.
3. Demand: In the same period of time, a billion new souls entered the planet, and China and India, the two largest consumers of gold and silver, increased the size of their economies by about 700%. Gold is sold to the middle and upper classes of China and India by the gram for $30 to $40/gram. There are different reasons why Indian and Chinese citizens are comfortable keeping their net worth in gold: from the tradition of gold jewelry (the dowry) in Indian weddings, to the experience over the millennia which have excised the wealth of the Chinese merchant class as political systems and currencies have come and gone.
4. Inflation Hedge: The nature of things is that prices rise. They do so, because the alternative, deflation, is worse. Gold, above all else, is an accepted standard of value that cannot be depreciated. If you look at what an ounce of Gold bought 100 years ago, it bought a nice set of clothes. Today, $950, (the current price of an ounce of Gold) still buys a fine set of clothes. That may not sound earth-shattering, but it is. A dollar in 1945 bought a nice steak dinner with drinks and everything at a very good NYC restaurant. What does that meal cost today, $100, $200? Theoretically one can say that your investments would have compounded at a rate in order to grow from $1 to $100. And they may have, but then again, they may not have.
5. Standard of Value: No matter what governments do: inflate currencies, conduct war, hyper inflate, gold has retained its purchasing power over five millennia. In the world today there are only a couple of currencies that are older than 200 years old. Investors know that gold will have an approximate value in 20 years of what it has today. That is comforting knowledge indeed.

For additional information about understanding what is driving Gold prices, look at US Global Investors excellent page at: http://www.usfunds.com/landingpages/whats_driving_gold/

Money is not about account balances – it is about people’s lives. While we may be in the middle of the worst recession in three generations, if you are 48 and being promoted to senior manager at Clorox, you are in a very different place than the 45-year old research engineer just released from Oracle.

In my introductory column in March I shared what drew me and my family to Lafayette. In the April column I discussed the recession and how we all are affected. Today I’d like to share some stories of families facing difficult financial decisions and how my firm works with them to make decisions to realize their dreams. What is key, is my ability to help clients identify their goals, and then lay out a solution to realize the lifestyle and sense of well-being, that they desire. These stories are fictitious but some of these stories may relate to you, or someone you know.

Jan is 53. Her husband died three years ago. Together, Jan and her husband used to have an estate of $2.75 million. But Jan hasn’t been able to work too much since her husband passed. In the meantime, her investments were battered. She now has a sail boat, her home (40% equity), $1 million in cash and annuities, and a $350,000 portfolio of stocks and bonds. Jan suffers from carpal tunnel and dislocated disks. She may be able to resurrect her career but she needs to secure her basic needs as well. What should she do? To help, I suggested she take a big step back and imagine painting a landscape of her next two decades. What appears on the canvas? When she described a life she wished for, I pressed her to describe her vision in more detail. Once we had a vision to pursue, I kept her accountable to finishing up the work that needs to be done with the CPA and estate attorney. The investment recommendation restructured her cash, annuities into a dividend focused balanced portfolio producing $6,250 of monthly income that will grow with inflation. With this security, she could freely pursue reestablishing her career while also refocusing on improving her health.

Jim is 62 and his wife Susan is 59. They currently live on $15,000 of monthly income. But when Jim retires, their monthly income will decline to $6,500. Susan makes $5,000 monthly, but she wants to retire next year. Can they pull this off? If so, how? They own a retirement home in Grass Valley that is cash flow negative $500/month. They have $500,000 equity in their home, $600,000 in retirement accounts, and a trust with $250,000 in it. They stand to inherit approximately $1 million, but that could be 10, or even 15 years down the road. What is the solution that’s right for Jim and Susan? At Barnes Capital we asked Jim and Susan: “What do you want your life to look like in 6 weeks? 6 months? And in 6 years?” The answers to these questions framed the financial plan and investment plan that we designed for Susan and Jim.

Rose is 75. Her husband passed away two years ago. She has an IRA and trust ($600,000) and she receives social security of $1600/month. Rose is blessed with four grandchildren. However, her daughter needs financial help. While Rose’s regular expenses run $3500/month she has promised to help with the grandchildren’s college expenses which she expects to cost $20,000+/year for most of the next decade. What should Rose do? Can she be invested in stocks? Does her broker have the knowledge and impartiality to advise her best through this delicate balancing act? And her broker works in Oakland, is 62 years old, and Rose don’t really want to travel to his office anymore. Is there a local solution, someone who Rose can work with one on one, for the next 20 years (because she can’t stand the thought of having to build a new relationship 5 or 10 years from now)?

—

These stories might be similar to situations of people you know. With questions and patience, I assist each client to envision their goals. On a basis of trust, I endeavor to explore and recommend decisions to realize client dreams — strengthening the linkage between their sense of financial security and their lives.

Daniel A. Barnes, CFA, Barnes Capital
3503 Mt. Diablo Blvd., Suite 201, Lafayette, CA 94549

Lately, there’s a sense of foreboding. A quality of life, based on conspicuous consumption and asset bubbles, was endangered—then exterminated—in less than 24 months. This is really unsettling to me. And I see it hitting home right here in Lafayette on and off Mt. Diablo Boulevard (our Main Street), and probably on your street.

I have always identified with Main Street, not Wall Street. Because I wanted to work with regular people, I decided in 2002 to go into the independent advisory business. I wanted to help people change their lives, with wise financial management. My primary goal has consistently been to develop strategies which protect client wealth in up and down markets.

If you follow the news, it seems that Boards of Directors, politicians, hedge fund kings, and AIG millionaires have nothing in common with those of us working on Main Street, for Main Street. I really feel for regular people who are
seeking to secure a safe retirement. Here are some of their concerns:

How high is unemployment going to rise?
How will we get out of this? Housing is still going down.
How will we pay the bills?
What if my business doesn’t pick up in the next 2 years?
What if my company restructures, or is bought out?
How am I going to find another position paying anywhere close to what I make now? I’m 54 years old.

For folks like this who are nearing, or in retirement, it’s really scary. I bet there might be several people in this situation who live on your street. As a small business owner, it’s not easy to stand apart in my industry and say that the Goliath’s just want to separate you from your money. But as we have seen, that is exactly what the Wall Street firms specialize in. It’s shameful, and it’s reality.

More than anything else, frustration is what so many feel. That feeling borders on a sense of “betrayal”, by government who facilitated the bubbles, by Wall Street firms selling product, and by the financial press — who is strongly supported by Wall Street advertising dollars. I too am frustrated with the product machine that my profession embraced, sold, and ultimately did harm to the financial security of Lafayette families.

I hear how people say that the promises that Wall Street and guru’s like Jeremy Siegel (Stocks for the Long Run) proselytized for decades, have led to busted retirement plans and busted dreams. I think that this sense of betrayal that Main Street is feeling is real and I feel terrible for those affected. In my recent Blog, www.danielabarnes.blogspot.com, I discussed how the social fabric, the implicit promise of retirement, now seems like just a bunch of hot air, created by Wall Street, just to hawk product. Stocks for the long term were supposed to get you there. But Merrill Lynch had you invested 50% in stocks, and now you are down 35%, and your company is about to be restructured. You might get hit with a double whammy: lose your main source of income, right after your portfolio and net wealth has received an awful pasting.

You’re thinking: “it’s not fair”. “I did most everything right.” “I didn’t buy a house or vacation home at the top of the real estate bubble. “I’ve lived in the same house for 15 or more years. I didn’t speculate. I didn’t run up credit card debt.” “I didn’t live beyond my means.” My financial plan and diversification were supposed to get me safely to a comfortable place with a large nest egg for retirement.

You “supposedly” did follow conventional guidance, and now you feel like you are in trouble. At least that’s what it feels like. You garner you’ve lost more than 35% of your nest egg in the last 24 months. You’re mad, and not sure who with. That’s what a lot of folks I meet and talk with around town are thinking and saying right now.

There are strategies which are very effective at protecting your assets, even in a substantial economic downturn. While the strategies which we employ are uncommon, they are precisely designed to protect clients in a down market, while producing gains in normal times. This year, they have been doing just that. If you would like to know more about this, just give me a call at 925-284-3503.

To conclude, the sense of disappointment and frustration so many feel today is palpable. As a Main Street business owner, I have been affected as well. I wish it were different, but I think that culturally, we will have a better set of collective priorities when we eventually recover. I also believe that independent, ethical business owners will prosper while the big firms, which in this recession have shown their inherent limitations, decline. In the meantime, spend time with those you truly care about, and take a walk down Mt. Diablo Boulevard once in a while, it’s filled with delightful shops and shop owners, and like you, they are looking for a good deal, honesty and a smile.

Warm regards,
Daniel A. Barnes, CFA Barnes Capital
3503 Mt. Diablo Blvd., Suite 201, Lafayette, CA 94549

Similar other anecdotes abound. The point however, is cleansing, repentance, and a return to core American values is the mandate today. While American society propelled consumerism it wasn’t always mass consumerism. That would be putting the cart in front of the horse. Prosperity requires productive core values. And Americans have these in spades: thrift, diligence, work ethic, tenacity, perspiration, inspiration, and idealism. Above all: Optimism and Faith. With these traits, the productive spirit of the individual is released, so long as the civic values are in place: good government, fairness, the rule of law, and the respect for natural laws. These principles of civil society have been with us, and improved upon, for over 200 years. The requisite values of a prosperous society are the individual ones, which, within the safe environment of civil society, propel the energy of man forwards in productive activity. These are: creativity, spirit, work-ethic and risk-taking (the good kind – entrepreneurial activity). These values come, by definition, first. Goods and services can not be produced in a vacuum or in an unfree-society. American industriousness and pragmatism, our utility, our unburdened consciousness- these are our collective cultural values which foster and drive our countries awesome industrial capacity. We didn’t need the value of conspicuous consumption in order to become a great production society. We only needed mass consumerism to create the bubbles of recent times. When CEO payoffs our in the $100s of millions of dollars, then something goes awry in the social fabric of our culture.

And it’s this pretense of reality, which embodies the only world Generation Xers (Born 1965-1979) and Generation Y’s (born 1980-2000) have ever known. Further, its this world that the Baby Boomers mainly know. Anecdotes of past generations and old movies seek to bridge our vapid experience, but fall woefully short if the educational goal. That’s where the invisible hand comes in to save the us from ourselves.

Thanks to Bernie, ourselves, and all others, we have economic hard times. The punchbowl has been taken away. As a great nation, we are retrenching. As a great people, we return to the core values that are the drivers of production and innovation, the mainspring of wealth and a consumer society. I have no doubt that economic prosperity will return to us in the next decade. Better yet, we will be wizened, and more appreciative, when it doth arrive.

In these Lenten days, let us cherish the solid values that we as a culture embrace, knowing in our hearts, that this too shall pass. The economy will begin to recover in 2010. Failed companies, fallen CEO’s can, and will, in time, be replaced. As the auto industry evaporates, and strip malls deteriorate, we can rest easier, knowing that the future will be brighter when domestic car manufacturers receive their due, while the consumer society of the future will engender nicer places to shop, than the suburban blight of the ubiquitous strip mall.

Early this week (March 9th) the New York Times picked up the “Going Galt” theme that apparently Rick Santelli of CNBChelped propel early this month; Good thinking, but beyond the scope of today’s Blog. See “The Opinionator” athttp://opinionator.blogs.nytimes.com/2009/03/06/going-galt-everyones-doing-it/?ref=opinion for more info.

Suffice it to say, that as long as the Chinese buy our government debt for 2% and 3% interest, we have the luxury to pay-off the excesses of past decades with cheap, easy money. The United States will lead in product innovation in new industries. We will continue to be a leader in advanced production technology. Collectively and individually, we will thrive again, as we come through this period in 2010-2012. For the moment: retrench, pay off debts, save, and find an intelligent, trustworthy person who really takes the time to know you, when planning your financial life. A new era is coming just as sure as global warming, it’s just a question of when and how fast. At Barnes Capital, we are expecting markets to begin to improve in 2010, and the economy a few quarters thereafter. Stay well through this difficult time. And button up.

Sincerely,

Daniel A. Barnes, CFA
Barnes Capital

Three years ago my family and I went looking for a new home. The cold cloudy days and nights in our beach-side home left us longing for sunshine, warmth, and a new community where we could lay down some roots. After looking at more than seven different areas in Northern California, we chose Lafayette. I’m so glad we did.

I’m Daniel Barnes, a professional Wealth Manager and Registered Investment Advisor with a view toward the future. Over the coming months I’ll be using this column to talk to you about topics I care a great deal about. I hope you enjoy these articles and find nuggets of wisdom that you can use. But before I get to that, I’d like to tell you what I really care about: family, community, and friendships.

My children both go to school here at Stanley Middle School. I enjoy picking them up after school and spending time with them, sometimes at my office, located just three blocks from Stanley, at the corner of 1st Street and Mt. Diablo Blvd. in the balcony suite.

There are many things I love about the Lafayette community.

• I love the downtown which is based on a Main Street.
• I love the park plaza, the residential areas close to downtown, the restaurants, and shopping, the public transportation. Lafayette is one of the few “suburb towns” in which you can truly get around, by walking.
• Interesting people. Lafayette attracts a lot of well educated interesting people. And they can be very friendly. Once just a few months after we moved here, we were in Flippers when a gentleman offered Max, the owner, some Warriors tickets for that night’s game. When Max declined, he saw my son Jonathan and I and asked if we might like them. I’ve not yet found a way to repay the favor to this man, but it warmed my heart, the simple generosity that afternoon. What a great introduction to Lafayette.

Lafayette is a true community. Most Lafayette kids go to Lafayette schools, and the town has more than 1200 businesses, which means that many people who live here actually work here. As a consequence, Lafayette can really come together as a community to share, discuss, argue and develop solutions to build an even better community here. I love this.

Since as long as I can remember, I have enjoyed learning. While California isn’t perhaps known for how it values education, Lafayette stands out with its pride in local schools. I am tremendously excited about the new Lafayette Library & Learning Center.

I am passionate about basketball, rotisserie baseball, skiing, my dogs, other languages and cultures, history and board games. I’m also passionate about helping people use their wealth wisely.

Barnes Capital delivers an unparalleled level of service to our clients. By spending as much time as it takes, we come to understand our clients and then build a custom plan and portfolio specifically designed to achieve their financial and life goals, while maintaining the level of security and safety that they require. If you would like to learn more about bullet-proofing your nest egg, call me to begin a conversation at 925-284-3503 or visit my website at www.barnescapital.com. Better yet, send me an email at daniel@barnescapital.com. My door is always open.

Warm regards,
Daniel A. Barnes, CFA, Barnes Capital
3503 Mt. Diablo Blvd., Suite 201, Lafayette, CA 94549

Microsoft is the evil empire. And most of us love to hate Microsoft. But what Jerry Yang represents so clearly, is the utter disconnect between CEOs and their fundamental lack of noblesse oblige. The term is french and translates literally to “nobility obligates”. I believe too many of today’s corporate founders and CEOs were too busy getting through B-School or starting their company’s to learn much humility and the responsibilities of great personal wealth.

As Yang was playing poker with Microsoft in takeover negotiations last year I wondered, “has he ever had fallen on his face before? Had he known great failures? The fundamental absence of fiduciary obligation to shareholders, employees and clients on the part of Yang and so many other CEOs, is just appalling.

A fundamental problem with corporate management is that there is an economic disconnect between CEOs, the Boards of Directors, and everyone else, including shareholders, employees and clients. When Microsoft generously offered $32 a share, a value Yahoo hadn’t seen in years, I can’t help but wonder if Yang would have chosen differently, if he didn’t have a $Billion in the bank. Had he the necessity of worrying about bills and mortgages and retirement (like the rest of us) would he have chosen differently? With a billion in the bank, what difference does it make to Jerry Yang, whether shareholders receive the best price for their company?  None whatsoever.

If you are a small business person, or anybody making less than about $250,000 a year, you feel every expense, every mistake, every consequence of your every decision.  Thus, you make better decisions in time. Its a learning curve. With infinite wealth, comes an insulation that desensitizes company leaders from their fundamental fiduciary obligation to check their egos at the door  and make decisions for the benefit of shareholders, employees and clients.

John Pierpont Morgan http://www.netstate.com/states/peop/people/ct_jpm.htm, and others, understood the obligation of stewardship that the noblesse oblige demands.

Today’s titans are driven by an ego morally disconnected from the pathos of greatness.  That’s why we are, where we are, today.

As a shareholder, it pains me deeply to witness the contempt with which so many company leaders have acted. In their bubble worlds of corporate excess and personal wealth they are disconnected from the rest of us. John Thain renovating his office for $1.2 million in a time that the U.S. money center banking industry is essentially insolvent. How does a person achieve such success while showing such a poor lack of judgement?

President Obama is right to make a big deal about CEO pay. The current crop of corporate leaders would learn plenty thinking about the legacy and heritage of corporate giants from the past.

Daniel A. Barnes, CFA

Barnes Capital is an independent investment advisor serving private clients in Lafayette, California. We help clients develop a vision for their financial future, embodying their goals, dreams and values. We help them achieve this vision acting as their personal chief financial officer.

2008 is finally over.  2008 was by all accounts, a watershed year — a year when at the end, nothing was as it had been before.  1989 was also such a year when the Berlin Wall fell (and Communism with it), as was 1981’s Reagan Revolution, and of course the fall of American Idealism through the assassinations of Martin Luther King Jr. and Bobby Kennedy in 1968.

The focus of our yearend issue is a glance at the past, then a firm eye towards the future. As we enter 2009, we are more optimistic than pessimistic.  Housing and credit issues, combined with slowing global growth, higher inflation, and rising unemployment, will make for a very tough year on investors.  However, many of the best multi-national common stocks, and their bonds, are selling at value prices.

For 2009 we are neutral on stocks, bullish on both corporate and municipal bonds, and bearish on government bonds.

2008 marked the repeal of the Credit/Finance economy.  However, the repeal is still in its infancy.  The breadth and magnitude of the dismemberment of financial institutions remains unknown.  The economic downturn starting in July 2007 affected everyone.   While few could articulate how much they actually were affected, one was left with the damning question, is this simply the normal course of the economic cycle, or did we bring the asset bubble collapse upon ourselves?  Millions of words have been penned trying to describe the collapses, from Bear Stearns and Alt-A mortgages, condominium price collapses and pyramid and ponzi schemes.  Wall Street greed, CEO greed, hedge fund fraud, is revolting.  If Hollywood wanted to show everything wrong with money and America, it couldn’t have done a better job than follow the headlines of 2008, which showcased all that is wrong with Wall Street, public companies, private companies (Madoff, Petters) and other folks in the Hedge Fund and LLC/LLP world of limited partnerships.  The Madoff Shame is such a potent reminder:  if it sounds too good to be true, it damn well probably is!

The origins of the asset bubbles and credit driven economy began 28 years ago with David Stockman’s economic plan & supply side economics.  Stockman was Reagan’s Budget Director 1981-1985.  http://en.wikipedia.org/wiki/David_Stockman.  Ultimately, the system of budget building and tax cutting pioneered by young Stockman brought us to our 10-Trillion dollar national debt (from $1 Trillion in 1981.)     Globalization charged forward in the 1990s on the basis of systemic overspending.  The system was financed by domestic and foreign lenders, and fueled by conspicuous consumption, housing appreciation and inflation.   Asset inflation abetted initially by corporate raiders, leverage buyouts, and junk debt: later by mortgage innovation, rocket scientist financial engineers, black boxes and hedge funds, created and sold their systems and products through a variety of financial companies and sales organizations (LLC’s, Investment Banks, Mortgage Banks, structured products). The dynamic of financial innovation fueled the conflagration of spending.

However, crazy it now appears in hindsight, systemic overspending was a stabile paradigm.
Government fiscal and monetary policy, from Reagan to Bush Jr, supported the existence and growth of these enabling factors.  The finance economy paradigm relied on the existence of:

• Availability of consumer credit
• Expanding governmental credit
• Rising US imports
• Creative US financial institutions with the capital and will to assume evermore liabilities
• An ever-expanding derivatives market backed by credit-worthy counterparties.

The paradigm of this system was destroyed in 2008.  Not some, but ALL of these requirements of the existing global financial system failed or were serious eroded in 2008.  The point to no-return was reached the weekend of September 15th when the government allowed Lehman Brothers, a firm with its tentacles in every crevice of the financial maelstrom, to fail.  With that decision, the virtuous cycle of the finance economy was irreparably torn asunder.

The term “reflexive” is used in social theory to describe circular relationships between cause and effect.   Billion George Soros, a brilliant money manager whose passion was philosophy, expanded at length in “Alchemy of Finance” (1987) how Reflexivity relates to economics http://en.wikipedia.org/wiki/Reflexivity (social_theory).   To Soros, the momentum of price change actually changes the fundamentals of the participants themselves.  A weak economy can be made very healthy, if credit is cheap and easy to get (and thus causing asset values to expand), thereby increasing the leveragability and creditworthiness of the asset base.   In a nutshell, the health of the U.S. and global economies were tied to asset inflation.

Since we are now in the midst of asset deflation, does this mean financial Armageddon?  Our answer to this question is “Maybe, but probably not.”  The essence of creative destruction is the “creative” side of the process.  Free markets and free people are intelligent actors.  They can, and do respond to change.  The duration and magnitude of a vicious cycle is unknowable.  However, we do know that intelligent actors and pragmatic people find solutions faster than expected.  The surprise of 2009 could be that the system heals faster than we expect.  With no further ado, here are the 2009 predictions.

Predictions for 2009

Likely to Occur

Prediction 1:
Obama’s coattails have the Teflon strength of Reagan.  Nobody thinks it’s a good idea long-term, or intermediate term, for the government to spend an extra Trillion.  But for 5 months, the general public suspends judgment, because Barack’s just a great communicator.  And both the American, as well as and world audience, has really missed having a good communicator at the helm. Obama’s legislation all gets passed, and the vultures are held off until September 2009 when they go ballistic at the 2nd Coming of the Works Progress Administration (WPA). See #5.

Prediction 2:
After a 30-year moratorium in Nuclear Energy construction, several nuclear energy projects are approved in 2009.  Together with clean technical regulations for the approval of retrofitting coal fired power stations, a small bull market is reignited in the infrastructure and engineering companies in late 2009.

Prediction 3:
The Republican Tax Cut will be approved in February together with a massive Infrastructure Works program.  The tax cut is total ineffective at stimulating demand in the economy, but the stock market rallies 10% on the hope of the infrastructure projects and the jobs that will be created through this.

Prediction 4:
Autos follow airplanes.  Like Boeing swallowed McDonald Douglas, so will go the automobile industry.  After reporting a total of $100 billion of losses in the previous 6 quarters, the government steps in and tells GM and Ford to merge and restructure.  Chrysler’s assets are dispersed to European and auto parts creditors.

Prediction 5:
The economy ends the year in the dumpster as official unemployment flirts with 10%.  Markets take it in stride, ending up 7% on the year.

Unlikely to Occur – but it wouldn’t surprise us if . . .

Prediction 6:
Iran, Venezuela and Russia announce liquidity crisis in the face of the worldwide slump in energy export revenues.  Iranian leaders face protests in the street, Venezuela announces a series of new nationalization attempts in its effort to stopgap the fiscal disaster (Venezuela is 94% dependent on oil revenues). Russian energy companies curtail expansion as the credit crisis imposes a liquidity crisis on them while the Russian government simultaneously increases corporate taxes by 40%. These disasters in the late spring lead to a bottom in energy prices below November 2008 levels.

Prediction 7:
Obama enacts WPA II after all other efforts (tax cuts, infrastructure plan) prove too slow and ineffective to halt employment losses (which reaches 9.5% in June 2009).  Between 1935 and 1943 the WPA provided almost 8 million jobs. Anyone who needed a job could become eligible for most of its jobs.  Hourly wages were the prevailing wages in the area; the rules said workers could not work more than 30 hours a week but many projects included months in the field, with workers eating and sleeping on worksites. Before 1940, there was some training involved in teaching new skills and the project’s original legislation went forward with a strong emphasis on family, training and building people up.

The WPA built 650,000 miles of roads, 78,000 bridges, 125,000 buildings, and 875 miles of airport runways.  Only 7% of the budget was allocated to arts projects, presenting 225,000 concerts and 475,000 artworks -which was the mostly widely criticized of the New Deal agencies, but it did succeed at getting money into the hands of the unemployed. Until closed down by Congress and the war boom in 1943, the various programs of the WPA added up to the largest employment base in most states.

Obama realizes in Q4, that local, state, corporate and other entities can not get money to the people fast enough to end the recession.  The triumph of free markets over communism in 1989 is replaced the nuclear fallout of a banking crisis and the profligacy of consumption.  Just before the Christmas recess Obama pushes through WPA II, a jobs program that proposes to spend $1 trillion making new jobs that purport to put American’s back to work.  Markets sell off violently, but hold above Dow 6000 as they see this inefficient government works program as a necessary evil.  Besides, as China and Japan continue to foot the bill, who cares what it costs?

Prediction 8:
Federal Reserve mortgage buying creates a boondoggle for Wall Street banks saddled with previously dangerous mortgage paper.  The Federal Reserve balance sheet balloons from $2 Trillion (up from $1 Trillion in 2008) to $6 trillion by year’s end.  The 30 year long bond, after languishing below 3% for much of 2009, falls out of bed, declining almost 20% in 3 months to yield 4.5% in the 4th quarter of 2009 on fears of the over-leveraged U.S. balance sheet, global reflation, and improving housing situation (the decline ends), and the shimmer of economic recovery on the horizon.

Prediction 9:
The Yankees reach the World Series, but fall short against the Dodgers whose scrappy no-star team reminds Boomers and Gen-x’rs of Lasorda and Fernando Valenzuela.

Prediction 10:
Gold falls to $595 in late spring 2009 on fears that a recovery and ongoing liquidity crisis and commodity bust will never end.  Alternative asset managers and hedge funds throw up their hands and sell all of their positions in May.  Gold shares revisit 4Q08 levels.  Subsequent reflation and a flight to safety brings Gold back by year-end to close at $978, within easy striking distance of its March 2008 high.

In Conclusion
We think we have our work cut out for us this year.  It’s likely to be another very tough year on client portfolios and their managers.  We continue to manage our clients’ money in the less growth sensitive areas and we are taking advantage of the once-in-a-lifetime opportunity in precious metals, while investing in many Dow stocks paying dividends of 4% to 9%.   Barnes Capital protects client’s wealth with less portfolio risk compared to the standard asset allocations of mutual funds, brokers, and other investment representatives.

Summer Recap
Well the Olympics are over, the Yankees are out of the pennant race, the lending markets are barely functioning, and the mortgage lenders are close to failing. Oh, this just in, the Commerce Department has determined a recession will begin by Christmas.

Let’s start with the facts. Last issue we were fairly obsessed with inflation ($90.21 fill-ups). Then we went to Italy and paid $150 for a smaller tank (14 gallons). Maybe it’s time to get serious about building an Energy-Star economy? If we can spend a $1 Trillion trying in insure cheap oil in the Middle East, imagine what $1 Trillion of government support for developing alternative/renewable energy industries in our own terra firma could achieve.

With a global economic slowdown in process, inflation fears are declining. Some continue to speak of deflation. And the deleveraging going on it credit markets supports this. With less lending occurring, assets have little ability to appreciate. Since June 30th Commodities retreated 10%–22%, while Equity Markets were flat. While commodities were declining and the equities were volatile but trendless, all hell broke loose in parts of the fixed income market.

The ongoing saga of the impending insolvency of Fannie Mae and Freddie Mac, crashed parts of the Fixed Income Credit markets in the 2nd and 3rd weeks of July. Reminiscent of other crashes (1987), many bond trading desks failed to answer their phones on July 15. Hopefully you weren’t watching while this was happening. Some bonds fell 20% while others fell more than 40%. A semblance of normalcy returned over the last 6 weeks but the widespread uncertainty due to the absence of a Fannie/Freddie solution remains. This is affecting every company that needs to raise capital. Last week, Wells Fargo, the only AAA-rated money center bank in the country needed to offer 8 5/8% interest on its new preferred stock issue.

The Greenback
A big surprise this summer was the strengthening of the U.S. Dollar. Just when every smart person thought the dollar is doomed, the greenback rallied hard, rising 10% against world currencies. Hint, when every person you meet says they want to be short the dollar, a reversal is in order. Remember 2006? After the dollar collapsed 15% in 2005, it rallied for nearly 15 months through 2006 and into 2007 before resuming its precipitous decline In any case, the easy money betting against the dollar has already been made (the Dollar Index has declined from 120 in 1999 to 77 today).

Real Estate
Housing prices nationwide continued to move lower as supply (sellers) gradually comes to accept lower price levels. The current situation is more normal than the bubble of 2004-2006 real estate prices. Buyers are discerning today. In time, sellers will accept lower prices and transaction activity will rise to “normal” again. Price levels will fall another 3% to 10% in many markets and then stabilize for several years before a new up cycle begins.

Real Estate follows a predictable 20-year pattern, 10 up years followed by 3 down years and then 7 flat years (adjusted for inflation, i.e. 3%-4% annual gains), and then the cycle repeats. The next 6-12 months will likely represent the end of the 3 down years, and then we will be in store for 5-7 flat years. That’s the likely scenario as we see it. If you are holding on to extra real estate properties, keep your expectations low between now and 2015.

Net Worth
Back in earlier issues we discussed GaveKal’s research that shows that asset growth has risen nearly 6% annually since 1945. The great anomaly of 2008 is that asset growth is likely to be negative for only the 3rd time since 1945. When the value of all assets is declining, the “haves” (Issue #27-those who own lots of assets) feel poorer. But it’s not all about the “haves”. Part of the hope of the American experiment is the promise of the “have-nots’ faith” in their own eventual material/financial success. This is why the aspiring middle class, those making ($30,000-$70,000 in annual household income), are not especially supportive of transfer wealth programs. They understand that a leveling of the economic pyramid reduces their upward mobility.

What to Do
It’s going to be okay. A bad market in stocks and real estate isn’t the end of the world. A real estate investor asked an old-timer when the real estate market would normalize. The wise old-timer replied–“this is normal”.
Make sure you are in a position to buy a house in the next 5-7 years; you don’t want to miss the next up cycle. For now, don’t be leveraged and reduce your expectations for asset growth. In a time of global deleveraging, assets don’t appreciate much. This is a period of low returns for nearly all asset classes including alternatives like private equity and venture capital.

Strategies
Recently we’ve been implementing income strategies for clients who need to generate significant annual income. Despite our long-term fears of rising interest rates, long-dated municipal bonds are trading at the top of their yield range of the last 20 years. So while they may not be dirt cheap, they do offer solid returns for investors in high marginal tax brackets who seek to minimize risk. Remember Issue #14, for many investors, “staying even” is half the battle. Municipal bonds can provide a partial solution to “staying even” during tough economic times.

We are sticking with our tangible asset theme, believing that the commodity bull market is not over – just experiencing a major correction. The consumption of raw materials by Asia and Latin America is likely to continue. Preferred stock issues offer good value. High quality issues (like Well Fargo and Prudential) are yielding nearly 9% and while lower quality issues like REITs and some less strong financial 12%. Since we don’t expect equities to average 10% annual returns anytime soon, these are attractive, particularly for retirement accounts.

In Conclusion
Excellent investment counsel minimizes fees and delivers wise counsel. Perhaps more importantly, the best investment counsel creates a safe environment in which clients can dream, think and share the hopes, fears, aspirations and doubts. Be discerning in your choices of who to work for, bank with, and invest in. Don’t just settle.
So what’s this mean for your portfolios? Equities and real estate continue to face heavy headwinds and are unlikely to produce consistent double digit returns anytime soon. However, the next bull-market may not be as far off as we think. Perhaps a bit of productive investment, rather than Middle East occupations, would increase equity returns? As we circle the wagons, we continue to find value in pockets of the fixed income market, gold and some equities. We are producing income with covered call strategies and biding time, in this “normal” market.

At Barnes Capital our approach is to protect and grow our client’s wealth with less risk while providing exceptional client service. This combination of benefits is uncommon amongst financial services companies. If you know someone we may be able to help, please let us know.

What does this number, $90.21, represent?

A. A Bag of Groceries at Whole Foods?
B. Your Kid’s used College Chemistry Book?
C. Your Water bill?
D. A Tank of Gas?
E. Dinner and Drinks at a not that fancy of restaurant?
F. All of the Above

Well, it happened to be my Chevron bill for my latest tank of gas at $4.85/gallon in Vallejo, California a week ago Saturday. But it could have been any of the above. In fact, we are seeing the “3rd Oil Shock” right now and its effects cascade across the world economy.

This picture is a bit shocking isn’t it?

Exhibit 1

Take a look at the price of a “Gallon of Milk” or a carton of good eggs lately? Try $6 and $4 respectively. Makes a “Gallon of Gas” seem pretty reasonable at $4.85 a gallon. Only problem is, most of us consume more gas than milk!

Today’s letter has 2 parts. Part 1 focuses on inflation and how it affects each side of our two-class society. Part 2 focuses on De-leveraging and its effects. The De-leveraging story includes the housing meltdown, the banking meltdown, and the asymmetric relationships between hedge funds, banks and investors which fueled the finance economy bubble.

How does the Energy Crisis affect YOU?
Well, it depends. Are you a “Have” or a “Have-Not”? In a 2-class economy the “Haves”, have enough income, to acquire assets; (i.e., they have a positive balance sheet in which their Assets (real estate, stocks, bonds) far exceed their liabilities.

The “Have-Nots”, haven’t got a positive balance sheet. They live on their income, and it’s difficult for “Have-Nots” to accumulate assets. It’s particularly difficult, when gas costs $5 a gallon. (This of course is all just another way of saying the middle class has disappeared.)

This socio-economic equation of “Haves” & “Have-Nots” is the product of the global economy. Wage competition by Asia keeps wages down – below the rising cost of living. The “Have-Nots” haven’t got much of a nest egg. They live on income of less than $75,000 per year. They live off their paychecks or retirement income. The Have-Nots’ income” is getting hammered by higher food and energy costs. Whatever left over money they had had, that may have gone to accumulating assets such as real estate, or their 401k contribution, is now swallowed up by $90 tanks of gas every other week (or every week if they commute).

For the “Haves”, inflation hammers their Assets – stocks, bonds, real estate & cash. In financial terms, the “Haves’” personal balance sheet isn’t growing. The reason is simple, in an environment of high uncertainty, and rising inflation in food and energy, it is exceedingly difficult to earn a real return (a return higher than the rate of inflation after taxes).

That’s why you feel bad when you get your account statements, the accounts are going down while your expenses are going up!

Inflation
The other impact of the energy crisis is that it focuses new light on the fact that there is significant inflation across the world due to rising energy and food prices.

Here’s the year-to-date score card in the price changes in commodities and stock exchanges.

• Crude oil up 43%
• Ethanol up 21%
• Heating oil up 44%
• Natural gas up 77%
• Unleaded gas up 40%
• Cattle up 1%
• Corn up 59%
• Soy beans up; 26%
• Wheat down 2%
• Coffee up 6%
• Aluminum up 33%
• Copper up 26%
• Platinum up 33%
• Gold up 6%
• Silver up 13%.
• S&P 500 down 10%
• Frankfurt DAX down 18%
• London FTSE down 12%
• Paris CAC down 20%
• Hong Kong Hang Sang down 18%.
• Tokyo Nikkei down 10%

• Singapore Straits down 14%.
• Seoul Composite down 10%
• Sydney All Ordinary down 16%
• Taipei Telex down 7%
• Shanghai B down 44%

In the Middle East and Asia many countries are experiencing current inflation of 10% – 20% or higher. Rice has doubled or tripled, energy tripled, and last week, China increased the price of gas by 20% (many Asian governments subsidize energy costs as a way to drive economic growth).

By most measures, it looks like food inflation will continue for some time as the current asinine governmental policy of replacing fossil fuels with corn has imploded the stabile pricing structure of grains. What’s more, the weather in the last 18 years was very stabile and kind to U.S. farmers. Since the average dinner table food travels 1200 miles from where it is grown in the U.S. to the table, food inflation isn’t going to abate for quite some time. On the other hand, the destruction of billions of dollars of mortgage debt, and the impairment of global financial institutions creates “deflation” (because when a trillion dollars of borrowed money goes up in smoke, there is less money).

Already parts of the debt markets are foreshadowing the rising cost of money. For the first time in a decade, investors can find opportunities to lend corporations money and get 8%-10% returns. The opportunity to build income portfolios is back! I believe that this opportunity is a prelude to rising inflation which will define the next decade

Exhibit 2 shows that in the 1970s, there was an 8-year delay between spiking inflation and spiking interest rate yields. Commodity inflation began accelerating in 2004. Ascending interest rates are on their way, it’s just a question whether they will arrive in 2009 or 2014.

Exhibit 2

The specter of rising inflation isn’t bad, it’s inevitable. We actually need significant amounts of inflation in order to more easily amortize existing liabilities. With $40 trillion in existing liabilities, the U.S., and the developed world (Europe, Japan) whether they announce it or not, have, chosen an “inflate or die” fiscal policy.

However, the specter of inflation must remain stealthy, lest it upset existing systems. But if the cost of borrowing for governments goes up too quickly, national budget deficits will spiral out of control. This is where Asia comes in. Japan and China buy more than a 1/3rd of U.S. government debt. When they no longer are willing to accept 4% interest on 10 year government bonds, our borrowing costs will skyrocket. Interest on the national debt is currently $500 billion/year. If that interest cost rises too quickly, say from 4% to 7%, the annual interest on the debt would increase by an additional $300 billion annually.

As long as wage inflation doesn’t exist however, the lid on inflation and rising inflation expectations stays on the bottle. But with Joe and Jane “Have-Not” spending $90 a week at the pump, how can we expect wage inflation pressures to stay in the bottle?

The De-leveraging Story
Didn’t we declare victory over inflation just a few years ago? How did we go from a goldilocks growth economy back to the brink of stagflation? Its amazing what complacency and a little victory, abetted by stupid policies can produce in a few short years … think: 100% depreciation gas-guzzling SUV’s & hedge funds borrowing billions at 5% to buy mortgages of Florida and Las Vegas condominiums paying 6%, and then leveraging that 1% spread 50 times with borrowed money from their bankers. We won’t even mention the Ethanol policy and what it’s done to the price of corn and rice grains. Try to remember this when hamburger costs $6/lb next year.

This “3rd Oil Shock” (The first was 1973 when Oil quadrupled from $3 to $12/barrel and the 2nd Oil Shock was in 1979 when the Oil price tripled from $15 to $40 a barrel). This 3rd Oil Shock has been more gradual, with the price quadrupling since 2004 from $30 to $134 today.

The “Oil Crisis”, together with the “Housing Meltdown,” is forcing relationships that were never fair or functional, to be disbanded and realigned. The de-leveraging in the face of rising commodity prices is driving corrective behavior throughout Wall Street and Main Street. You might be surprised; this isn’t all such a bad thing in the long run (we will forget for now Keynes, who likes to remind us that in the long run we are all dead.)

The Banking Crisis
Every crisis facilitates the changing of common perceptions. The economy today is bringing a reality check, first and foremost to the lenders of the world. It was the lenders who “screwed up.” This is similar to the dot.com boom/bust. The difference, however, is in magnitude. In the dot.com boom, 100’s of billions of dollars of capital was misallocated. In the housing boom, reckless lending amounted to trillions of dollars of misallocated capital.

Investment banks lent to hedge funds to leverage “safe” investments in mortgages against government bonds, to produce double digit returns and take their 20% performance fees. Today those same banks are facing tens of billions of dollars in losses and you can bet they aren’t lending money to those hedge funds anymore. And, this is the significance of the credit crisis and the energy crisis; it forces corrective behavior on practices that need correcting.

Who are the lenders? Well, yes they are the banks, but more importantly, they are the investors who facilitated the bubble of real estate that facilitated the fantasy world where money is lent for 4% to 7%, irrespective of the risk level to the underlying assets.

Why was that crazy? Well just think, houses which had gone up 200% in 4 years were being mortgaged nearly 100% at 5% and 6% interest rates. Hedge funds would buy up this paper and leverage it 10 or 20 to 1 against government bonds and earn their 15% returns and a hefty bonus of 1/5th of the profits. When the credit crisis arrived last summer, many hedge funds lost so much capital that they couldn’t recover. Many simply closed shop. Did they return the tens of millions $ in performance fees that they had collected for themselves from their investors’ profits in the last decade? Most not!

Why the stupid lending? Because some managers are paid to bet the house’s money!

To explain how markets and why markets go to extremes, George Soros used the sociological term “Reflexivity” in his 1986 real-time experiment chronicled in The Alchemy of Finance. Reflexivity refers to circular relationships between cause and effect, where the effect is so strong (think wealth creation in home equity or dot com stocks), that the positive/ or negative feedback loop actually changes the underlying fundamentals of the prevailing system. So in this way, the lending and housing practices of financial institutions were logical and rational within the context of the positive fundamentals. In reflexive markets, forces pursuing their individual interests, leads to ever more bullish or bearish disequilibrium. When a tipping point is finally reached, the rug is literally pulled out from all the participants feet as equilibrium (the exit) is suddenly and simultaneously sought by all participants in light of the new recognized fundamentals — i.e. the crush at the door as all try to exit the party at the same time. Since last summer, the banking system is now experiencing such a reversal.

But alas, these are the symptoms of the disease. The cause of the disease is the nature of the business relationships that our finance economy perpetuated. Namely, the root cause of the credit crisis was prevailing asymmetric risk relationships that existed and grew within the global finance economy.

Hedge Funds: the 2+20 Proposition

2 + 20 refers to the common hedge fund fee relationship. 2 is 2% annual management fee. 20 is the 20% performance fee that hedge funds pay the managers from the client’s return. While hedge fund managers only risking their start up capital, 100% of the risk of the investment strategy is being borne by the clients, but the clients only receive 80% of the profits. Its asymmetric risk, when performance fees are paid when the bets come in–but not penalized when the bets go south. The failed fund manager may lose his business entity, and tarnish his reputation, but he keeps his prior years’ fat profits. If I am a hedge fund manager, and for $250,000 in set up charges, I can launch a fund, from which I can make Tens of Millions in performance fees, there is little incentive not to take risk with client assets. When the hedge fund manager’s upside is 8 digits, and his downside is only 6 digits, how can you expect him to resist the temptation of taking extraordinary risk: particularly if the chance of that risk materializing before his next bonus is small?

John Meriwether, legendary trader from Solomon Brothers became notorious for losing a few billion at his hedge fund, Long-Term Capital in 1998. Yet, just 18 months after blowing up $3.5 billion in client money, Meriweather was on his “meri” way running a new $250 million fund.

High Net Worth clients should understand that many Hedge Fund managers are not betting with their own money. And even if they “have their own money invested beside yours”, remember, they probably don’t have the same rising profile as their clients. So the fact that they have their own funds invested in their fund should not provide so much comfort as is commonly thought. They are not carrying a commensurate amount of risk compared to the client. This is what I call an asymmetric business relationship, when the interests of the client’s capital and the motivations of the fund manager, are not aligned. This problem leads to managers leveraging their bets. It is leverage that led to a trillion dollar bust in banking and real estate.

As long as “2+20” hedge fund business models persist, there will be hedge funds that leverage capital. When the merry-go-round reverses, capital evaporates. For a different outcome, the structure of the business model of the participants must change. And that can only happen, when clients choose to not send their accumulated assets to “2+20” funds. Were the hedge fund structure “1+10”, my viewpoint would be significantly less vehement. The same argument and perspective applies to CEO compensation, but that’s a discussion for another day.

While Rome parties . . .
Or
It’s the Government, Stupid!

The deficit, taxes, the economy, the dollar, how are we going to pay for the $40 “trillion” in unfunded Liabilities? Well don’t worry, it’s Sunday, and while the Vandals may be stormin’ over the Alps, Rome…err, I mean Washington, is oblivious . . .

Don’t worry, be happy. Buy our “safe” gas guzzlers. “Don’t drill for oil”, “don’t do nuclear”, don’t stop the consumption parade, don’t stop buying, and “never, never run out of money.” It will all get paid for with cheaper money. Whose cheaper money? Why your’s, of course!

De-leveraging is the Dam that’s got that Genie corked up!

When’s the dam going to break? Despite energy and food inflation, rising inflation expectations have not become a problem, yet. Labor remains emasculated as The greatest dividend for capitalism from the Cold War victory was the emasculation of labor. In a low-inflation/deflating world, few workers (who were growing nest eggs like never before) complained. But in a spiking world of $5 gas and $5 bread, how long will it be before white collar and blue collar workers demand real wage increases so that they can fill up their respective tanks at the station? And, when that happens, won’t the genie have escaped the bottle? Remember the chart? In the 1970s, it took almost 8 years for interest rates to accelerate following a corresponding rise in inflation. When the “Have-Nots” begin demanding wage hikes, inflation will really rake off.

Can global wage competition keep this genie in the bottle? A lower standard of living is the fudge factor in this equation. As long as wages can not keep up with rising expenses, the standard of living for the average family will decline to make up the shortfall.

Presently, according to the spread difference in the Treasury Inflation Protected Securities (TIPS), the bond market is expecting just 2.5% inflation annually over the next decade. If that number rises due to the current pressure on “Have-Nots” to pay their bills, then the 1970s scenario is going to gain traction. If healthcare costs and higher education costs could rise at double digit rates for the last 20 years, can’t energy and food do the same?

Perhaps not. Rising health care costs are borne largely within the system. 45 million Americans couldn’t manage/afford to stay in that system, so they don’t have health care. While higher education costs, on the other hand, are borne largely by the most affluent part of the republic. Food and Energy are different than health care and education. 45 million people can not opt-out of using energy, or eating! Oil costs are borne by everyone in pretty equal degree.

In housing, people can choose to live in much more humble surroundings, thereby reducing their housing costs by a factor of two, or even three. They can’t reduce their food and energy costs by a factor of three. Food consumption isn’t going to decline.

However, Americans can reduce energy consumption by a factor of two with over a period of time. Germans live just as well as Americans, yet consume only 14 barrels of oil per capita, versus the United States’ 25 barrels of oil per capita, per year. Energy consumption can go down.

In Conclusion
As providers of wise counsel to our clients, we are darn concerned about how tough this environment is for the “Haves” and for the “Have-Nots”. Sometimes the best we can do is to break even, or lose just a little. This concept certainly applies to the current environment. The day will come again when asset values for the “Haves” will resume their natural long-term growth of 6% annually. Just don’t expect it to happen this year.

As for the “Have-Nots”, I’m not too sure when white or blue collar labor will get pricing power again. It’s doubtful that it will in my lifetime. Better to read the Great Books (Plato, Aristotle, Chaucer, Shakespeare, Goethe, Hayek) and focus on learning, thinking, and education, so that more of the “Have-Nots” can acquire the knowledge to get an edge up and climb into the “Haves” court. Labor’s day in the sun had its fleeting day in the sun, extended and harvested during the Cold War. That sun has set. Globalization has dealt a fatal blow to the middle class as those of us over 40 knew it.

Excellent investment counsel minimizes excessive fees and delivers wise counsel. Perhaps more importantly, the best investment counsel creates a safe environment in which clients can dream, think and share the hopes, fears, aspirations and doubts. Be discerning in your choices of who to work for, bank with, and invest in. Don’t just settle.

So what’s this mean for our portfolios? It means that equities have heavy headwinds and bonds offer plenty of downside with the occasional opportunity. As we circle the wagons, we continue to find value in pockets of the fixed income market, and gold. We believe that despite a dismal near term outlook, some sectors are attractively valued.

At Barnes Capital our approach is to protect and grow our client’s wealth with less portfolio risk while providing exceptional client service. This combination of benefits is uncommon amongst financial services companies.

Don’t touch your retirement account. Always be thinking about your future. Invest in yourself. You can’t mess around with a retirement account. You can’t do options in your IRA. Always invest. Never invest. Sacred Cows, Sacred Retirement?

Are you confused yet? You are not alone. There are so many advertising dollars bombarding consumers with “solutions” that few consumers can separate the wheat from the chaff. Financial Institutions’ spend more than $1.5 billion a year, marketing their services to consumers in the United States. That’s nearly $40 million a week of advertising dollars trying to catch your attention, tell you what to do–get your business and get your money. No wonder people are confused.

The bottom line is that if you don’t have an interest in finances and investments, all that advertising isn’t going to help you a bit. You will be a confused consumer just waiting to taken advantage of by some financial sales person whose hocking product for their employer. These hucksters aren’t bad people; they are only trying to put food on the table for their families. They are relying on those $40 million per week on advertising to get you in the door and get you to invest your savings through their product channel.

Customers of financial services firms can be poorly served in a variety of ways. The most common approach is to get you to buy mutual funds. This earns the salesman a one-time 3% commission on your invested money. The Financial Institution (FI) earns about 1% on your money, and you receive minimal service and limited expertise for your ongoing 1% mutual fund fee. The sales person has already pocketed your 3%; they are on to the next prospect.

The worst deal that most consumers can get is bad advice. Bad advice can ruin a retirement plan, and more importantly your financial security in your “sunset years”. Recently, we’ve heard some ghastly stories. More than one person we know transferred their retirement account to Pensco Trust, a custodial bank that allows investors to invest their retirement account in leveraged real estate. Consumers have the opportunity to invest directly in real estate with their retirement funds. While this is a good thing for knowledgeable investors, it can be a disaster for others. In a leveraged investment, you can lose ALL YOUR MONEY, quite easily, and we’ve known a few people who have.

We all know some of the things that can happen to people’s savings. A brother-in-law opens a Pizzeria, asks for $400k to get the restaurant off the ground. You oblige. A year later the restaurant closes its doors and you’ve lost your $400k.

Some of the most valuable advice the best advisors deliver is to serve as a patient ear and voice in helping clients sort out their choices and reach prudent decisions regarding their money.

In Conclusion
Excellent investment counsel minimizes excessive fees and delivers wise counsel. Be discerning in your choices of who to work bank and invest with.

Despite this tough up and down year, we’ve not found a lot of reasons to do anything significantly different. We have recently seen good value in some pockets of the fixed income market. Despite the high volatility in recent months, we’ve made few adjustments this year. We continue to manage our clients’ money in the less economic sensitive sectors, and we are still taking advantage of the once-in-a-lifetime opportunity in precious metals, while using solid dividend paying blue chip companies as our core equity holdings.

At Barnes Capital our approach is to protect and grow our client’s wealth with less portfolio risk while providing exceptional client service. This combination of benefits is uncommon amongst financial services companies.

What’s this? The lowest levels of consumer confidence in 70 years and the stock market is going higher? How can that be? Aren’t things now clear? Isn’t it obvious? The economy is getting worse. The real estate market mess looms ahead as a complete train wreck. The Dollar is dropping like a Peso. What is wrong with investors, don’t they see? The facade is finally broken. The finance economy is kaput. The end is nigh!

Last Monday (March 17th), JP Morgan purchasing Bear Stearns, an 85 year-old investment bank on brink of insolvency to stave off disaster. If Bear Stearns had ceased operating, the status of trillion’s of dollars of derivative contracts and clearing operations would have been unknown. Apocalyptic reverberations would have pushed the global financial system to the brink. Had Bear Stearns not been rescued, we could have had the market sell off 1000 points, maybe 2000.

Democracy would have suffered, as systemic risk would have run wild, and job losses would have been much higher, on Wall Street and on Main Street. Democracy (the public good) required that Capitalism act to save the system from implosion.

Capitalism versus Democracy = Creditors versus Debtors

You see, in monetary policy we see the political balance of the social compact. It is the balance between Capitalism and Democracy. Democracy is ruled by the law of 1 Person, 1 Vote; whereas under Capitalism, the law is: $1, 1 Vote. The arbitration of the peaceful coexistence of Capitalism and Democracy is the job of the Federal Reserve. The Federal Reserve orchestrated the JP Morgan takeover of Bear Stearns. And the Stock Market DID NOT TANK. Systemic collapse was avoided. What does that mean to us as investors?

Stock Market Talks – Is Anyone Listening
The stock market is prescient. It sees today’s bad news, and it foresees solutions that are going to make today’s bad news less bad tomorrow (or at least 6 months from now). In January, the market sank to new lows, (11,922 on the Dow Industrials). These lows did not represent phenomenal values in price. Stocks at their January 2008 lows were still pricey compared to the Armageddon witnessed in the stock markets of 1932, 1949, and 1974 and 1980 when great stocks paid 6% dividends. But the January lows were impressive and similar perhaps to other market lows in 1957, 1962, 1970, and 2002. It just may be that the market is seeing solutions that will make today’s bad news seem less bad tomorrow.

Technicians get fooled by massive inflection points less than the fundamentalists, because they are focused on the biggest picture, the price action of the aggregate knowledge of all investors. That price action is smarter than any one, or group of people. We think that there is a good chance that we will not crash through to lower levels in equities this year. Here’s why.

Since January 22nd, the market has experienced 9 trading days in which more than 90% of the trading was down (these are known by Lowry’s Research as “90%” down days). They represent panic selling. But last week we had our first 90% up day of the year. More impressive, despite 9 different panic selling days since January, the market averages are 4% to 10% higher than their January lows. The prescience of this price action indicates that the market may have already discounted most of the bad news of 2008. We may have already seen the lows.

Helicopter Ben
Let’s think for a minute why, and how, that may be. Last week, Federal Reserve Chairman Ben Bernanke rescued a bankrupt 85 year-old bank by utilizing little known emergency powers of the Fed which were put into place in 1932.

Bernanke is an expert in the Great Depression. He wrote dissertations and books on the subject. In 2002 when deflation was rearing its ugly head, he referred to Milton Friedman’s statement of using a “helicopter drop” to inject money into the economy to prevent deflation. The “Bernanke Put” has since come to be the implicit guarantee from the Fed that it would drop money from helicopters before it would allow a depression to take place here (in the U.S.) again. Helicopter Ben just isn’t going to let the deflationary forces of wage pressure and the mortgage massacre drag down the U.S. Economy.

Bernanke will sell the Dollar down the river, dump money into the system like a drunken sailor, securitize the bad debt of our commercial banks… but deflationary forces and bankruptcy are just not going to be granted seats at the table under his reign.

And that is what this stock market is seeing. It is seeing that an inflationary process calling the tune. And in an inflationary process, world-class companies (i.e. stocks) have pricing power and real value. This is why stocks might not go any lower than they did in January.

Who Pays for Inflation?
But Barnes, isn’t this a frontal attack on America’s fixed-income investors? Are you not saying that monetary inflation is high while interest rates are low? Who is going to pay for the reported $460 billion in credit losses in the commercial banks?

Folks, I hate to break it to you, but yes, the fixed income class, otherwise known as risk-adverse investments, is being sold down the river. As an asset class, fixed income has averaged. What does that mean? It means every bank account holder, every bond holder, every foreign investor buying our treasury debt, every buyer of Bank CD, loses.

But wait, don’t be surprised. It’s not uncommon at all. In fact, economically, and politically, we’ve seen this time and again.

What does Payment look like?
Payment can take many forms. However, in order for payment to be exacted, it must be disguised for public consumption. The time-proven disguise is inflation. Inflation defines our progressive democratic institutions, because inflation by definition is a tax on the asset owners (Capital).

Inflation is democratic. Inflation levels the field. Inflation is the political force that Democracy demands, to ensure a system that provides jobs, schools and public institutions to every person (Jedermann). Inflation is the payment is disguised as a tax. No one ever votes for a tax increase. But the social contract demands goods, services, and the public good. When the government can no longer tax people enough to pay for government services, they are forced to create money (i.e. inflate).

So who does Inflation hurt Barnes?
Inflation hits creditors hardest. Stocks and bonds both suffer in periods of higher inflation. However, we believe that the primary price of the inflation tax is going to be paid by the owners of the least risky investments, fixed-income securities.

Savers get Screwed
Fixed-income investors will be most harmed by today’s solutions being enacted by your inflationist Fed. So who are these fixed income investors you ask? It’s you!!! Your checking account, your savings account! It’s your Dad’s money at the local credit union, it’s your Grandma’s treasury bonds, your brother’s fixed annuity. It’s any investment guaranteeing a 5% return.

More than half of all wealth is held in the fixed income market, about $20 Trillion. High Net Worth families, those with millions of dollars of municipal bonds, and the Risk Adverse, those with low interest bearing bank accounts and insurance contracts, will be hurt the most by today’s solutions because the inflation that is being created will exceed the interest generated by low-risk investments. Currently, 10-year government bonds yield 3.5%, while 2-year notes yield 1.67%. If real inflation is 4%, then the real return of your bonds is -0.5% or -2.33% respectively. When you lose 2% every year, you fall more and more behind every year. Does this sound familiar?

The following Chart shows how the stock market (DIA) is beginning to outperform the bond market (AGG). You can see this by seeing how the DIA has broken above the 1.20 level. This shows the market discounting at work. The market is saying that stocks are cheap, relative to bonds. A floor seems to have been set in January. Whether that floor will hold, is another question, for the moment, it seems like it will.

Inflationist solutions should come as little surprise. By hitting creditors (the affluent and rich) hardest, inflation is by definition populist and democratic. The costs of maintaining the public good, of saving the system from collapse, are borne by those most able to absorb the hit. Today’s spending is paid for by incipient inflation tomorrow. Get ready. Oh, gas is already $4/gallon. I guess you don’t need to get ready, it’s already here.

The Social Compact
This transformation of communist economies into market economies imposed a similar dilemma to our situation today. In order for the new and developing social contract between capital and democracy to be honored, governments in the early 1990s in Czech Republic, Poland, Hungary, Russia, Ukraine and Romania, were forced to choose between supporting the retirees of the ex-communist state system, and investing in the infrastructure for a modern economy. The choice that they faced was analogous to the solution that caring parents make with their children: the welfare of the old, were sacrificed for the opportunities of the next generation.

Economic growth and transformation was achieved at the standard price: INFLATION. This is always the pattern. Creditors lose on the value of assets, or order for social compact between capital and democracy is upheld.

While retirees lived on fixed pensions in economies experiencing 10%, 20% oven 100% inflation, the ground was set for their grandchildren to be able to earn a living that could afford them better shelter, motored transportation, and discretionary income. The State governments in Poland, Hungary and Russia could simply not afford to pay a living wage to its pensioners while it was transitioning to a market economy in what was essentially a bankrupt state. They did indeed honor, for the most part their pension obligations, but due to rampant monetary inflation, the pensioners were lucky to be able to pay for a week’s groceries on their monthly pension checks. And to a lesser extent, so it will be today.

Inflation: The Fudge Factor that balances all Budgets for the Public Good.
Let me show you how the monetary policy of emerging democracies, and the monetary policy of Federal Reserve, is similar.

The Fed is creating inflation via low interest rates, higher inflation and a declining dollar. Today’s creditors (you, your Dad, Grandma and Brother): you are all underwriting and subsidizing today’s financial bailouts by accepting higher inflation in the years to come, and consequent lower returns on your low-risk investments.

This is not a bad trade-off. Those most able to pay, the creditors, who are the affluent, the retired, subsidize today’s spending, by accepting low and even negative real returns on their fixed income investments. It’s a small price to pay for actions which protect Main Street, jobs and the public good (salus publica).

In summary, the struggle between Democracy and Capital is always with us. So long as capital is willing to pay the price of lower returns in times of crisis, the system serves us well, the public good is preserved and the competing interests between debtors and creditors remain in balance, mostly.

If you would like to read more on the subject of the struggle and compact between Democracy and Capitalism, look at Paul McCulley’s archived letters including “In Democracy We Trust” August 2004, at www.pimco.com/LeftNav/ContentArchive/Default.htm

Barnes – What’s the Bottom Line?
The actions of the Fed this month, will go a long way to solving the systemic problems of 2008. The markets’ refusal to break to new lows indicates that the market sees a better future for equity securities. The price that will need to be borne to pay for the Fed’s solutions is unknowable. Perhaps a good guess is that real inflation will be 1% higher than it would have been. On a market of $20 Trillion in fixed-income assets, that amounts to a tax of perhaps 5%-10% over the next decade after accounting for discounting that cost over a 10 year time frame (1/2% x 10 years x 20 Trillion equals a total tax of $1 Trillion. Can see that through the obfuscation of monetary inflation, the government just taxed the more affluent constituents and every person with a bank account balance, an additional $1 Trillion to pay for today’s financial pickles? You know what they say, a $Trillion here and a $Trillion there and pretty soon you are talking about real money!

The bottom line is that monetary policy will lead to lower, possibly negative real-returns on low-risk investments over the next decade. It remains to be seen if higher risk investments will be equally damaged. But for now, it seems like the answer is a resounding ”No!” The stock market is confirming this conclusion through its reaction to current bad news. It’s speaking to us. It is saying that it sees the future, and the future is not worse that the present.

In Conclusion
We believe that capital preservation and growth strategies will fare significantly better than low-risk assets such as Certificates of Deposits & Government Bonds. The action of the markets bares this out. Today’s dividend yields on the world’s best run-corporations, while not at historic highs, are on very sound ground, many with dividend yields higher than the interest rates paid on 10-year or even 30 year government bonds. For example, General Electric pays a 3.4% dividend. That dividend is growing at 10%-12% a year. Meanwhile, many of today’s wealthiest, and the pension funds of the middle class, are invested in “safe” securities like the 10 year Treasury bond. These yield 3.5% interest. With real inflation in excess of 4%, you tell me who is going to lose over the long term, the equity investors or the debt holders?

We’ve made no new adjustments this year. We continue to manage our clients’ money in the less economic sensitive sectors and we are still taking advantage of the once-in-a-lifetime opportunity in precious metals, while using solid dividend paying blue chip companies as our core equity holdings.

As always, we appreciate any referrals by our network of colleagues, friends, and clients. Our approach is to protect and grow our client’s wealth with less portfolio risk than standard stocks and bonds. We are still accepting clients with portfolios under $250,000.

Gold’s going to $1000 this year: Maybe $2,000 in the next few years… Maybe higher. More importantly, Gold stocks are finally poised to really take advantage of these moves after years of retooling for growth – more on that later in the article. Let’s start at the beginning.

The Element
Gold- is unlike any other element. It is indestructible, imperishable, portable, identifiable and beautiful. The source of numerous fables and legends, Gold is the ultimate medium of exchange. Due to its unique properties, Gold is the universal, time honored standard of wealth, a “storehouse of value”. Civilizations have used Gold as currency and wealth since antiquity. Due to its physical properties, Gold backed most governmental issued currencies from antiquity until the 1970s.

Gold maintains its purchasing power over time. “With an ounce of gold a man could buy a fine suit of clothes in the times of Caesar, Shakespeare, Jefferson, the Great Depression and today.” No other good has maintained purchasing power over the ages.

Why is Gold likely to Rise more?
There is a great battle going on in the financial markets, to save the big banks who recently got into so much trouble holding bad mortgage paper. There is also a smaller battle to ensure price stability. In fact the fight for price stability was the last great war waged by the Fed. Ancient Gladiator Paul Volcker declared that war in 1979, and the Fed declared the war won a couple years back following Greenspan’s easy money of 1% Fed Funds from 2003-2005. Today, the Fed’s primary role to ensure price stability, is being sacrificed at the altar of its true mandate, to ensure the viability of the banking sector. The banks must be saved, come hell, high-water, inflation or all three. Banks drive the exchange of goods and services through our 15 trillion dollar economy. Their dysfunction would drive a dagger through the heart of that economy. It’s a dagger that in time, we could heal from, but it’s pain that neither the government – nor the politicians, neither Wall Street – nor Main Street – is willing to bear. The moral hazard of an inflationary economy has been permanently embedded in the cultural, fiscal and political landscape of our lives. There will be no resurrection of Mr. Volcker to save the dollar, nor the asset owners who will bear its cross in the coming storm.

Why is Gold $950 an Ounce?
So what’s the average investor to do you ask? Bear with me just a few more paragraphs.

Price stability is paramount, and persistent inflation is a highly progressive and stabile policy, if albeit, an activity in wealth destruction. But in a dysfunctioning banking and mortgage world, price stability is subservient to bank viability.

For the banks to be saved, the currency must be debased because the only way to save the banks is to liquefy the markets through the creation of credit and to achieve a stalemate in a housing market that has stopped imploding. While the tonic of easy money will be an elixir to bank balance sheets, it is a toxic potion for price stability and in-turn, currency stability.

Bottom line: the rescue of the banks is causing further erosion in the dollar. And that, my friends, is why Gold now trades at $950/ounce, and that is why is pretty darn likely to continue to advance. Gold, as a “storehouse of value” will continue to rise to offset the inflationary effects of the easy money credit policies. So Gold will, at a minimum, inflate. The market is seeing the hand it has been dealt, and market forces are acting in accordance with reality. If you would like to review the primary factors that drive demand for Gold take a look at Barnes Capital Insight #8 Gold is Timeless Money.

Since 2005 Gold has been rising against all major currencies, financial assets, and commodities. In fact, Gold has been rising against pretty much every asset classes since 2005. Let’s take a look at what Gold’s move against Blue Chip stocks, the Euro, Government Bonds, and the CRB Commodity Index has actually looked like.

This next chart shows how Gold has fared against the Dow Jones Industrials average since 2005. Remember, the bluest and most international stocks make up the Dow stocks (Coca-Cola, Caterpillar, Microsoft, Exxon, Johnson & Johnson, General Electric, Boeing, etc). They truly represent the performance of America’s largest and most international stocks. The fact that Gold is rising against them indicates that Gold’s strength is not at all just a U.S. phenomena. Gold has increased more than 85% more than the Dow in just over 3 years. Adding back dividends, the out performance is still more than 75%.

This is how Gold has fared against the US 10 year Treasury Note. It has more than doubled.

This is how Gold has fared against the Euro Currency since 2005. It has risen 93%.

Even against the CRB index, a broad basket of commodities including a great amount of Crude Oil, Gold has outperformed by 47% over the last 38 months. Something’s going on here folks.

So there you have it, that ancient barbaric relic has done okay. But really you are thinking, Barnes, haven’t we missed it? Why hold the pretty stuff? Let’s examine that question for a minute.

The Comfort of Gold
We own Gold for Wealth Preservation. It won’t always go up, but it will never go to zero. Gold offers investors an attractive opportunity to diversify, reduce risk and protect portfolio wealth. Gold is the insurance part of the portfolio because gold itself will always maintain value, no matter what disaster may happen. Gold may rocket up to thousands of dollars per ounce in the coming gold rally or it may struggle and fall lower, but it will always be worth something.

Owning physical gold in your own possession is like having fire insurance on your house. While most of us don’t expect a fire, we do know that things happen that are simply beyond our control. Gold in your portfolio is insurance on your accumulated savings and wealth. Since 2001 Gold has been in a powerful bull market following a 20 year bear market from 1980-2001. Do I have your attention yet? So you want to add some Gold exposure, now the question is: how?

Isn’t it the Wrong Time to Invest in Gold?
Good question. Maybe is the short answer. However, if you try to trade in and out of this large, long Gold bull market, you are unlikely to do well. Gold is making its move in its own sweet time, and to is own cadence. Gold and Gold stocks could easily correct 10% and 30% respectively. But if you try to trade in and out of them, you really are unlikely to do well. You will buy high, sell low, and then the train will leave the station without you. It’s really that simple.

How do I invest in Gold?
Answer: you could buy gold itself from a Dealer in your locality, buy gold stocks, or buy gold derivatives such as the Exchange Traded funds such as GLD, the Gold-Trust closed-fund or mutual funds. You can also subscribe to gold newsletters and follow their suggestions or put your money with a mutual fund. There are problems and advantages in each option, not the least that is the transaction cost or ongoing fees.

Time to Buy Gold Stocks
Currently, we believe that Gold stocks are finally poised to move much higher now that the retooling of the industry has largely been accomplished. David Galland at Casey Research (www.caseyresearch.com), one of the better Gold Newsletter’s has recently written a very good article about this. In 6 years, Gold has risen from $277 on January 4th, 2002 to $950 this week. Meanwhile the S&P rose 22% in over the same period. Since Gold stocks have leverage, a $10 increase in the price of Gold can translate into increased earnings of 5% or more. Gold stocks should outperform gold bullion because they are much more risky that the mineral itself.

And in fact, Gold stocks are indeed up 625% from January 2002. However, they have not outpaced Gold Bullion at all in the last 6 months, as bullion rose 42%, but the stocks just 37%. Galland believes that’s about to change in a big way. Here’s why:

Gold companies were run in survival mode for most of the late 1980s and all of the 1990’s and into this decade. It wasn’t until the last few years that the yoke of survival-thinking and perpetual cost-cutting was taken off. Gold companies have needed to retool for growth and rising profitability, and this has led to abysmal operating results in 2004, 2005, 2006 and 2007 at many Gold producing companies. That work is largely behind them now, and Gold stocks are likely to begin to outpace the change in the price of gold to the tune of 2:1, 3:1 or more for the next up legs of this bull market.

How Can Barnes Capital help?
We view Gold as a strategic asset class. And even though we anchor virtually every portfolio with dividend paying Blue Chip stocks that increase their dividend every year, we also diversify our clients’ portfolios with positions in Gold and when appropriate – Gold stocks.

Few Advisors do this. It’s still early in this big, long, powerful trend, in which the banks and the Fed are your friends.

For 2008 we are bearish on stocks and bonds. We think housing and credit issues, combined with slowing global growth, higher inflation, and rising unemployment will make for a very tough year on investors. Our response to this will be contrarian protection of our client’s assets. We are selectively picking plain vanilla stocks that pay solid growing dividends. Barnes Capital continues to build portfolios to match market returns with less risk using a variety of standard and alternative assets.

In 2007 we achieved double the return of the S&P 500 for every one of our clients. Favor shone upon our client’s portfolios as our investments played out over the year. Our 2007 predictions were on target (see recap at bottom of article in the postscript). Let’s see what 2008 may have in store for us all . . .

Predictions for 2008
Likely to Occur

Prediction 1:
Gold will keep rising, breaking $1000 in the first half of the year, and $1100/oz. by year-end. Gold is real money. The world is gradually rediscovering this now. There is little reason to think their enlightenment will suddenly abate.

Prediction 2:
Slowing global growth and consumer prudence and frugality, particularly in driving patterns will moderate Crude oil’s hyperbolic ascent. Crude will be range bound in the $80-$110 area, but Energy stocks will continue to outperform the market.

Prediction 3:
The Democratic nomination. Once again, political pundits will lament the days of brokered conventions as Clinton will win enough of the delegates on Super Super Tuesday (February 5th) and coast to the Democratic presidential nomination. The market won’t react well to a surging Clinton candidacy. But it will also not be reacting well to other events such as the housing fall-out and the bear market.

Prediction 4:
The Republican nomination will remain wide open through the spring, sparking questions of the party’s absence of leadership and direction. Democrats will seem unbeatable for most of the winter and spring.

Prediction 5:
Bush’s Presidency will accomplish little in its final year, which is in keeping with most final presidential years. The market will have little reason to wax optimistically as the uncertainty of politics and future policy gives portfolio and corporate managers much to worry about.

Unlikely to Occur – but it wouldn’t surprise us if . . .

Prediction 6:
Housing prices collapse in the summer in California and Florida, driving worries of a full blown recession. Finger pointing will abound and the stock market will quiver with violent swings through the political conventions. Home sales prices will fall an additional 10-15% in the spring and summer in the overbuilt areas of Florida and California while Countrywide, Washington Mutual and at least one more major bank seeks governmental help to remain solvent. This will mark one of the first bottoms in the year’s short and vicious bear market. Housing prices will stop falling nationwide in spring 2009 but will continue down in Florida and parts of California in the most overbuilt areas like Miami, Modesto, Sacramento and Las Vegas.

Prediction 7:
The acceptance of Global Warming will continue to grow, while Ethanol politics (taking the pledge) will be publicly blamed for driving up the cost of agricultural food stuffs across the nation and the world by the end of the year. The last effort of the Bush presidency will be to back renewable energy legislation. Alas, this attempt will die a pitiful death in the fall sessions of Congress.

Prediction 8:
The Bond Market will hit new highs and then fall off the cliff in the summer. Following a six week decline in the Dow from 12,000 to 10,000 in the spring, the Dow will dip below 10,000 intraday. Meanwhile the 10-year note will touch 3.25% in the same week and then the wheels will fall off the Fixed-Income apple cart.
Following a year of “flight to safety” in the longer dated bonds, foreigners will look at the stalled supertanker economy, the surging Democratic Party, and higher inflation numbers and suspend their purchases of U.S. Long-Term Government Bonds. Long-term government bond yields will rise from 3.25% to over 5% by October. Inflation reports of 5% inflation will serve to confirm the drop in bonds and the media will discuss the similarities to the 1970s.

Prediction 9:
With significant losses in equities, bonds and real estate, a bear market selling climax will occur in the late summer, but due to higher volatility, headlining bad news, and inflation, few will identify the July low’s and the August retest and the November collapse, to be triple bottom of the 2008 bear market. That will change after the Dow rallies 3000 points in early December and January ‘09 following the confirmation of President Bloomberg.

Prediction 10:
The Presidential Election: With the Grand Old Party in disarray and patrician John McCain trying to build the base for a national campaign, Mayor Mike Bloomberg enters the Presidential Election as a Republican Candidate. Bloomberg looks presidential, is a billionaire, and has an impeccable record. Despite his lack of organization in more than 20 states, Bloomberg gains enough delegates to go to the Republican Convention. With the delegates being split between McCain, Romney, Bloomberg and Huckabee, Bloomberg emerges as the strongest candidate to defeat Senator Clinton. In a historic showdown of a political outsider versus the most established former 1st Lady, the Election shapes up as a titanic duel of two New Yorkers, a Jew versus a Woman. The fall campaign is fascinating and the election night is a nail biter, but in keeping with tradition, the Senator loses. Bloomberg emerges on top, carrying 300 electoral votes and 48% of the popular vote. Once again, in the key battleground states of Florida and Ohio (which Bloomberg wins), there are complaints of voting irregularities voiced by the Democrats. With the urging of her husband, Clinton refuses to concede the election and the country is once again thrown into Constitutional turmoil at a time when the economy is weak. The markets collapse for the last 3 weeks of November while this goes on, then rally spectacularly in December following confirmation of the election results selecting a Republican president.

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In Conclusion
We think we have our work cut out for us this year. It’s likely to be a very tough year on client portfolios and their managers. We continue to manage our clients’ money in the less growth sensitive areas and we are taking advantage of the once-in-a-lifetime opportunity in precious metals, while using solid citizen dividend paying blue chip companies as our core equity holdings.

As always, we appreciate any referrals by our network of colleagues, friends, and clients. Our approach is to protect and grow our client’s wealth with less portfolio risk than standard stocks and bonds. We are still accepting clients with portfolios under $250,000.
Have a terrific New Year.

Blessings,

Daniel A. Barnes, CFA
Barnes Capital
Lafayette, California January 9, 2008

About Barnes Capital
Barnes Capital builds and protects wealth for individuals, families and business owners.

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PS: For those of you who would like to review our 2007 predictions and the 2007 Year in Review, keep reading . . .

2007 Review:
We turned more bullish in Issue #11 (January 23, 2007). But even our new bullishness couldn’t keep pace with a market that ignored all bad news. It was as though God himself choose to levitate concerns away. It didn’t even seem to matter that California and Florida and many other areas were choking on an oversupply of homes, and the housing crash was beginning in earnest. It’s funny, even though the stock market is the best forecaster around, Mr. Market doesn’t always wake up on schedule. The inflow of global profits, savings and recycled petrodollars trumped all of our in-house domestic economy concerns until the credit markets began to seize in late July.

The market wobbled through the remainder of the year falling about 6% from its July high’s. For the year, the S&P 500 gained about 4% and added another 2% in dividends. The Dow faired better with a total return of 7% plus 2.2% in dividends. The Dow’s overall strength reflected the strong exports that the weak dollar has brought about as American companies like Coca Cola, Caterpillar and Proctor and Gamble flourished in the weak dollar environment. So how did those 2007 Barnes Capital predictions work out? (See them in Issue #10)
Let’s take a look:

Prediction 1:
We predicted that ETF’s would flourish and multiply. This they indeed have done, growing from a few hundred to more than 600. This was a lay-up prediction, we’ll raise the bar this year.
Score 1/1

Prediction 2:
We said that news of Chinese and Indian growth would send commodity prices reeling more than during the year, but that later restatements would show that double digit Asian growth isn’t ready to abate just yet… The commodity prices were slammed at least 3 times in the year, but overall were up substantially, as oil rose 60%, gold more than 30%, and Agricultural prices more than 20%. The whole Asian subcontinent seems likely to experience rising living standards. This in turn supports commodity prices by increasing demand in metals, foods and industrial materials. We believe that betting against commodities continues to be akin to betting against Asian growth.
Score 2/2

Prediction 3:
We said that the U.S. Economy would slip into a mild recession in summer ’07. Well the housing crunch and credit crunch certainly took an axe to growth around mid-summer, but we underestimated the resilient strength of other parts of the economy, particularly, the strong ties that accelerating global growth has to maintaining the U.S. economy. In this global world, it’s hard to fall off the cliff, if your partners are all doing well. While we got the timing on the big picture slowing right our thoughts that the Federal Reserve would see the coming storm, and act in time, were way off. Bernanke is playing Dr. Dad, and he seems to be repealing, for the time being, the law of Keynesian Economics.
Score it a miss, 2 for 3

Prediction 4:
We said that Crude Oil would tread water between $53 and $70, but Energy stocks would post 10-20% gains. We kind of nailed this. While we underestimated the strength of demand to drive oil prices over the $70 mark and (finishing at $99), we correctly estimated the strength and value in oil stocks. These posted solid gains, as steadily moving higher all year to post 20%-30% gains for the year.
Score 3 out of 4

Prediction 5:
We said that volatility will return to the markets and investors will again need to get used to 1%-2% daily price swings. Outcome: This happened. Until summer, volatility was very low, but beginning in late July, the market reacted violently with more than 1% price moves several dozen times.
Score 4 out of 5

We titled our predictions in two categories, “likely to occur” and “unlikely to occur”.
The next five we admitted were unlikely to occur. Let’s see if any of them happened.

Prediction 6:
We said that Hillary will decide not to run. We were WRONG.
Score 4 out of 6

Prediction 7:
We said Gold will tread water for the first six months, and then break $800-$1000 in the 2nd half. We were RIGHT. Gold flitted between 600 and 700 in the first half before moving to $840 by year end (and finally breaking its all-time high on January 2nd of ’08). In retrospect, we don’t know why we put this in the “unlikely to occur” category, as we were confident that this would happen, and we positioned client accounts accordingly. I suppose it was the loneliness of contrary thinking that had us hedging our prediction with the “unlikely” sticker.
Score 5 out of 7

Prediction 8:
We said that the Presidential Candidates will delay entry to conserve cash, and wait to see what Clinton, Obama and McCain will do. But we also predicted those governors would enter the race and upset their apple carts. Outcome: We got this partly right. Huckabee certainly has upset the Republican apple cart, but Bloomberg doesn’t seem to be running, and he wasn’t delaying announcing due to money issues. It’s an exciting event as today the Iowa caucus kicks off.
Score 5.5 out of 8

Prediction 9:
We weighed in on Consumer Technology, saying that Consumers would not use PC Televisions, that Skype would fail, and that hosted software will accelerate and some cool new things will gain traction. We scored here. PC Televisions clearly haven’t taken off, Skype is a bust, and some other cool things are happening. Going forward however, we will refrain from tech/consumer predictions. It’s not our forte’.
Score 6.5 out of 9

Prediction 10:
We said that King Google will stumble a bit, but not enough for Yahoo’s sake. Well let’s see, Google’s stock rose 50%, while Yahoo lost nearly 7%. Guess we got this half right, as Yahoo indeed became increasingly marginalized. However, we missed the 100% gain Apple Computer and Google didn’t exactly stumble, so it’s hard to take much credit.
Score 7 out of 10

2007 will be tough to top
~db

About Barnes Capital
Barnes Capital builds and protects wealth for individuals, families and business owners.

Another Interview with Joe on-the-Street.

Barnes Capital: Last month Joe-on-the-Street asked us about inflation and how to protect himself in inflationary times. But since that last letter, the credit crunch returned, sending stocks down, down, down, as Countrywide, Citibank and E-trade solvency issues were raised.

The decline in property values in the U.S. and in other countries is exerting high deflationary pressures on the economy. We caught up this week with Joe-on-the-Street who didn’t understand how last month we could be talking about inflation and this month about deflation.

Joe on-the-Street: Where should I put my money? Stocks, CD’s, Real Estate?

Barnes Capital (BC): You asked us that last time.

Joe on-the-Street: Yes. So in the last Issue of Barnes Capital Insight you said prices are rising and stocks will rise too. Did everything change in one month?

BC: We did. You’re right. No, everything didn’t change. But what did change was that the perception that the Federal Reserve would lower interest rates right away to re-inflate the bad loans on the balance sheets of commercial banks didn’t happen.

Joe on-the-Street: What do you mean, it didn’t happen. Didn’t the Fed see the unemployment in housing, the resets of loans, the ten’s of thousands of foreclosures in California and Florida?

BC: Yes Joe, the Fed saw all that and more. But they also see Oil at $90, Bread and $3/loaf and rising commodity prices across the board. The Fed doesn’t to help the inflationary pressures by dropping rates until the absolutely positively are forced to do so.

Joe on-the-Street: So they will drop rates next week.

BC: It’s likely Joe, very likely. But this isn’t your Dad’s Easy Al Greenspan Federal Reserve, no not at all. This is the Big Bad Ben Fed and his Board of chatty Governors who have recently converted their thinking to moral hazard doctrines.

Joe on-the-Street: Barnes, you lost me.

BC: Ben Bernanke has to play it both ways. He’s the guy who gave the helicopter speech in 2002. That was the last time the jaws of deflation were snapping at the U.S. economy. He said if the Fed had to “they could drop money from helicopters, because they have a printing press.”

Look Joe, Bernanke wrote his doctorate on deflation in the Depression Era. He knows what he doesn’t want. But at the same time, he see’s his job as keeping policy as tight as conceivably possible, bringing the U.S. economy to the precipice edges of deflation, like Johnny Stockton around a Karl Malone pick, before he cuts rates to re-inflate at the last possible second. It’s like a game of chicken.

But as our venerable ex-chairman Mr. Greenspan said, Central bank management this isn’t a perfect science. So asset classes are adjusting, the market is adjusting, because it freaked out when it seemed that Fannie Mae, or Washington Mutual, or Countrywide, could become insolvent if the Fed doesn’t act. Of course that was last week. This week these fears have been, for the time being, brushed aside.

The other thing is, the Fed doesn’t want to cut rates, because inflation has been rising, not falling, in a lot of the data that they look at. And there is another issue. Easy Al conditioned the market to expect rate cuts. Better Ben would like to remove the so called “Greenspan Put” from the markets because the put has made it so that it always paid market investors to take more risk that they should, because they knew that Easy Al would bale them out when times got tough. Ben’s seems to be trying to prove that he is no Easy Al. And he’s going to play hard ball aka Paul Volcker, for just a little while longer.

Joe on-the-Street: Umm, okay, so what does this mean to my stock portfolio?

BC: It means that only a little has changed, and we should make some modest changes, depending on how you were previously allocated. We should use the opportunity of this week’s rally to increase your cash positions above 10%, possibly above 20% depending on your situation. It means that we might be in a recession, and some of our favorite stocks may go on sale, and we need cash to buy them in the year ahead. It means that if you own non-dividend paying stocks, or speculations, you better do a gut check if you are ready to ride them down, if a bear market takes hold like it seems it might. Because if we are in a bear market, it will probably last for another 12-24 months, and that will seem like a long, long time, if you aren’t in quality companies with solid dividends. But a last thought, we don’t actually know what is going to happen, and trying to out guess the market with all your money is a fools game. So we keep mostly invested, with some cash on the side. But the investments we hold are the core dividend stocks that carry less risk.

Joe on-the-Street: But what about gold?

BC: Gold is like insurance. And it’s in a primary bull market, so yes, most people should also have some gold, perhaps some gold stocks and some energy companies.

Joe on-the-Street: So the bottom line is that you just get a bit more conservative, in case the Big Bad Ben Fed continues to play hard ball, sending the whole shebang down the poop-shoot (like Paul Volcker in 1980 and 1982) is that right?

BC: You got it.

Joe on-the-Street: What about those bank stocks, should I own them.

BC: You have to Joe. Because if Ben does come back to the flock and lower rates like he might (some say ought) to do, then those stocks will shoot up faster than Old Faithful and you will be, as Heidi Klum likes to say in the only reality show worthwhile– “Out!”

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Joe on-the-Street: Why is the government now thinking about using my money to bail out the sub prime borrowers who shouldn’t have been buying homes to begin with?

BC: Do you mean “Hillary’s” new plan? Boy Joe, for a guy on the street, you sure do keep up with the word-on-the-street. Hillary’s/Paulson plan is to prevent further harm to the economy to cap the problems using your hard earned tax dollars. It’s not pretty, but besides the ballot box, I suppose your only option is to write to your congressional representation.

Summary

Last month we said the last four months have been more volatile. Well volatility increased even more these last five weeks. The professionals are horribly frustrated by it all, because it has been very easy to be wrong. We continue to stick to our knitting, raising a bit more cash, and looking for good values in shareholder friendly enterprises with great businesses.

We believe the likelihood of a recession continues to grow, but that in the long run are stocks are positioned to grow their dividends through both good and bad markets.

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Have a very Merry Holiday Season. And Happy St. Nicholas Day today! Latter this month we will unveil our 10 Predictions for 2008 and review Barnes Capital’s 2007 predictions from Issue #10.

Daniel A. Barnes, CFA
Barnes Capital
Lafayette, California December 6, 2007

About Barnes Capital
Barnes Capital builds and protects wealth for individuals, families and business owners.

An interview with Joe on-the-Street.

Barnes Capital: Stocks were recently at all time highs. Most commodities are at all-time highs. Oil was over $90/barrel last week. Van Gogh paintings are selling for $10-$50 Million. Now Real Estate has busted, down 20%, but that’s after its 10-year sprint that created more wealth for more Americans than any other society has ever known. Joe on-the-Street: on the well heeled street want’s to know: Where should I save and invest my money?

Joe on-the-Street: Where should I put my money? Stocks, CD’s, Real Estate?

Barnes Capital (BC): Stocks are near all time highs?

Joe on-the-Street: Yes.

BC: What about your other costs? Are they at all time highs?

Joe on-the-Street: Why yes, most of them are.

BC: Gas?

Joe on-the-Street: Yes, it’s $3.50 a gallon.

BC: Dog Food?

Joe on-the-Street: No idea, it’s like $40 a bag.

BC: Food? Milk? Bread?

Joe on-the-Street: Hmm, my average Costco receipt has climbed $100.

BC: Plumbing?

Joe on-the-Street: What?

BC: How much did your recent plumbing repairs cost?

Joe on-the-Street: Well, let’s see, last summer we had all the faucets replaced, 4 faucets total, for $850. You see we got a discount off the regular price of $250 a faucet.

BC: Did that include the faucet.

Joe on-the-Street: No, just the install.

BC: Movies?

Joe on-the-Street: We went last Saturday with the kids, 4 tickets with hot dogs and popcorn ran $74.00

BC: Do you see the problem? Your costs are skyrocketing! We haven’t even talked about the other two killers: Health Care and Education costs. The point is, as the price of everything is going up, so will stocks. Inflation is running, depending on the authority, at something between 5% and 10% annually. I am not an economist, I won’t measure all the data, but just take a second to think about the recent increases in prices that you yourself have witnessed. A piece of redwood lumbar costs $40 bucks at the lumbar yard.”

Let’s Look at more examples:
Other examples A gallon of

If the cost of most goods and services is going up, then all else being equal, the fractional ownership in corporate America ought to be rising to the same degree.
If inflation is running 10%, then stocks can climb 10%, without actually getting more expensive.

However, historically there is a correlation between rising inflation and stumbling stock prices. That’s a concern. Historically, stocks have traded down in periods of rising inflation (think the 1970s); because the stock is discounted by expected value of future cash flow. If inflation is high, than the value of future cash flow is lower because each new dollar isn’t worth as much. Think of it, a dollar in 1977 bought you a matinee movie ticket; today it only buys you 1/6th of a movie ticket.

Why? Because of inflation, so a company that is producing a dollar in 2007 of earnings per share is probably worth 6x as much as a company that produces $1 of EPS in thirty years from now.

Joe on-the-Street: “But if stocks across the world are outperforming, in a period of rising inflationary pressures, what gives? And it seems this weeks events indicate there is actually a lot of deflationary pressures from the housing bust.

BC: That’s what makes it tricky, we’ve got contradictions. Let’s explore one of the reasons for the contradictions.

BC: Let’s say you are an oil sheik. Your CFO reports that you will have $400 million in cash in the next 3 months after all taxes and capital projects and expenses have been paid.
“What do you do with the money?”

Joe on-the-Street: Put it in the bank?

BC: What Bank, you’re in Iran, do you want it in the local banks there?

Joe on-the-Street: I guess not, the government might nationalize them.

BC: Right. What currency do you want that money in?

Joe on-the-Street: I’m not sure, why don’t you just run through a bunch of my options if I am this Oil Sheik with an extra $400 million.

BC: Okay, great idea, let’s do just that:

Question: What does one do with an extra 400 Million?

10 Options

Option 1: Put it in a bank, lend it to other corporations.
This strategy will earn about 5-6% annually, with low risk. The problem is that if inflation really is 10%, a 6% return is actually a -4% real return. And if the currency you put it in declines, you’re your real return is even less. Since 2002 the US Dollar has depreciated an average of 4% every year against the world currency market. Remember Insight #14 Staying even . . . it isn’t easy.

Option 2: Put it in US Government Bonds.
Short-term, this strategy is the lowest risk. Expected returns of 4-5%. But Government bonds are subject to interest rate risk (rising interest rates because bond prices to go down. And the dollar can go down too.

On the flip side, buying government bonds and helps keep U.S. interest rates lower. By buying US Bonds, our Sheik is indirectly adding purchasing power and demand to his U.S. consumers, by helping to ensure higher demand for oil, and higher prices (and hence higher future cash flow to his oil operations). This is the rationale behind China’s massive purchases of US. Government Bonds.

Option 3: Get fancy.
Hire a couple investment consultants to find the best Hedge Fund managers. Pay those hedge funds a 2% annual fee, plus 20% of your investment return as a bonus. Expected return: “Who knows”, probably 12% less fees, so about 8-9% net return. Risk Level: higher than bonds, with maybe more, maybe less, uncertainty compared to stocks.

Option 4: Buy the world’s best companies.
(In other words: “Buy Stocks”) As a fractional owner of these companies, particularly US multi-national firms, your investments participate in global growth, there is no danger of civil unrest, seizure of your property. The managements generally are competent, and the barriers to entry for many of these companies, are the strongest in the world (procter & gamble, Citibank, Caterpillar, Johnson & Johnson, American Express, United Technologies, What’s more, these companies are enjoying good pricing pressure, and there is a lot more money out there facing the same situation, where to put the excess cash flow…

Joe on-the-Street: So what other alternatives does our Sheik have?

Option 5: Buy Gold
Downside: it pays no interest or dividend.
Upside: Gold is considered real wealth. It can’t be depreciated away like a paper currency, because there is no gold-mine that can be run like the treasury printing presses can. Since you can’t create Gold out of thin air, and nobody found a way to make alchemy work, Gold should maintain it’s value over time, through inflation, deflation, war, recession etc.

Option 6: Buy Local Stocks
Downside: your in the Middle East, the local companies are not-trustworthy, and the governments aren’t to be completely trusted either.

Option 7: Local Bonds
Downside: see local stock issues, plus interest rate risk

Option 8: Real Estate
Upside: this is usually good over the long term, but maintenance and upkeep costs can be high. And if it is raw land, that is non-interest rate bearing, and suspectible to legal and other liabilities.

Option 9: Expand your business:
Buy other operating companies,
Downside: this is a lot of work, with all kinds of operational risks.

Option 10: Buy Large Cap stocks
These entities are durable, returns over time should average return on equity of the entities, which provides for an inflation/interest rate hedge. Rising asset values stabilize the status quo, provide increasing leverage for a finance-based economy, and pay a 2-4% yield in many cases.

Joe on-the-Street: So what should I do?

BC: Invest a portion of your income every month. Work with an Investment Advisor who thinks outside the box, and is not compensated by commissions, but rather by a percentage of Assets. Compound your savings, reduce your debt, max-out your Roth IRA contributions, and don’t worry.

Summary
The last 4 months have been more volatile. But the long term trends that we have identified through out the year are playing out. Looking forward we expect equities to continue to climb a wall of worry. We are focused on good dividend payers and we continue to believe that diversified portfolios should include commodity and precious metals exposure. We continue to believe that fixed income securities are priced for very modest returns. We do however like the medium maturity municipal bonds for high net worth client portfolios due to their relatively high after tax returns.

The likelihood of a recession has grown in recent months, but we still believe that with Fed interest rate cuts, a real recession will be avoided, inflation will continue, and diversified clients with tangible assets and shareholder friendly dividend large cap stocks will be rewarded with real increases in wealth over the next few years.

Enjoying the Autumn air,
Daniel A. Barnes, CFA

Blocking and Tackling
It is amazing how much good a financial adviser can do by simply coaxing clients to streamline their financial affairs and diligently contribute to their investment accounts every month and year. That’s the stuff that makes million dollar accounts by retirement age.

At Barnes Capital we believe that financial planning is an integrated set of tasks that are a part of the Investment Management process. In this newsletter we often talk more about the asset allocation and our market outlook than we do details of financial planning. That is because we passionately work to understand the fascinating currents of the economy. In so doing, we believe we are better able to build client wealth through solid returns.

However, we know that the big picture is always about the fundamentals. For most families, getting ahead and building their net worth is a function of time and contributions, analogous to football’s blocking and tackling. Successful blocking in investments is making regular investment contributions. Without regular contributions, the accounts just won’t grow as they must.
Successful tackling in investments is time. With enough time, all investors would be millionaires due to the magic of compound interest. But time is finite for all of us. The sooner you make that contribution the better: PERIOD.

That said, at Barnes Capital, we don’t neglect the basics, and the basics are about diligently setting up and funding accounts. If our clients don’t sock away money into their investment accounts on a regular matter, for most of them great returns won’t matter, they will have lost the power and the magic of the 8th wonder of the world, the magic of compounding interest.

The 8th Wonder of the World
Perhaps it’s instructive to think back to your 20s. Some of you certainly made some decent amounts of money, but fewer of you invested it. It’s fair to say that most of you did not. A year or so ago, we discussed an amazing chart, showing the story of two twins: John and Jane.

Jane invests $5,000 a year for 10 years into her IRA from age 22 to 31. Then she becomes a homemaker and never invests in her IRA again. Her twin brother John travels the world, goes to graduate school, and takes a job in an expensive city. He doesn’t start investing in his IRA until age 32. He invests for 34 years, a total of $170,000.

At age 65, Jane’s $50,000 in investment contributions compounding at 8% annually grow to $1,071,000, an increase of 21x. Her brother John’s $170,000 investment contribution compounding at the same 8% rate increases less than 5x to $856,000.

Investment net performance after all fees and expenses clearly matters in the long term.

If Jane’s account compounds at 10% annually, instead of 8%, then the account value at age 65 will rise to $2.239 Million. An account invested in CD’s or bonds yielding just 5% would only grow to $346 Thousand.

Summary
As Investment Advisors, our job to help client execute on their blocking and tackling as early as possible. Ultimately, this diligence and execution on the investing fundamentals is more important than anything else, including any ability to deliver market beating returns. However, market beating returns can definitely help, as the above table clearly shows that there is a whale of a difference between an account which compounds at 8% ($1.07 million) versus an account compounding at 10% ($2.24 million), an improvement of 110%.

2007 Third Quarter Review
Wow, what a quarter it was. July got off to a blistering start for the first 3 weeks as the markets 5% and our client accounts gained nearly 10%. Then the Credit Crunch Crisis settled in, and the markets traded violently for 5 weeks, with a crescendo on August 16th. From that point the markets recovered steadily, and closed this the quarter 1% from their highs on the year.

The current market is becoming an increasingly narrow market. It is very reminiscent of 1996/1997. Small and mid-cap stocks are lagging, and the great international brands are doing best, together with Oil, Agriculture and Minerals stocks.

Looking forward we expect large capitalization equities to continue to do well. We are focused on good dividend payers and we continue to believe that diversified portfolios should include commodity and precious metals exposure.

We continue to believe that fixed income securities are priced for overly modest returns. We do however like the medium maturity municipal bonds for high net worth client portfolios focused on capital preservation due to their relatively high after-tax returns.

Blessings,

Daniel A. Barnes, CFA

We would like to thank all for the exuberant encouragement we received from the last issue. Due to overwhelming demand, Cheech and Chong have agreed to return this week to teach us a few things about risk, getting rich, and what’s a CDO anyway.

Risk. Risk is a great English word. It can mean a lot of different things to different people. And it, like many other words in the English language, is a flexible word.

Cheech: “Hey Dude, like, what’s with the market?”

Chong: “Cheech, you already know the basics. A bunch of smart rich people, did what they always do.”

Cheech: “What’s that?”

Chong: “By taking risk with other people’s money.” The great American housing boom was exactly that. In 2005 and 2006 14 million people, many with mediocre incomes, were buying houses, using the banks money to do so. But the banks didn’t keep those loans. They sold them to structured product specialists, who then packaged them into loan portfolios that were supposed accurately rated by the ratings agencies. But then what happened, is the ratings agencies did a piss-poor job rating the holdings in these portfolios of mortgages. Them gave some of the Collateralized Debt Obligations (CDO’s) AAA-ratings when they were filled with subprime-mortgages.

Cheech: “You mean those folks making $15 bucks an hour that drive in from Modesto were classified as AAA-rated borrowers!”

Chong: “You got it Cheech”.

Cheech: “But the Fed helped out these banks didn’t they Chong, last Friday before last?”

Chong: “The Fed did step in Cheech, hit the shorts square between the eyes to inflict maximum pain. But that’s history, Cheech, yesterday’s news.”

Cheech: “So what’s today mean Chong?”

Chong: “More of the same issues Cheech, issues that won’t go away for another year or two, the real estate mess of mortgage resets on variable loans that were issued between 2003 and 2006. In the first 6 months of 2008 more than ∏ Trillion of mortgage debt will reset, and when that happens a lot of people may be giving their keys back to the mortgage servicers.”

Cheech: “Isn’t Countrywide Financial a mortgage servicer?”

Chong: “Yes they are Cheech.”

Cheech: “But Chong, is it really such a big deal, I mean, The Dow is still up 5% for the year, and it has also paid out 1.4% in dividends on top of that, year-to-date. If things are really so bad, wouldn’t the market be doing worse?

Chong: “Exactly, Cheech, you amaze me, the noise and smoke and fog and mirrors, it’s worse than T-J in ’73 and you still see the big picture…Milton should see you now!”

Cheech: “Dude, I just mean, like, my Uncle gave me some Coca-Cola stock a while back, and it’s up like $5 bucks this year, and I also have some Caterpillar stock, and it’s up over 20% this year. So I don’t get it, if the housing picture is such a mess, why doesn’t it seem worse in the market?”

Chong: “Where do I start Cheech” You’ve hit 3 nails on the head with two stocks. First, people don’t buy less Coke when their mortgage payment goes up. Also, Coke sells like a gazillion gallons a year to India, China, Brazil and Bali. What’s more, Coke sells them for other currencies. In the current falling dollar environment, that meets their profits are even larger when those currencies are repatriated into US dollars.”

Cheech: “But don’t those academic wonks always say that NO ONE is smarter than the market Chong? And the market is saying, like, “We’ll get through this.”

Chong: “One thing at a time Cheech.” “Let’s cut to the chase: As you’ve already alluded, the market is looking ahead, and it sees salvation in ’08, not despair.”

Cheech: “You mean it sees short-term rates going lower, so all those people with the adjustable rate mortgages will be able to refinance their ARMs and not lose their homes, that’s what you mean, right Chong?”

Chong: That’s exactly what I think the market is forecasting Cheech. And let’s not forget the greatest market observer of them all Cheech.”

Cheech: “Who?”

Chong: “Russell” Cheech, Richard Russell. Richard Russell has been watching every move of the market, and writing about it, since 1958. And he thinks things are looking pretty darn good.”

Cheech: “You mean, like our Grandma said, we should buy when other’s are fearful”

Chong: “Basically.” Russell believes you do better watching the market’s reaction to the news, rather than the news itself. Because the news is known, the reaction is what contains truly new information.”

Cheech: “So what’ he saying?”

Chong: “The primary trend is up, world wide growth is strong, but mostly, there has been an awful lot of dire news, and the market has just shrugged it off.” That’s bullish action “He’s saying that the market seems to believe that Fed policy will solve the liquidity crisis of 2007/2008, and that the bull market from the entrepreneurs of Asia will power things forward after this correction runs its course – unless it doesn’t of course.”

Cheech: “How will we know if it doesn’t?”Chong: “The market will close lower than it did on August 16th, which was 12,845.”

Cheech: “So shouldn’t we do something in case the worst happens.”

Chong: “Cheech, do you own any gold?”

Cheech: “Sure, I’ve got about a hundred old $20 dollar Gold coins I picked up in the 1970’s after we retired from show-biz and my uncle told me to buy them for long-term safety.”

Chong: “So what’d you pay for them back then?”

Cheech: “Dunno, maybe $40 bucks, or $50 a piece.”

Chong: “Any idea what they are worth today Cheech?”
Cheech: “None whatsoever.”

Chong: “’bout $900 smackers a piece”. Those old Liberty Gold coins have just over an ounce of Gold in them Cheech. You want some safety, own some Gold, and a bit of Silver for good measure.”

Cheech: “What about cash?

Chong: “That too.”

Cheech: “My head hurts.” So let me see if I get it. “If it sells worldwide, and pays a dividend, it’s probably going to do well. Anything more I need to know Chong, I’m wiped?”

Chong: “The beer’s cold and in the fridge. Let’s grab some and stay cool”

Cheech: “Ahh!!! (Grab’s a Corona)”

Cheech: “Chess?”

Chong: “I thought you’d never ask”

Have a terrific Holiday weekend everyone.

Blessings,
Daniel A. Barnes, CFA

This issue, was originally slated as a diatribe on Inflation and Stocks, but the apparent death of easy money has trumped it. The credit cycle isn’t easy to understand, let’s see if Cheech and Chong can help us out.

Cheech: “Hey Dude, my bank won’t approve our home equity line increase to redo our pad!

Chong: “Duh!” “Of course not Cheech.” “Haven’t you heard, the banks are all afraid that they are upside down on their loan portfolios, due to the rising defaults and sinking housing market and the folks who shouldn’t have been buying houses to begin with.”

Cheech: “But I know a bunch of those Boomers and Gen X-ers who were making money hand over fist with condo’s in Miami and whatnot.”

Chong: “Indeed. The flippers did make money, lots of it, but that game is over.” “And anyway that’s not the big deal, the big deal is that Private Equity needs something like 300 smackers to close all the recent mergers and buyouts.”

Cheech: “What’s the big deal Chong- what’s $300 million in a $14 Trillion economy these days.”

Chong: “Um, your right Cheech, any of these big companies can borrow $300 Million, but were talking about “B’s”.

Cheech: “Huh?”

Chong: “Billions . . . Cheech, billions.”

Cheech: “Didn’t somebody once tell me that if you owe the bank 100,000 dollars, you have a problem.”

Chong: “That’s right Cheech, and if you owe the bank $100 Million.. .”

Together: “Then the bank has a problem!”

Cheech: “So I guess, If we are talking like, dude, um, 300 billion, you could say the banks have a problem.”

Chong: “Yes you can Cheech, you can indeed say that.”

Cheech: “So what’s the real deal Chong? Is my Bali money for my Christmas Safari safe . . it’s in a CD at JPMorgan?”

Chong: “Well Cheech, that’s the billion dollar question for all those shareholders of JPM stock. Actually, your CD is safe, but the equity in the house of Morgan is in question.”

Cheech: “So you mean Chong, that that’s why JPMorgan’s stock fell in the last two weeks from $50 to $44, shaving off a cool $20 billion in market capitalization?”

Chong: “You’ve got it Cheech.” “The market has marked down the price of JPMorgan stock, because they don’t know how much of a hit JPMorgan is going to take on its loan portfolio.”

Cheech: “Well, isn’t that a big hit Chong, I mean, how big is their loan portfolio with these shaky loans Chong?”

Chong: “No-one knows exactly Cheech, their loan portfolio is about $600 billion, perhaps like, 10% of these loans could be termed higher risk. But that doesn’t include all those complicated derivatives.”

Cheech: “But wait a minute Chong, isn’t this fear about those bad housing loans; and maybe some private equity buy out’s, not derivatives?

Chong: That’s true Cheech, we haven’t heard them waving the red flag about JPMorgan’s derivative business yet, but if this thing keeps unraveling, they will.

Cheech: “But Chong, what about this private equity danger you spoke of? Isn’t private equity just a way to buy back shares of a company because it is trading too cheap, and thus, make the company a part of another company, or a private, closely held company again (like my daughter’s in-law’s dry cleaner business (you should see their cash flow!)

Chong: “Right again Cheech, but remember, your Daughter-in laws doesn’t need $12 billion to buy back stock and debt.” “Yesterday JP Morgan admitted that they couldn’t find a buyer for the $12 Billion that Private Equity firm Cerberus needed to close their deal of buying out the Chrysler division from Daimler Benz. So Morgan and their syndicate of seven other banks are going to assume $10 Billion in loans themselves, because they couldn’t find any institutional buyers willing to buy the debt.”

Cheech: “But Chong, isn’t their always a price for anything?

Chong: “You truly amaze me Cheech, I thought you were dazed and confused all through our Economics classes, now you quote me market forces? Milton Friedman would be proud.”

Cheech: “Isn’t he dead?”

Chong: “I don’t know, it’s not important.” “The important thing was that the credit desks shut down this week, and JPMorgan and their cohorts are screwed, and have to take on $10 billion in debt.”

Cheech: “Why doesn’t JP Morgan just walk away Chong, let the deal die?”

Chong: “That’s the right question Cheech. I’m not really in the loop on this one, but probably because JP Morgan made like several billion dollars last year in fees doing deals like this, and they already promised to get the deal done (which is why they get paid those astronomical advisory fees of $10-$100 million for a deal like this”

Cheech: “So what’s the bottom line Chong, my Bali money, my 401k, what do I do?”

Chong: “You have a 401k Cheech?

Cheech: “Course man, heck we’re boomers aren’t we Chong, we all have 401k’s.” “So what do I do”.

Chong: “Sorry dude, go work with a professional.” “ Don’t do anything rash, there’s so darn many petro-dollars and Asian savings sloshing around, that this sell off will probably run its course in a few weeks. And if it get’s really bad, Ben Bernanke will bail us out with a rate cut.”

Cheech: “But he’s like the real deal, a Fed head that actually says what he thinks.”

Chong: “That’s right Cheech, but he’s still got to wear them Greenspan pants, protect the put and all that.”

Cheech: “You lost me Chong”

Chong: “Cheech, the system doesn’t allow for systemic failure any more.” “Remember Y2K, why didn’t anything go wrong?

Cheech: “Well, I was making lot’s of money marketing for some Dot-com.”

Chong: “Of course you were Cheech.” “The Fed pumped money like crazy, and the Bankers gave it to the Dot.com kids, who blew it on dopes like you and bad business models.” “Remember the Asian meltdown in 1998 after Russia defaulted on their loans in August, and the Long-Term Capital blew up and destroyed the credit markets?” “What did the Fed do?”

Cheech: “Didn’t they call an emergency meeting Chong, lower rates inter-day?”

Chong: “You bet they did. And what happened in September 2001.

Cheech: “Didn’t the buildings go boom, and the Fed came to the rescue again with lower rates?”

Chong: “They did indeed.” “And they will do it again.”

Cheech: “But if the Fed would stop bailing us out every time people are reckless and ignore risk, wouldn’t they then be more cautious with their money, and wouldn’t banks be more cautious, Wall Street’s power brokers be more cautious?” “And wouldn’t that keep the costs of things going up less quickly because there would be less money in the system?” “Isn’t this like a Merry Go Round that won’t stop, and every time crazy stuff happens, we pump more money into the system, and destroy the value of the dollar?”

“Isn’t this series of Fed interventions into the money supply, this dependency on cheap money- while the masters of Wall Street can do whatever they want (like make $20 million a year, and then get bailed out by the Fed), isn’t that all like wrong for democracy, wrong for society, wrong for our souls?”

“Hasn’t this Federal Reserve a created a hazard, because their interference and support of easy money have institutionalized reckless risk-taking?” “Doesn’t this mean that the US. Financial system itself is the modern Moral Hazard, Chong?”

Chong: “Bingo Cheech!” “But, don’t worry about Bali: a beer might cost $18, but you will get your money back from the House of Morgan” “That’s a promise as good as Gold, you’ve got the Greenspan Put on your side.”

Cheech: “But Chong, didn’t Greenspan like Gold?”

Chong: “That was 1966 Cheech.” It’s late, will do more on that another day.”

~And we’ll have fun.fun.fun ‘til Daddy take’s the T-Bird . . .

Blessings,
Daniel A. Barnes, CFA

Energy is too cheap. I don’t mean that $70 for a tank of gas is inexpensive, unless I compare it to my mortgage, which is two orders of magnitude larger. Energy is too cheap, because it is not yet affecting consumer behavior patterns in any meaningful way in this country.

Developing Countries are ravenous consumers of energy. Energy demand is increasing at double digit rates in China, India, Brazil, and many developing countries. Oil consumption is among the fastest growing part of increased energy demand, because only oil can currently fulfill the transportation needs of an emerging economy.

Currently we have robust global growth, even greater demand growth in energy, yet at best, 1-2% supply growth in refined Oil. The result is that oil prices in particular, and energy prices in general are going to go higher, because the supply of energy can not keep up with the demand for energy.

You’re not convinced? Then look at what the market is saying, look at the stock price of Exxon Mobile, the largest oil company in the world:

To quote one of my favorite academic economists, long-time Fed Watcher Paul McCulley of PIMCO in his recent column:
“In the long run, the world needs the real price of energy to go up enough to encourage conservation efforts and the development of alternative forms of energy. That way, everything works out—eventually.”

It’s the eventually part, that is going to be painful. Eventually every new home in California will come with water osmosis filters and solar panels. Eventually the soccer mom’s will stop buying SUV’s and drive mini-vans and station wagons again. Eventually nuclear power will be a major source of electrical power in North America. Eventually fewer people will commute 50 miles a day or more. But what is it going to take to get there? That I think I know, it’s going to take $10/gallon gas.

Energy prices must climb to a point where consumer behavior is modified. Energy prices must climb to a point at which alternative energy sources are economically superior. It’s the bottom line that will effect change, not the tellers of fortune or the prognostications of economists and tree huggers.

So I am rooting for higher energy prices. This most likely scenario means that energy companies are going to do well, and that portfolio managers need to allocate portfolios to take advantage of inevitable rising energy prices. It’s that simple.

First Half 2007 Review
The second quarter finished with mild hysteria over housing, rising interest rates, defaulting mortgages and a few busted hedge funds run by Bear Stearns. Bond Guru Bill Gross went nuts over the eventual fall-out in the housing markets in his June column while the average American yawned, and just let their employers send in the 401k contributions on time.

Wall Street yawned too, and global growth hit front page status, so much in fact, that the $14 Trillion U.S. supertanker economy has been unseated by robust growth of the global economy. In Asia, South America, and even Europe growth rates have risen. The developing world is growing at something like 7% or more. Meanwhile the developed world is growing at 2-3%. Overall world economic growth is a very healthy 5%.

For the first six months of 2007 the S&P 500 had a total return of 6.6%. The Lehman Aggregate bond index returned 0.8%. The average account at Barnes Capital returned 7.2% over this period. Precious metals and precious metal equities were flat, while major oil stocks rose 20% and oil services equities gained 28%.

Our View
Looking forward we expect equities to continue to do well. We are focused on good dividend payers and we continue to believe that diversified portfolios should include commodity and precious metals exposure. We continue to believe that fixed income securities are priced for very modest returns. We do however like the medium maturity municipal bonds for high net worth client portfolios due to their relatively high after tax returns.

Have a nice holiday with you and yours.

Blessings,
Daniel A. Barnes, CFA

As the second quarter enters its final act we see a difficult environment in some ways, an easy one in other ways.

It’s a difficult environment because the noise of different viewpoints is loud.

It’s easy because if we can turn off the noise, we see supply and demand balance that which is creating a benign environment for investors of many different asset classes, particularly equities.

What is the BIG picture?

The below chart shows that WORLD stock markets have de-coupled from the rising trend line. When this happens, it is natural for the average to return to the rising trend line sooner, or later. That’s our question of the day, will it be sooner (2007) or later (2008/09)?

One of the most important factors in this equation is the supply of equity shares. The number of equity shares outstanding is shrinking. In fact, some estimate that the global supply of equity will decrease 5% this year, representing $1.75 trillion of invested assets will need to be re-allocated to other securities.

There are four factors driving this trend of equity evaporation.

1) Private Equity: Private equity is removing billions of shares from portfolios. Just this week, two groups announced an 8.2B buyout of Avaya, the Telecom Equipment maker.

2) Cash Mergers. Cash Acquisitions by public corporations are also reducing share count such as the $18 Billion in cash that Freeport McMoran’s ponied up for Phelps Dodge, the largest US copper producer, earlier this year.

3) Corporate Buy-Backs. The third cause of equity shrinkage is corporate share repurchase programs, otherwise known as “buy-backs”. Financially strong companies have always had repurchase programs in place, but what used to be an occasional event, has turned into a massive re-allocation of capital out of corporate treasuries and into an ever-rising stock market.

You see, buy-backs are bids for common stock that emanate from a company’s treasury. Quite a lot of the rising earnings per share of the S&P 500 can be attributed to share repurchases. IBM for instance, has reduced its outstanding shares by 255 million (15%) since 2000.

4) Fewer IPO’s. Historically, any extended period of declining equity shares has been met by Wall Street Investment bankers, eager to bring to Joe Public, a host of new and exciting companies in alleged growth industries. The investment bankers do this well (remember Ethanol a year ago?). The resulting new supply of low-quality stocks brings new supply into frothy markets and sets the stage for market declines. Indeed, it was the investment bankers that brought every bright idea to the public (do you remember theglobe.com?) that eventually imploded a stock index filled with such companies (Nasdaq 5000).

Given the 60% rise in the US Stock market since 2003, it is surprising that there are so few IPO’s. But something out of the ordinary transpired over the last five years. In the wake of the 2001-2002 crash, the mutual fund scandals, 9/11, and Sarbanes-Oxley legislation, the cost to becoming a public company has dramatically increased. At the same time, retail investors focused on the real estate sector as the go-to place to make fast money. New public companies have not come anywhere close to fulfilling their traditional role of adding equity supply to the public markets.

Bulging corporate coffers have only acerbated the equity evaporation problem with their stingy dividend payouts. Due to tax advantages of buy-backs, the poor record of acquisition strategies, and the general disdain that public companies and their shareholders have shown for high dividend payout ratios, corporate treasuries have chosen to put their cash back into their own shares, reducing outstanding shares by millions and billions of shares.

Meanwhile, the retail public partied at the real estate trough and shunned active participation in IPO’s and any “new economy” concepts fewer new public companies were brought to market. In this back drop, the overall stock gains have been solid indeed as Global demand for shares outstripped supply and the DOW has ascended 5000 points since 2003. We don’t expect this to end anytime soon, because not only are corporate treasuries a driver of global demand for common stocks, but there are also many global factors, more so than ever before (these include the recycling of petro-dollars (oil profits) from the Middle East and Russia, as well as the balance of trade with China ($1 billion per day), much of which is finding its way into common stock investments). So we believe that this is actually a market in which solid equities will perform well. But we are still cautious and therefore recommending for our clients only the most solid companies with stated policies growing their dividends for their shareholders.

Our View
Let’s start with our conclusion. Contrary to some of our peers, we expect buy-backs and higher barriers for companies wishing to go public, to persist for the foreseeable future. This is significant and was a factor that motivated our shift to a less defensive stance three months ago.

We believe we must provide our readers with both sides of the picture. Yes, stocks look as though they want to go higher. Yes, the forces of supply and demand favor higher prices. And yes, stocks, based on historical measurements, are expensive.

So we remain cautious, because with such thin margins for error, we’d really rather be in higher quality companies that offer less upside, but also less downside: namely robust dividend paying companies that believe in sharing their success with their shareholders.

Blessings,
Daniel A. Barnes, CFA

Berkeshire Hathaway. Study the life of Warren Buffett, and you will learn a lot about investing. If you want to become wealthy, then adhere to the tenets of Warren Buffett, and you will have a good chance of achieving your goal. For a summary of Buffett’s amazing life, look him up at www.wikipedia.org.

What I like most about Warren is his ability to use humor to explain business, investments and common sense. I am not sure where he got it, and I am not a Buffett disciple, but I know Buffett took a Dale Carnegie class on public speaking when he was about 21 he taught a night class on investing to people twice his age at the University of Nebraska. Hmm, I read Carnegie’s book when I was about the same age, but it failed to have the same affect on my own presentation abilities, oh well, the Buffett standard is a tough one to match.

Seriously, read the Berkeshire Hathaway annual report. It’s literally worth reading, or at least skimming the first 20 pages, since Warren’s wit abounds through every page. 2006 was a good year says Warren: “our most important business, insurance, benefited from a large does of luck: Mother Nature, bless her heart, went on vacation. After hammering us with hurricanes in 2004 and 2005 – storms that caused us to lose a bundle on super-cat insurance (super-cat insurance is catastrophe re-insurance where Berkeshire insures the insurance companies so that they don’t go broke when a Katrina disaster occurs)… Last year, the red ink from this activity turned black – very black.”

Here’s an example of the business productivity that are a part of the Berkeshire Hathaway empire. Between 2003 and 2006 GEICO insurance productivity per employee increased 47%, as the number of employees decline by 3.5% while the number of policies increased from 5.7 million to 8.1 million.

With such business acumen, the 2006 operating results for Berkeshire Hathaway included an increase of per-share book value of 18.4%, a gain of $16.9 billion. Berkeshire’s stock gained roughly 17% in 2006 so asset basis Berkeshire became 2% less expensive, relative to the S&P 500. That’s why it isn’t crazy to hold B shares of Berkeshire selling for $3600 a piece, they are well diversified, tax efficient, and getting cheaper relative to other securities.

1st Quarter Review and 2nd Quarter Outlook
So what happened in the first quarter of 2007 and what can we expect for the rest of quarter? Well, with a crystal ball, perhaps I could best Buffett, but I wouldn’t bet on it. The Dow Jones Industrial Average is headed for 13,000 and 14,000, and large cap stocks are beginning to outperform small cap stocks. After finishing the first quarter at close to even, stocks have enjoyed a strong sprint this month, gaining 5% or more to flirt with the 13,000 level. The dollar is weakening substantially, flirting close to the edge of its all-time low’s of 80 on the dollar index.

Some of you became very bearish on the dollar in early 2006, following the dollar’s stunning 10-20% collapse in 2005. Well markets, being the nature they are, did a rope-a-dope, as the dollar performed rallied more than 10% in early 2006. For 15 months through 2006 and into 2007 the dollar climbed higher in a zigzag fashion, before returning to its longer-term downward trend that it established 2001-2005.

Large capitalization stocks are the primary beneficiary of a declining dollar. That is so, because a large amount of their revenues and profits are denominated in foreign currencies. When the dollar index declines, the earnings per share of most America’s largest companies goes up, because these companies repatriate their international profits into a larger number of dollars, due to the lower price of each dollar, as denominated in Euros, Yen, Yuan, Canadian Dollars, etc.

Barnes Capital took advantage of these long-term trends with investments in large capitalization stocks, energy and gold. These asset classes have performed well while the dollar has meandered through is long-term decline in the same period. Barnes Capital is protecting client’s accumulated savings through investments in assets that we believe provide a hedge to inflation and a declining dollar index.

In our next issue we will delve into some new, yet to be determined material. Check in next week for the launch of www.barnescapital.com. The current website, www.barnescap.com will be ceremoniously put to rest and linked to the new website. It served us well, but it did not describe our new service offerings of Wealth Counsel and Business Services for families and business owners.

We are happy you all made it through tax-season, and look forward to serving you for the rest of 2007. Spring is here, remember to take notice, its beauty is all around you.

Blessings,
Daniel A. Barnes, CFA

Ten years. 10 years ago long term interest rates were at 7.1%. Today they are 4.7%. How can I remember you ask? That is when I began to track the equity markets on a daily basis. Only 10 years you ask. Well yes, but 3652 days of watching markets (okay, maybe just 2612 days?there were some Saturdays and Sundays) have shown me a few things.

Back then the Dow was in the six thousands. Yahoo and Dell were driving the tech markets, Asia was about to melt-down and Apple Computer was headed off the cliffs. Today it’s an Apple-Exxon world; interest rates are 2½ points lower, Asia is driving a commodities boom, and housing is about 150%?200% more expensive. Overall people made a fair amount of money over these ten years, but easy it was not.

Over any longer time frame, capital protection, or staying even, never really is easy. Inflation, the steady march of the decline of the purchasing power of a single dollar, guarantees that it isn’t easy to stay even. You don’t believe me? Think of your house: If you needed $75,000 of income to buy a 3 bedroom California house in Contra Costa County in 1997, you need about $150,000 of income today to buy that $800,000 home. So even if your assets have doubled or tripled or more in the last 10 years, you may not have the income today to buy your current house that you live in, at today’s real estate prices. That is what we mean by staying even, it’s never easy.

As bonafide generalists we do a couple things besides fundamental securities analysis, to help keep a breast of the best way to protect and grow our clients’ accumulated assets. One thing we do is watch price action the other, is read what smart people are thinking.

Price Action
Technicians (a term for market watchers who use technical (price action) analyses, to explain and analyze securities markets, have it right: the market knows more than any one of us. Right now the market is speaking clearly, stocks remain attractive.

Smart People
One of my daily reads is Richard Russell. Richard has been writing Dow Theory Letters since 1958. He hasn’t missed an issue in 48 years. Richard is a joy to read, and his newsletter is a bargain, published daily to the web for just $250/year (www.dowtheoryletters.com). Richard is 83 years old and he believes that he escaped death as an 18 year-old when WW2 in Europe and then Japan, mercifully came to an end. You see, according to Richard, the average career of an American bombardier was about 20 missions, and Richard had completed about 25 missions up to that time. When he returned to the states he enrolled in New York University and was one year ahead of Alan Greenspan. When Richard talks of Alan, it reminds me of Francisco telling Dagny in Atlas Shrugged that one of them has betrayed their family heritage. You see, Greenspan wrote famous essay’s about the corrosive power of government intervention in monetary policy. Earlier this week, Richard wrote: “Alan Greenspan was once a fervent believer in gold as the basis for money… the following two paragraphs are from Greenspan’s famous essay on gold “Gold and Economic Freedom” written in 1966:

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
“This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.”
Is this the same man who presided over an increase in aggregate debt from 10 Trillion to 40 Trillion in 18 years? You might ask, “What happened? Thinking the way he did, how could Greenspan have ever accepted the job of being head of the Federal Reserve?” Well, that is a story for another day, probably he rationalized it.

The point is, gold is going up, and stocks are going up. Are they both inflation hedges? I think they might be. Look at stocks! They have been up for four years in a row, and this year they could well be up again.

What is the market doing? I think that maybe it is treating common stocks, as tangible assets. Stocks represent partial ownership in businesses. Business prospects are tied to the economic cycle, not the value of a dollar. So a share of Microsoft should be worth about the same number of dollars in real terms (inflation adjusted), because if everything doubles in price, Microsoft’s earnings and its stock price, will also double in price. The broad market is treating stocks as an inflation hedge. And historically over very long periods of time, this has been true.

Question: So Barnes, what’s the bottom line?
Answer: Bottom line, stocks are a better inflation hedge than bonds or cash.

Question: So what should clients do?
Answer: They should diversify into both.

Question: So what do we do with this information?
Answer: Broad Diversification. Call us, we can help.

1. Dividend-paying common stocks
2. T-Bills
3. Gold/Silver
4. Other tangibles
5. Some bonds
6. Some Real Estate

In our next issue we will recap the 1st Quarter and discuss the 2nd Quarter Outlook. We will be launching www.barnescapital.com later in April which includes descriptions of our new service offerings: Wealth Counsel and Business Services.
Have a Happy Easter and Spring Break.

Blessings,
Daniel A. Barnes, CFA

Build wealth. That’s the goal, how do we get there? The first rule of investing is this: Don’t lose money. They say, the surest way to a small fortune is to start with a large one. Losing money is just not acceptable once you have acquired some savings, because it takes twice as much effort to make 20% as it does to lose 20%. Why? It’s the mathematics. If your investment declines 50%, then you need a 100% return get even. If your investment declines 80%, you need a 400% return to get even.

Four hundred percent returns are hard to come by, but that’s what Nasdaq technology investors needed in order to get even after the internet bubble burst (hint, they are not there yet).

The second rule of investing is to compound your returns. The reason portfolios can grow magically to the sky is all to be found in the magic of compounding interest tables. Some of you may have seen this power in an IRA table before. Take two twins: Lisa and John. Lisa starts investing right out of college, $2000 a year for 10 years. At age 32 she exits the work force and never invests in her IRA again. Her brother John goes to graduate school, and then chooses to not fund an IRA his first five working years. When John is 32 he finally starts funding his IRA and contributes $2,000 for each of the next 33 years. Guess who has the larger portfolio at age 65, assuming an 8% compounded return: that’s right, Lisa. Her initial $20,000 in retirement contributions increased 21x, to $428,378. Her brother’s 33 years of contributions, $66,000, grew only 5x, to $342,634. John’s portfolio is $86,000 less than Lisa’s portfolio, despite the fact that he contributed $46,000 more to his retirement plan than his sister. That’s the power of compounding.

So to recap: the rules to successful investing are:

1. Don’t lose money.
2. Compound returns

Let’s recap our basic philosophy at Barnes Capital.

Equities
We believe that equities can fail to achieve returns commensurate with their risk for long periods of time (10 years +). We call these periods secular bear markets and they occur every other decade or so. This is why we are very selective in investing client money in equities.

Dividends
We prefer that companies paying steady growing dividends. We prefer dividends to share buy backs. One of the reasons we prefer companies that grow their dividends consistently, is that growing dividends lead to capital appreciation through higher stock prices. There is a 93% correlation between the growth of a divided and the growth of a stock price.
Growth versus Value
We prefer value to growth. It is easier to make mistakes in the world of “growth stock” investing. Value stocks tend to be less volatile, and pay dividends. They also can surprise to the upside.

Asset Allocation
Asset Allocation plays the biggest role in investment returns. We spend much of our research on tweaking the standard allocation in order to achieve better returns. An example of this is our overweighting of precious metals which we have maintained since 2002.

Diversified Low-Volatility Portfolios
High Net-Worth families have already won the risk game. For them, we develop lower volatility portfolios with less-correlated assets including alternative investments and conservative hedge funds through our partnership with an alternative investment specialist.

Fixed Income
Bonds play a vital role, particularly in retirement income accounts. Our partners at RB Capital Management excel at building bond portfolios that outperform bond funds, are tax efficient, and provide a source of consistent income and higher returns than equivalent portfolios of large brokerages.

At Barnes Capital, we build client wealth by adhering to the above tenets; We add value in a half dozen other different ways including business financial services and wealth counseling for individuals.

We will be holding classes this spring in investing basics. Some of the topics will include: Retirement Income strategies, Defined Benefit Plans for business owners, All about Bonds, & Building diversified portfolios. Please let us know what other topics you that you are interested in.

Oh, and about that down 500 point day today: we may have hit an inflection point as the crisis in sub-prime lending works its way through the credit markets. China also hinted they may begin to tax capital gains. The resulting 9% loss in the Chinese markets sparked today’s sell off. It remains to be seen if the good market is gone. In all likelihood, we think, not yet. It doesn’t feel like the top yet, but we are in the later innings. Anyway a correction was certainly overdue, as the market had galloped up for the last 8 months.

Blessings,
Daniel Barnes, CFA

After the last letter went out, we caught flak alleging we’d changed our tune (gasp! Shock!) and chosen to embrace the bull market in equities. That interpretation was not accurate. We’ve made no radical 180 degree turn. Rather, we hinted that the factors motivating our bearish stance have declined in number and degree.

The visceral reaction to our perceptible shift brings up a very important point: namely, what immutable ground shall a portfolio manager stake out, and how dare he (or dare he not?), change.

Investment decisions represent change and wealth building is a process, not a proof. Building wealth requires taking risk. As such, there are ups and downs in investing and that includes the value of a portfolio. Wealth creation is not a linear event. It is a stair step process, and sometimes the step taken is one headed the other way. Now at the risk of being labeled a disciple of Mad Money let us be clear: at Barnes Capital, when we believe that we can prudently make more money by changing our stance, we change.

On the portfolio management side, conviction levels change, and points of view change. From time to time we moderate our views on different sectors and economics on the basis of value, growth and other dynamic factors. That’s portfolio management, and the reasons for trades in your portfolio. When something really big happens, our paradigm shifts. Those don’t happen often (Summer 2002 was the last time when we decided to overweight precious metals). The point is, changing one’s point of view is part of the investing process. As Keynes stated:

“When the facts change, I change my mind. What do you do, Sir?”

Now let us take a look at some staggering data about “average investing” and how very hard it is for the average self-directed investor to bat average.

Investor Underperformance
Professional money managers go through a lot of ups and downs on the road to making consistent money for clients. And even though most professional managers fail to make the returns of the averages due to fees and errors of judgment, they do achieve risk adjusted returns that approximate their benchmark, and widely exceed the march of inflation. Ninety percent of the active managers of mutual funds fail to match the performance of their own benchmarks. But other investment strategies are worse. In 2004 investor research firm Dalbar (www.dalbarinc.com) examined the flows into and out of mutual funds for the previous 20 years and found:

“that market timers in stock mutual funds lost 3.29% per year on average”.

That statistic is deeply troubling for do-it-yourself investors who trade their accounts actively, or follow a market timing service. But many have suspected that active traders fair poorly, so the earth is in tact. However, the following Dalbar research literally knocked us out of our socks. In the same 20 year period from the early 1980s to the early 2000′s:

“Over a period when the S&P grew by 12.98%, the average investor earned only 3.51%”

The implications of this finding are horrifying: in the 20 years of mostly great bull markets, the average investor barely matched the returns of inflation. In other words, in real terms, the average investor broke even, and made zero return after adjusting for inflation. Late stage entrants in the tech-laden Nasdaq in late 1999 and early 2000 only wish that they had averaged a 3% return.

Our point is that the role of an investment advisor is to quarterback your financial house to attain the market “average”, a modest accomplishment not achieved by 90% of individual investors managing their own money.

At Barnes Capital, we build client wealth by achieving market average returns or better, with less than market risks. We keep client fees low, and adding value in a half dozen different other ways. In summary, we are differentiated from the other 400,000 other purveyors of financial services by our strategy and our exceptional service.

We will be holding some seminars on Investing this spring in Lafayette. Stay tuned for details. The next letter will highlight our investment philosophy and strategies and come out later this month.

Blessings,
Daniel Barnes, CFA