Thursday, October 19, 2017

Visit to a Nuclear Submarine

A junior officer from the submarine USS West Virginia, regarding the status of 170 crew members on-board the submarine as quoted October 11, 2017:

“We go out to sea for approximately three months in a steel tube, no fresh air or water. Every minute underwater, no sunlight, and often in hostile waters... Between us and the sub’s engines is a nuclear reactor, and on-board we can carry up to 24 intercontinental ballistic missiles which have the capability of carrying multiple warheads and combustible torpedoes… what could possibly go wrong?”

I have always been interested in submarines and the military in general, so after actually seeing a nuclear submarine up close, I decided it was time to learn more about what they do. I have always assumed that there were thousands of submarines out there, when in fact there are only 66 submarines in the U.S. Navy fleet. This is surprising given that this is the largest submarine fleet in the world.

Submarines are apparently very difficult to operate and extraordinarily expensive. No military apparatus was more instrumental in bringing down the Russian empire during the Cold War than the nuclear submarine. With billions of dollars spent on building submarines in Russia, they quickly found out they couldn’t keep them running in an efficient manner without creating a safety hazard to the sailors. Thankfully, the deep pockets of the United States protected us from experiencing a similar situation.

In preparation of this blog, I read the book Blind Man’s Bluff by Sherry Sontag, Christopher Drew and Lynette Lawrence. This is a very interesting book that relates the actual day-to-day activities aboard a submarine. If you think the junior officer quoted above sounded crazy, wait until later when I discuss what they do in these bona fide tin cans.

It is funny how things happen in life that make you reflect on the past. In 2009, I took a tour of the Greek Islands aboard a cruise ship. One of the first stops along the way was Istanbul, Turkey. Istanbul is a very interesting city in that it is where Europe meets Asia. It is also unique in that it is essentially the only way you can get from the Mediterranean Sea to the Black Sea. One day while sitting on the deck of the cruise ship eating brunch in the harbor in Istanbul, I happened to look over and saw three, clearly marked Russian nuclear submarines passing through the straits into the Black Sea. Not only was it an incredible and impressive sight, but a truly fascinating one. It certainly made you think twice about your security. And I certainly would have never guessed that years later I would actually see a nuclear submarine, even more technically advanced, up close and personal.

The nonprofit I belong to, which supports the military and the United States security, was recently permitted access to Kings Bay Naval Submarine Base located in Kings Bay in southeastern Georgia (just north of Amelia Island, Florida). You haven’t seen tight security until you’ve seen how tough it is to gain access into a nuclear submarine base. By virtue of this security clearance, we were able to actually climb aboard the USS West Virginia with a guided tour of the submarine and the entire base. This submarine was put into service in 1990 and is almost two football fields in length (560 feet). A submarine is nothing like it is depicted in most movies. It appears neither organized nor particularly suited for the task that it so ably accomplishes. The ceiling is very low and more suited toward shorter seamen. Needless to say, I was not able to walk upright. The ceiling was packed with cables, pipes and other communication aids that have clearly been repainted over the years with white paint. The main control room, where the periscopes are located, is a blur of dials and apparatus that boggle the mind. I was completely surprised when I found out that a submarine has no windows or portholes – its ability to discover and guide the boat is done by sound alone.

We were also able to experience a submarine simulator, and in real time were able to submerge the submarine and then practice an emergency trip back to the surface. It is almost amusing that the submarine moves up and down at a 20-degree angle. They indicated that at 20 degrees the crew can continue to work without interruption. If you have ever tried to walk in a normal manner at 20 degrees, you know that this is not an easy task.

Just to make sure you understand that we are talking about strategic submarines, you have to understand the extent of what nuclear weapons bring to national security. Also, the significance of this sub base could not be overemphasized. As one of the junior officers explained to us, if Kings Bay was a country it would be the third largest nuclear country in the world based on all of the nuclear weapons they have. If that doesn’t make you pause to reflect, nothing will.

There are 170 sailors on the USS West Virginia at any time. As explained by the junior officer, there are only three bathroom facilities for the entire crew. Each submariner is assigned a bunk, which from the surface appeared to be roughly three feet tall and six feet long. In this bunk they can keep whatever personal items they have, such as clothes, reading materials, etc. A typical deployment is around two and a half months and they are only permitted to wash their clothes once a week. Since they have almost no space on the craft, they typically only bring two changes of clothes.

It is also amazing that there is virtually no space for personal time. A typical submariner’s sleeping quarters would include 9-12 sailors. I asked to see the recreational room and it was roughly 10 feet by 12 feet, full of electronic equipment, one small television and a few video games. They have no internet and no communication with the outside, except on a very limited basis. Although they travel near exotic locations, the crewmen never get to see them as the submarine will not surface during the entire voyage.

It is important to understand that every sailor on a submarine is a volunteer. They are selected after extensive research, training and psychological evaluation. Obviously, it takes a special individual to endure the long periods of time under water with no sunlight and away from their family. There are two complete crews to every submarine. After one crew returns from a deployment, the other crew takes the submarine back out, keeping it in continuous operation. The only time that a submarine is taken out of operation is if, by chance, it needs maintenance. These men and women are very committed to their task. Virtually everyone that I spoke with on this day was very excited about being in the submarine corps and intends to stay as long as their superiors will allow them to. I guess there is a double meaning to being committed to a sub.

This particular submarine is called a “boomer”. These submarines go out into the ocean and essentially hide. Since they have the capability to carry nuclear warheads, they are the first line of defense in the United States and their job is to stay undiscovered in the ocean. Often, they do nothing but circle and do figure 8’s for weeks at a time. But what you have to understand about a boomer boat is that they can shoot a nuclear warhead missile 4,000 nautical miles away, meaning they could reach virtually anywhere in the world. With nuclear subs continuously active in both the Pacific and Atlantic Oceans, no country is safe if the U.S. Navy were to launch a nuclear missile.

In all of the famous movies regarding submarines, you often see the submarines floating on the surface, and it always looks like the crewmen are having a great time playing in the ocean. What was not self-evident to me was that submarines, up until recently, were actually driven by diesel engines. You can imagine the smell in a submarine running a diesel engine and the fumes created by burning off the diesel fuel. By necessity, a diesel driven submarine would have to surface every night to let the fumes escape from the submarine. Obviously, this was a detriment to the submarine since they could not operate in hostile territory unless they had the option to surface on a nightly basis.

When the nuclear submarines came along, it avoided this issue entirely. A nuclear submarine does not have to surface and can essentially be under water forever, if necessary. Most people are confused by how a nuclear submarine works. Basically, the nuclear reactor is only used to heat water and the steam then runs the engines of the submarine. If you can envision the old steam driven railroad trains in cowboy movies, you understand exactly how it works – except in this case, we have nuclear energy heating the water and not a fire on-board the train. Because a nuclear driven engine does not produce any fumes that are toxic to the crewmen, there is no necessity for the submarine to surface, and in fact, most do not during the entire tour at sea.

All of this dates back to the 1962 Cuban crisis, when the Russian government wanted to put nuclear missiles on the island of Cuba. They wanted to be close enough to attack the U.S. with on-land nuclear missiles, should the need arise. Now, such missiles are not even necessary. The U.S. Navy can shoot missiles from anywhere in the world from a sub that is totally silent and likely could not even be detected with today’s sophisticated tracing electronics.

I never truly understood what submarines did in the everyday world of the nation’s defense. In the movies you usually just see them torpedo boats and create havoc, but that is not their primary purpose. From the book Blind Man’s Bluff, you get an inside feel for what submarines actually do. Some of these tasks are almost inconceivable.

For example, during the Cold War with Russia, the submarines were used primarily as our eyes and intelligence service. Some of the risks that they took bordered on fantastic. One example cited by Blind Man’s Bluff was that a single submarine would leave San Diego and sail underneath the North Pole in order to reach Russian territory where the Russian boats and submarines were harbored. At 20 knots, this would take longer than one month. The U.S. submarine would enter the 12-mile legal limit of Russian property, and in fact, would even go within the illegal 3-mile border. The submarines would actually sit underneath Russian ships and subs and record conversations taking place. Envision the trip from San Diego halfway around the world in a submarine that would not exceed 20 knots at any time. Also, imagine being in a submarine for three months in an extremely high-risk environment where if discovered by the Russians would almost assuredly mean sudden death.

The various components of a nuclear submarine, like the USS West Virginia.

Another example cited by the book is that a submarine from the U.S. Navy went into Russian territory water and discovered telephone lines connecting the various land masses. Knowing that these telephone cables actually relayed confidential conversations between Russian boats and their superiors, a sub would actually come from the U.S., go into the Russian harbor and sit on the floor of the ocean to install wiretaps to these telephone lines. Given that these lines were essentially in the same harbor where the Russian boats were based, that was an extraordinarily risky venture. In addition, due to the high confidentiality of the mission, these subs contained an explosive system that would self-destruct (destroying the submarine and all of its crew) if discovered by the Russians. The Russians were absolutely amazed that the U.S. seemed to know every step taken by the Russian military during the Cold War. They clearly had no idea that every telephone conversation was monitored by the CIA thanks to taps installed by subs in their own backyard.

I learned a great deal over the last couple of weeks regarding submarines. Quite frankly, I guess I had never taken the time to really understand what submarines do and what an integral part they played during the Cold War. Basically, the Cold War did not end because the U.S. and Russia met a philosophical understanding regarding democracy and communism. The Cold War ended because the United States was far superior in its military capabilities and Russia realized they could never catch up. It is also very clear that neither country had a desire to launch an offense against the other. Now, Russia keeps virtually all of its submarines near their own shores in the Mediterranean Sea as defense, rather than offense, against the U.S. While I wish I could say the same for the U.S. submarines, based upon all of my research, it appears they continue to collect intelligence for both the military and the CIA. Whatever their purpose and mission is today, we as Americans certainly owe them a debt of gratitude. Every time I read that the government is trying to reduce the military force and cut funding going forward, I will always remember how important submarine warfare was in ending the Cold War. Also, I will remember how old the submarine fleet is getting without any attempt to update and modernize the existing submarines. Hopefully, a new philosophy regarding defense will improve upon that reality.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins

Tuesday, October 10, 2017

Is this a great country or what?

We have just ended what is historically the worst month of the year for stock market performance. Not surprisingly, given the very strong markets that we have had for all of 2017, the S&P 500 was up a sterling 2.1% for the month of September - so much for this being the worst month of the year. In fact, it was the best September since 2013. The economy continues to grow, earnings continue to increase and interest rates continue to stay low. The components for future positive stock market performance are all in place.

I would like to talk to you about various aspects of the stock market performance and why I do not see a large downward shift coming anytime soon. I will illustrate what happens when the “Wealth Effect” starts to take over the higher end of the economy. We are now seeing this in the U.S. economy, and more importantly around the world, which should lift stock markets around the world higher. However, before I begin all of that terribly interesting information, I need to cover the performance of the markets through the first nine months of 2017.

Ava horseback riding in the mountains and building sandcastles at the beach - all in the same month!

As mentioned, the Standard and Poor’s index of 500 stocks was up 2.1% for the month of September and is up a very respectable 14.2% for the year 2017. For the one-year period ended September 30, 2017, that index is up double digits at 18.6%. The Dow Jones industrial average was up 2.2% for September, up 15.5% for 2017 and up 25.4% for the one-year period ended September 30th. The NASDAQ Composite index was up 1.1% for the month of September, 21.7% for 2017 and up 23.7% for the one-year period ended September 30th. For all of those forecasters that continue to forecast gloom and doom for the equity markets, they must be truly amazed to see close to 20% performance for all of the major market indexes for the one-year period. As the above numbers indicate, we have been correct in our insistence that one be fully invested during this highly profitable time.

I always like to illustrate what the bond index reflects given our projections that you are not likely to make money in a bond index portfolio. For the month of September the aggregate bond index was down 0.5%, for the year 2017 it was up 2.9%, and for the one-year period it was down 0.2%. Therefore, if you have been invested in bonds over the last 12 months, you have actually had a negative rate of return as compared to an almost 20% gain on any of the other major market equity indexes. Not much explanation is needed to see why we forecasted negative returns in bonds and positive returns in stocks.

Last month I wrote about how much happier my life has been since I quit watching the news. Don’t get me wrong – I keep up with current events, I just do not watch the editorials that try to explain them. The one thing that I do is make a concerted effort to look at what is going on around me rather than what people are telling me. I am convinced that a lot of commentators believe that they can influence the thinking of the population by slanting the news in a fashion that meets their agenda. I decided I would rather make those decisions on my own, and I feel much better about the world since doing so.

You have to admit though, when disaster strikes, this country steps up. Over the last couple months, we have had hurricanes in Texas, Florida and Puerto Rico along with mass murders and other shocking news developments. However, this country rallies at the time of disaster, and the response is overwhelming. Who would have ever believed that a defensive end for the Houston Texans would raise $20 million for hurricane relief by simply asking for it? When the federal government gets into disaster mode, the relief is overwhelming. They move in with housing, clothing, support and take care of thousands. Not to say there is not human suffering and, of course, financial loss, but the attempts to alleviate the basic discomforts of the disaster were in full exhibit over the last two months. What other country can you think of that has done so much to help the average person? We continue to help Puerto Rico due to the tremendous issues its government and infrastructure currently face.

While the financial news has been quite positive, the doomsayers still want to argue that the price earnings ratio of the markets continues to be at an unsustainable level. However, perhaps they missed that earnings have been so strong that the price of the S&P 500 has actually fallen lately. How is it possible that the price earnings ratio could fall when stock prices have increased almost every month in 2017? The simple explanation is that corporate earnings have gone up higher than the index has. As a basic example, the S&P 500 price index has risen 15.4% over the last one-year period ended in June, however the earnings during that period grew at an even faster rate of 18.1%. Therefore, if the index grew 15% and earnings grew 18%, based on simple arithmetic, the price earnings ratio would fall rather than go up.

Every day, we are confronted by forecasters who say the stock market cannot sustain a continued increase. I would agree with them to the extent to say that if earnings cannot keep up with the increase, then it is true that the markets cannot sustain this valuation. However, to this point, earnings have not only kept up with the index, they have exceeded it! I am always amused by those who like to report statistics to support their forecast that the earnings are going to go into free fall. They often point out that sales to earnings are declining. They also point out that book value is a multiple of valuation and our revenue per employees has fallen and that the dividend yield per stock is falling, rather than going up.

If you have read our posts over the years, I hope that you have learned a very important point. Stock valuation is very much like real estate. As it is said in real estate, the three most important aspects are location, location, location. In stock market performance, the three most important components of valuing a stock are earnings, earnings, earnings. Yes, in both sectors interest rates are important and the economy is important, however, the MOST important aspect of valuation is earnings, and earnings continue to move up nicely at the current time.

Yes, it is important to look at prior earnings, but the most important component of stock market valuation is future earnings. Just like the last 12 months ended June 30th saw an 18% increase in earnings for the S&P 500, forecasters now project an increase in earnings of an additional 18% over the next year. As long as earnings are moving up, it is highly unlikely that any one event (other than a geopolitical disaster) could move the markets down.

We are also seeing an all too obvious economy that continues to strengthen. Unemployment is now at a multi-year low at 4.2%. Literally, anyone who wants to work can get a job – it is just a matter of finding a job that suits his or her skill set. There is no shortage of jobs as “help needed” ads continue to pop up for unfilled positions. Now that we are operating at essentially full employment, the flow down of wealth is occurring at all levels. Each person that has a job supports other people in his or her household as well as their community with their income and spending. The compounded effect is that you are seeing all aspects of the economy grow in some respect. The strengthening of employment is by far the most important component to keeping the economy strong. At the current time, we are in a “Goldilocks environment” as it relates to employment since the unemployment rate is extremely low but not so low as to create a strain on the labor markets.

In addition to the good news on the economy, the tax cut policy is going to bring further economic growth soon. I even have to quote the famous Warren Buffett, who is clearly a democrat when it comes to economic terms, as he admits, “I think they can get it done (commenting on Congress). It is not a tax reform act, it is a tax cut act. Any politician that cannot pass a tax cut is probably in the wrong line of business.” I believe he is exactly right on this subject. How could any congressman not vote for a tax cut with the general election coming up next year?

The natural outrage of the progressive wing of Congress was that the tax cut would benefit the rich. First off, the rules are very basic – 50% of the population pays no income taxes whatsoever. You cannot cut income taxes on people who pay no income taxes. If you are to have a tax cut, it must (by definition) cut the taxes of the people that actually pay taxes – the higher paid 50%. The other explanation was almost laughable. The progressive wing of Congress expressed outrage that the tax cut would explode the deficit. Lest we forget, this is the same progressive wing of government that over the last eight years has accumulated deficits greater than each and every president in this country up until the last. So, if you need experts on deficit producing economics, the current progressive wing are your experts.

But I also see an opportunity for enlightening that is going to change America going forward. Even the most liberal of commentators realize that what the progressive wing of the party has been doing is a mistake. When it comes to progressive agendas, Bill Maher may be one of the most progressive. Recently, it was a shock to hear him say, “We need to get some Democrats elected, and that is hard when the movement to childproof the world has made the Republicans a party of freedom and the Democrats a party of poopers.” I think it is fairly clear what he is saying. You cannot overregulate Americans, as U.S. citizens will not tolerate it. All of us were wringing our hands about the Obamacare disaster, but the reality was a lot simpler. At its maximum, Obamacare only covered 13 million Americans out of a total of 330 million people in the U.S. Therefore, the coverage of Obamacare was 4% of the population. However, the rules and regulations that controlled Obamacare affected 100% of the policyholders of medical insurance. This type of regulation is not only nonproductive, but also a waste of economic resources. Finally, we have an administration today that is cutting needless regulations which will clearly benefit the economy going forward. Good news for the economy!

Also, for the first time in many years, I see the “wealth effect” taking place. The wealth effect is when the consumer feels confident enough about their job that they will use their gains in wealth to buy consumer goods. Every day you see investors taking money out of the markets to buy new houses, new cars, new boats and other assets. As the markets move higher and the confidence of the average investor is secure, there is a slippage in investing and a tilt toward consuming. I do not need to illustrate to you how useful this wealth effect will be in making the market higher. When profits from investing slip out into the economy, it puts more people to work, creates higher tax dollars for the government, and it makes the economy better. With gains now up over 20% for the last 12 months, the wealth effect will very much be a positive going forward over the next year. The evidence is as overwhelming as it is remarkable that more people do not see it. If you will notice, restaurants are full on Friday nights, construction cranes are everywhere and consumers are buying all types of goods at record levels. Those who do not see the positive economics of the current economy clearly have blinders on, but it is not just in the United States. Growth is occurring in Europe, Asia and around the world.

Recently, I read an interesting statistic that illustrated this point. Basically, it was a boring article on corporations’ dividends but it said that dividends would grow this year from the S&P 500 by 7.7%. That was interesting considering they grew the prior year at 4.8%, and therefore have grown 10% over the last two years. But the number that struck me was that the actual number of dividends paid by the S&P 500 companies was $436 billion in actual dividends. That is up from last year’s $404 billion. As most of you know, dividends are used by many investors as their income stream. If their income stream grew at 7.7% this year, and pumped $436 billion into the economy, the wealth effect will only further increase going forward. Just for reference, the GDP of Puerto Rico was $101 billion in 2012 – 25% of the dividends paid in the U.S.

In summary, things are great in the U.S. at the current time. There is no question that there are terrible events occurring around us, but the good is definitely out there. Those who think the economy is faltering clearly do not see what is going on around them. Until this changes or a geopolitical event that is unexpected knocks it down, I see nothing but further gains over the next 18 months. Yes, they may be muted to the prior gains but up is always better than down.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins