Some of you may have noticed – at least the kind few that take the time to read these updates – that this is our first commentary since early last year. Yes, everyone is just fine and dandy, and we are all still here. The reason for the absence was this:
I ran out of anything new to discuss.
And I’ve always been told, “if you can’t find anything new to say, don’t say anything at all…” (or something like that).
Quite honestly, that sentiment largely remains today, with a few important exceptions. To make matters worse, less a few stragglers that have managed to evade me thus far, all clients just got done listening to my long-winded synopsis of the investment world during our review discussions.
So, while the topics today may prove somewhat redundant at times, my hope is that this format will allow me time to expand further and (hopefully) to add additional clarity. Either way, I need to vent. So as usual, anyone reading along is also unknowingly serving as my therapist – helping me to accept my feelings toward the fact that “they” (the political and corporate oligarchs) have intentionally turned financial markets (and the economy overall) into a complete circus for the sole benefit of themselves.
On that note of unsurprising cynicism, let’s get into it, shall we?
The One Thing That is Definitely Different
From our update in October of 2020, referring to the prospect of inflation (or deflation):
“Unfortunately, we cannot know which of the two will ultimately occur – nor can we know when. What we are more confident in is the idea that the Fed has put us in a spot where one or the other is going to show up in significant fashion. While we acknowledge that we cannot answer this question with certainty, we do lean toward the inflation camp….”
You don’t need me to tell you that this question has now been answered. Inflation is here, and calling it “significant” is an understatement. This is where I am self-obligated to remind everyone that the inflation the Fed tells you is here (using CPI - the Consumer Price Index) and the inflation you experience personally are two very different measures. I’ll let you guess which of the two is based in reality (hint: it’s not the one coming from the Fed).
But while one question has now been answered, it leads to an even more important one:
Have we entered into a period of secular (lasting) inflation, or is it truly “transitory” as the Fed (until a couple of weeks ago) promised it would be?
Make no mistake about it, the answer to this question matters. A lot. As such, I am going to spend significant time in this update discussing why this question is so important, our attempt to answer it, and what we plan to do about it…
The first thing we all must understand about inflation is that it is a “hidden tax on your money”. Also commonly referred to as “taxation without legislation”. Remember, money - whether in a checking account or a stock certificate - is worth nothing more or less than the products and services you can purchase with it. That’s it. So, when the products and services that you want or need become more expensive, you automatically have less money. It’s really that simple.
As a result, inflation hurts low-income and retired families much more than it does the wealthy or those still working, for fairly obvious reasons. With that in mind, if you do not find yourself wanting to throw a brick through your TV every time you hear a politician or the Fed telling you how much they care about “the middle class” or “wealth inequality” – while at the same time dismissing inflation as “nothing” – it might be time for some personal reflection…
Disclaimer Time #1:
As a reminder, I identify as neither Republican nor Democrat. I despise both sides and likely more than you know, as I do not believe that either side acts in the best interests of those that elect them. Furthermore, I believe that they are all near-universally corrupt. As such, whenever I discuss something that might be deemed “political” (which covers just about everything these days) – and you find yourself offended - I offer no apologies. I view myself as an “equal-opportunity offender” when it comes to anything political. And whether we like it or not, politics play an almost entirely (now) significant role in the economy and financial markets.
Fair enough? Good. And by the way, do NOT throw a brick through your TV – both the brick and the TV have gotten significantly more expensive these days…
Back on topic. Since we all fully understand that inflation is eroding the value of our money, we must now examine what to do about it. Many of you reading this remember better than I the 1970s and early 80s – the last time we saw significant and sustained inflation. And one thing that might come to mind about that period was the interest rates. Since most of you were working at the time - and had a mortgage on your home - what might trigger in your noggin is the double-digit interest rate you were likely paying on that mortgage. What you might not remember as well – given your stage of life at the time – was that you could also earn double-digit interest on your CDs or treasury bonds.
Inflation doesn’t hurt quite as much when the bank is taking care of the rising cost of living for you - by paying you interest to compensate for it.
I don’t need to tell anyone that this is not the case today. Far from it. Today, the Fed was nice enough to:
- Help create said inflation (their own words when they listed it as their new mandate last year)
- Kept interest rates at near-zero for most of the past decade, including still today
- In addition to directly keeping your CD rates at near-zero, they are still printing billions of dollars monthly to buy treasuries in an attempt to keep longer-term rates artificially low
- Last but certainly not least – a topic which we will of course cover at length – they have correspondingly (and intentionally) created a “bubble” in now virtually all asset prices, so your fixed income alternatives to try to combat said inflation are as expensive (if not more) than any other time in history
Hey, thanks J-Pow! Can we have another?!
(By the way, “J-Pow” is my preferred nickname for the current chairman of the Federal Reserve – Jerome Powell)
Kidding aside - and I know I have stated this many times before – the above listed is what keeps Dave and me up at night. Obviously, our most pressing issue is trying to manage risk/return appropriately for our own clients faced with the above-described dilemma. But quite honestly, we are much more worried about “the system” as a whole – given that we can directly control the amount of risk our clients are taking. What we fear is that - in an aging society where virtually all pension income has been replaced by assets in 401k accounts – how much of that money has flowed into “risk assets” due to the absence of interest rates? There is no way to know that answer for sure, but we are all but certain that the answer is “too much”.
So, when we think about tail risk – or the risk of something completely unexpected or catastrophic happening to financial markets or the overall economy – this remains at the top of our list. What exactly happens to the economy overall when markets finally “revert to the mean”, in light of everything described above? Again, I unfortunately can’t know that answer, but I sure wish that many more – specifically our “leaders” – would at least acknowledge the problem. A problem that they themselves have created...
Simply put, the only way one can keep up with current (or future) inflation these days – in the absence of interest rates – is to take on additional investment risk. For some of you, this is uncomfortable because of your own tolerance (psychological) for risk. For others, it means you are faced with taking more investment risk (actual) than you can afford - based on the resources available to you. For those of us still a way off from retirement – or that have more money than they will ever need – this environment is more of an annoyance in its complexity. And just in case I haven’t yet made this clear, the “risk assets” to which I refer are historically expensive – making the risk that much greater. More on that to follow.
Regardless of where you might fall on the risk spectrum as described, the arrival of inflation along with the absence of interest rates does not make for a pleasant (or easy) experience. The good news for most reading this is that you don’t have to sit around all day, pondering what to do about it – you have hired us to do so on your behalf. The bad news is that it also comes with longer newsletters or discussions during the year – this being one of them…
Inflation and Mr. Market
Hopefully, I just properly detailed how inflation affects the value of your money – and the havoc it has created on the investment decision-making process. Equally important (and related) is the effect inflation itself may have on financial markets and various asset classes themselves. Of course, this is largely dependent on whether this bout of inflation does indeed prove to be transitory – or whether it persists. We promise to attempt our answer to that question later in this update. For the time being, we will just assume that inflation is going to stick around for a while. This section will also allow us to revisit some of the valuation discussions that many of you seemed to enjoy from previous updates.
First and foremost, let’s look at the role of interest rates in a different light. Historically, periods of high inflation would be accompanied by rising interest rates. For one, holders of longer-term bonds would expect higher interest rates as compensation for said inflation. This is historically accomplished through free-markets doing their thing – bond prices will fall until the corresponding interest rates are satisfactory to a purchaser based on their perception of current and future inflation.
If you all would please excuse me for a minute here…
Sorry about that, I’m back. I started laughing uncontrollably after writing that last sentence to the point where I could write no more. You see, when a central bank (The Federal Reserve in our case) is printing BILLIONS of dollars each month to purchase said bonds, you no longer operate in a “free-market”. Instead, it is a heavily manipulated – dare I say “rigged” – market. Just so everyone is clear, that is the bond market as we know it today. To be sure, one of the most fascinating questions of our day is whether interest rates on longer-dated bonds are as low as they are solely because of manipulation by the Fed – OR is the market signaling that the inflation will not only be short-lived, but deflation might instead be on the horizon. More on that to come.
The second reason one could expect rising interest rates in periods of inflation – this time on shorter-term or banking vehicles – is that the Fed (who directly controls short-term rates) will want to raise rates themselves in an attempt to slow the economy/financial markets, and therefore inflation in the process. In other words, they attempt to curb demand by creating higher borrowing costs. Remember, while we look at interest rates as a “lender” (holder of bonds) with your assets – the rate of interest one must pay to borrow the money will have a big impact on how much they can or are willing to borrow. If you can’t borrow as much, you won’t spend as much. This then slows demand and economic activity in return. The reason interest rates were as high as they were in the 70s & early 80s was in no small part due to the Fed relentlessly raising interest rates in their attempt to get the persistent inflation under control.
So how exactly is it that we are in the midst of the worst bout of inflation in some 40 years, yet the Fed not only has short-term rates at zero, but again is continuing to print billions of dollars each month to keep long-term interest rates lower as well? Effectively the exact opposite of what one might expect if they were interested in curbing inflation. Are they that dumb? Do they not care at all about inflation? Well, not exactly….
To answer that question, now is a perfect time to revisit some of our favorite valuation metrics around stocks. The point of studying any of these metrics is to evaluate where we stand today vs other periods in history. This can help us determine how expensive (or cheap) stocks might be in a historical context – and also allows us to examine how markets performed following periods where valuations were similar to where we stand today.
It is extremely important to note that NO valuation metric (or any other metric for that matter) tells us when markets might revert – stocks can remain over (or under) valued for very long periods of time. The past several years are a breathtaking reminder of this…
Following are a few of our favorite valuation metrics, with brief descriptions of each:
The Shiller P/E (Cape Ratio)
Reminder, the Shiller P/E ratio is a better metric (our view) than traditional price to earnings, as it measures the previous 10 years of earnings and adjusts for inflation – therefore largely removing the noise around the cyclicality of earnings.
S&P 500 Price to Sales Ratio
We prefer price to sales over P/E mainly because earnings (the “E” in P/E) are so easily (and often) “manipulated” through stock buybacks and accounting gimmicks. Sales, on the other hand, cannot be easily manipulated without committing (actual) fraud.
“The Buffett Indicator”
Market capitalization of the S&P 500 as a percentage of US GDP – Uncle Warren’s favorite…
Ok, so we can all now agree that – absent corporate earnings/sales exploding in a never-before-seen fashion – stocks are at the very least on the expensive side. I will argue that they are historically expensive. But we started this analysis by asking the question “What in the Good Lord’s name is the Fed thinking with their interest rate policy in the face of all of this inflation?!”
Let me share one additional chart, and see if you might come up with an answer on your own…
S&P 500 (orange) and Fed Funds (short-term) Rate (purple)
The vicious spike in the S&P over the past decade (especially the last 3 years) might make it difficult to see – so I will point out that the S&P 500 lost over 50% in value (peak to trough) following both the peak of the dot com era (2000) and the peak of the housing debacle (2008).
I will now defer comment to the following page, giving you time to ponder, and see if we arrive at the same answer as to why the Fed has chosen the path it has – even in the face of this vicious bout with inflation we have at the moment…
If you arrived at the answer “because they know they can’t raise rates without causing chaos in the markets” – ding, ding, ding - you are a winner! I know I mentioned last year that we were particularly proud of correctly anticipating (long before Covid was ever here) that the Fed would ultimately end up having to buy corporate debt. At the same time, I mentioned the one thing that we got so very wrong. We were mistakenly under the assumption that the Fed was unaware of what a “house of cards” they had created – and so the damage would already be completely done before they ever acted in that manner. (I was also under the assumption that they would have to at least CONSULT with Congress before using taxpayer money to buy bonds of corporations, but I digress…)
If we learned one thing from last year - in how quickly they acted in bailing-out all of the excess corporate debt – it’s this:
They know full well how dependent the entire system is on their “free money” policies.
Some things make a lot more sense in this light. The Fed spent most of the last 12 months telling us that inflation was “transitory” and “manageable”. If they didn’t say that, then they would have to answer for why they were not raising interest rates in response. Believe me, J-Pow is fully aware of how many millions of dollars his predecessor (now our Treasury Secretary – I’m laughing uncontrollably again) made in speaking engagements when she left the Fed. He ain’t giving up that gravy-train by letting this whole thing unravel on his watch – inflation be damned!!
But they have one other problem – and it’s a big one. Even if the Fed doesn’t care much about how inflation might hurt us peasants, in whom they so eloquently feign interest, there is another concerned party that must appear sincere on the matter – even though certainly laughing behind closed doors:
The politicians. Or, the oligarchs, if I may…
I mentioned to many of you in our chat that I was envisioning a conversation between our two favorite oligarchs of the day – Biden and J-Pow. One where our President tells his newly re-appointed Fed Chair “Come on man, this inflation is killing me. I’m polling lower than Trump, and everyone believes he’s an insurrectionist! You gotta get this inflation under control…”.
In response, I could almost hear J-Pow replying with “Um, Mr. President, I can respectfully give you 2 choices. One, inflation is going to stay hot for the foreseeable future. The other? I raise rates appropriately, and the markets and economy will suffer at best - collapse at worst. Let me know what you would like me to do…”
Apparently, this conversation did in fact take place. You might imagine our lack of surprise when the Fed recently and very unexpectedly announced that they will be “ramping up the tapering” (slowing of bond purchases), and that “actual rate hikes may be necessary sooner than expected”. I guess we now also know how that conversation ended, and will now wait to see if J-Pow is forced to follow through (against his will for sure). Of course, in the end, the oligarchs always win. If Powell was unwilling to fall on the sword, he would have been replaced with someone that would – end of story.
But the walls are quickly closing in. I hope none of them are claustrophobic…
At this point, we have covered valuations of stocks, the interest rate environment, and why the Fed may finally be forced to change course on rates. We have also discussed why we believe that these things do in fact matter – regardless of what the last salesperson on CNBC (or Cathie Wood) might say to the contrary.
Now is as good a time as any to share some updated projections from one of our favorite money managers / “market historians”, which a few of you had requested. These brave souls consistently publish their long-term forecasts for stocks (and other asset classes). They derive their conclusions mainly from studying historical valuations – much as we have discussed above.
From GMO (of which the infamous Jeremy Grantham is the “G”):
To summarize, GMO believes that US large and small cap stocks will achieve annualized “returns” of about negative 7.5% per year over the next 7 years (relative to inflation) – based on current valuations and their assessment of the economic and rate environment going forward.
Ok, that’s not fun. Do we fully subscribe to the numbers presented? That would be an emphatic “no”. Personally, I find it just as nonsensical to make specific predictions such as these as I do Goldman Sachs telling me every December what the S&P is going to do over the next 12 months. Now, do we agree with the sentiment and reasoning behind their numbers? I think you know that answer. Yes. Yes we do. And while history seldom repeats – but often rhymes – we are rather confident that interest rates and inflation will once again be a major part of the conversation. It really isn’t rocket science…
Some Final Notes on Inflation
Don’t get too excited yet – I said “on inflation”, not just “final notes”! In our view, it’s way too lazy to simply blame the Fed for our current state of inflation. There is little doubt that supply chains around Covid have played more than a small role – and they continue to do so. At the very least, supply chains are playing a significant role in the timing of this inflation. The election results also certainly play a role – even the most hardened Democrat will have a hard time justifying the last round of “free checks” as helpful to the situation. And if the current Oligarchs residing in DC come to an agreement on “Building Back Better” or “Social Infrastructure” – or whatever catchy phrase they finally land on – it will also hardly be helpful toward combatting inflation. Free money never is - though it does help that this latest type of free money never seems to end up back in the economy as promised, but rather dies in the laps of fellow Oligarchs.
It is also important to note what the word “transitory” really means when considering whether or not inflation will persist. Here, an example is most helpful. Let’s say the cost of your favorite cereal increased by 20% this year. The producer of said cereal blamed the 20% rise in the cost of oats for having to raise their prices. Question – if the cost of oats falls by 20% next year, do you believe that this cereal company will correspondingly drop the price of their cereal?
If you do, I would like it known that I have a bridge for sale. These oligarchs have stock to buy back – then sell personally afterward - mind you. That 20% premium comes in handy…
When they say “transitory”, the Fed is telling you that they expect the rate of inflation to slow – not that the inflation that has already occurred will revert. So, if inflation is 6% (as measured by them) this year - but then prices do not rise at all next year (from the now higher levels) – then inflation was in fact “transitory”. Technically, they are correct. I just want to make sure that anyone reading is not sitting home waiting for prices to revert back to 2019 levels. You are about to be sorely disappointed if you are – at least for now.
In summary – it is complicated. Very much so. We consume hundreds of hours worth of analysis on this topic alone – on top of the countless hours we spend analyzing ourselves. In the end, I’m fairly certain that no one really knows how this inflation story will ultimately play out – at least in the short-term. Of course, that is the nature of inflation itself – very hard to predict, and horribly difficult to control once it sets in…
Longer-term, however, our thesis has not changed – and this is where I fulfill my promise to give our answer to how we think this ultimately plays out. This thesis is best described as “inflation (now that we know it is here), followed by significant deflation – at least in asset prices. In essence, we have already laid out our base case in everything we have written above, never mind the countless updates you can still find archived on our website. We believe that the past 30 or so years are much more constructive in laying out a case for what is to come in terms of the “how” and “why” it will play out – while earlier decades could rhyme a little more closely with the “what” might occur (unfortunately).
This historical chart of the Shiller PE is a great visual in helping us explain our answer, so let’s stop and talk about it for a minute. Here it is again to you don’t have to go back:
Rather than me drawing a bunch of arrows along with text that no one can read because of its size, I am going to summarize a few periods below. For each period listed, you can reference the chart above to see where we stood leading up to each of them – and what then ensued in the years following – and compare to where we stand today.
I’m going to (hesitantly) keep this analysis to the past 60 or so years, and refrain from discussing the Great Depression era – mainly to keep the analysis more “current”. Of course, one could argue that we should remove all periods prior to our coming off of the gold standard – as it is now much easier for the Fed and politicians to “print their way out of trouble”. Still, I want to include the 60s and 70s for reference, as it was the last time we dealt with significant inflation. Let’s start there…
1973-1974 Bear Market
- S&P 500 lost about 48% over 1.7 years
- Took until 1980 (7 years) to recover
- Shiller PE peaked around 19, and bottomed around 8
- Fed Funds Rate started near 7%, and rose to over 13% during period
- Fed funds bottomed around 4.5% in 3 years following
Again, many are now looking back to this period because of the similarities around inflation. Imagine a stock market losing almost half of its value, while the Fed Funds rate spiked higher during the same period. Seems nearly impossible today – it was only 2018 when the Fed reversed course with rates a shade over 2%, simply because Mr. Market threw a 20% temper tantrum. Still, as they say, history tends to rhyme…
(Also, I’m leaving out discussion of the “Nifty Fifty” from this time period – only for the sake of time. For those interested, I highly recommend reading about it on your own, as some of the similarities with today are striking – especially around valuations and concentration. Possible topic for a future update.)
2000-2002 “Dot Com Bust”
- S&P 500 lost about 49% over 2 and ½ years
- Took until 2006 (6 years) to recover
- Shiller PE peaked around 44, and bottomed around 21
- Fed Funds Rate started near 6%, and dropped to a low of near 1%
- Fed Funds didn’t start to rise again until 2004
You certainly hear a lot of comparisons drawn between this era and what we are experiencing today. In our view, some of it is warranted (some tech stocks, penny stocks, crypto, etc.), but a lot of it isn’t. To be clear, the leaders of today’s market are real companies with real earnings. This was not necessarily the case back then. It is for this reason that I don’t mention the over eighty percent drop in the NASDAQ over that time period – I just don’t think it’s a useful comparison (though is certainly a fair comparison for some pockets which shall remain nameless in order to get this through compliance).
That said, look at valuations today using this metric compared to 2000 – we ain’t that far off folks. And when you acknowledge that the index today is largely “real” companies - unlike the dot com era - one can start to more easily make the case that we are even more overvalued today than we were then…
2007-2009 “The Great Recession”
- S&P 500 lost about 57% over 1.5 years
- Took until 2013 (5.5 years) to recover
- Shiller PE peaked around 27.5, bottomed around 13
- Fed Funds Rated started near 5.25%, and fell to near 0% by the completion
- Fed Funds never began rising again until 2016
This period was arguably the last time that stock valuations (S&P 500) actually did “revert to the mean”. However, if you blinked, you missed it. The Shiller PE was back above 20 by 2010. This is largely unsurprising, as the Fed immediately took rates all the way down to zero, and began their bond purchase program from there. I mean, it worked so well the last time – why wouldn’t they? Sarcasm intended.
Which gets us to the point…
Where We Are Today
- Stocks have gone up in the proverbial “straight line” for more than a decade
- Shiller PE currently sits around 39
- Fed Funds rate started near 0%, and still sits near 0% today
Hopefully, everyone can already see where we are headed with this. I hate to ever say this, but it seems clear as day in our view. In the 90s, things were getting nuts – though for legitimate reason as the internet came into prevalence. The bubble eventually popped – made worse when 9/11 was thrown in the mix. And the Fed decided the best way back was to take interest all the way down to 1% at the time.
It worked. As discussed above, valuations never truly ever reverted to historical norms. Stocks rebounded, and of course, the values of homes started rising like never before in reaction to all of the “free money” slushing around. This time, the Fed did raise rates in attempt to slow things down. The rise in rates ultimately brought about the worst recession since the great depression – and another 50%+ loss in the S&P 500, while home prices simultaneously cratered.
Because it worked so well last time, the Fed then took it even further and lowered rates all the way to zero. Things were so bad this time, however, that they also devised and implemented their QE policies for the first time – in an attempt to control even longer-term rates and the borrowing costs associated with them. Of course, this was all supposed to be temporary. Give them time to bail out the banks, and they would reverse course in due time.
Yet here we sit, interest rates still at zero – and the money printers still buzzing with the latest rounds of QE ongoing. Stocks are at all time highs. Real estate is again exploding higher. Commodity prices are surging. We’ve got Bitcoins, Shitcoins, and NFTs joining the party. Leverage in the markets at fresh, all-time highs.
All of this should make perfect sense. Of course, so should the aftermath…
The problem arises when you run out of rates to lower. The threshold for how much they can raise rates before “bursting the bubble” is lowered with each cycle. In our view, this is most clearly demonstrated in the chart shared previously showing Fed Funds with the S&P over the past 30 years – while simultaneously looking at what happened to markets when they raised rates to a mere two percent in 2018. So, what happens when the rate threshold is so low – and (all) asset prices are so high – that there is simply no more room for manipulation? Or, worse yet, something unforeseen happens – and the asset bubble bursts with rates already at zero?
Something unforeseen like – just spitting here – a serious bout of inflation?
To be sure, I am not suggesting that our current bout with inflation is definitely the prick that pops the proverbial bubble – only time will tell. But I am making the case as to why it could serve as such. In the end, our thesis remains unchanged that we are in the midst of yet another market (now “everything”) bubble – fueled by interest rate policy and manipulation – which will ultimately end with valuations reverting back to the mean (painfully) as they always have.
They (the Fed and the oligarchs) truly are stuck at this moment in time. In our view, they have dangerously little room to tighten monetary policy without creating significant deflation in asset prices (mean reversion, or bubble bursting). As we have explained in previous updates, it is our belief that the economy is a function of asset prices – no longer the other way around. If we are correct, deflation in asset prices could very well bring the economy to its knees.
However, if the Fed doesn’t act appropriately, they run the risk of inflation getting progressively worse. In that case, the economy and asset prices might very well collapse simultaneously, under the weight of unmanageable input and labor costs. In that scenario – much like the 70s – the Fed is then forced to raise rates at the exact same time they would want to be doing the opposite, making matters worse.
It seems to us that their best – and most likely, given their track record – course of action is to act with extreme caution with their rate policy, erring on the side of doing too little. Then pray that inflation recedes on its own, and stays manageable. The alternative is to tighten aggressively – then pray that the corresponding deflation in asset prices remains manageable. See the next section below as to how we believe they will attempt to “manage” asset prices in either scenario.
Either way, you can now see how it has become a “damned if you do, damned if you don’t” situation for them. Of course, they have no one to blame but themselves. They could have been slowly raising interest rates 10 years ago – never mind exiting their QE programs as promised countless times. We’ve only been ranting about this for, I don’t know, 10 years now? But they didn’t, and we now know that they understood that this day would come. Like just about everything else in our society today, long-term pain was ignored in favor of short-term gain. So here we are…
All of that said, one very important note before we move on to how we are choosing to handle all of this. If I have done my job properly, I have clearly laid out our case that the Fed is running out of options – though they completely understand that they cannot afford to lose control of asset prices. If the current bubble bursts - with interest rates already at or near zero – what are they to do? I’ll take a stab at it:
Instead of printing money to buy only bonds (treasury and corporate at that point), they will then print money to also buy stocks.
I already mentioned this in previous updates, so I won’t go on for pages today. Still, I cannot stress enough how emphatic we are that this will occur – nor can I stress enough the importance when it does. We spend more time in our office talking about this possibility than just about anything else these days. Why? Because at that point, even we could make the case that valuations truly no longer matter. If the Fed can just print money and buy unlimited stocks, why would they ever go down?
This is long enough, and we don’t have to spend another 10 pages analyzing insanely complicated hypotheticals. But while on the topic, we have tossed around the idea of creating our own version of a podcast. Our version wouldn’t be a scripted one of us babbling on a random topic – but rather a published recording of our strategy meetings, where we talk through matters such as this. Not sure if we will do it – the cursing alone might make it impossible to get through compliance. But you will be the first to know if we do – and feel free to let us know if you would be interested (or not)…
Some Additional Thoughts on the Landscape
Before diving into our thoughts on navigating through the current environment as described, let’s first revisit our views on headwinds & tailwinds for the economy and markets for additional context. Below, I will list each – in order of perceived relevance to us – and whether we view the importance of each as short-term, long-term, or both:
- Valuations (short and long-term concerns)
- Interest Rates / Inflation (short-term)
- Margin Compression (short and long-term concerns)
- Labor Shortage (short-term concern – maybe?)
- Geopolitical Risk (short and long-term concerns)
- Government Reaction to Covid (short-term – maybe?)
- Unemployment (replaced by labor shortage)
- Reduced Stock Buybacks (that ship has sailed)
- Increased Taxes (will never get it through in time)
- Covid Variants / Vacccine Ineffectiveness (I'm not going there)
- The Federal Reserve (short and long-term)
- Re-opening of “Blue States” / Travel (short-term – maybe?)
- Transitory Inflation (short and long-term)
- AI / Automation (long-term)
- Modern Monetary Theory (Democrats will lose control ’22)
- Lay-Offs (there is a massive labor shortage actually)
Thankfully - for those that have made it this far – I can summarize the above very succinctly. As it pertains to stocks – in our view – number 1 in each category is all that really matters. The rest is just noise at this point. The tailwinds could all prove stronger than I would ever expect, and stocks still couldn’t escape the extreme valuations they currently enjoy. Conversely, valuations can get even more extreme in the coming year – believe me, they can – for as long as the Fed can manage to keep this party rocking on their end (with rates and free money).
Any further analysis from there would be to assume that stocks were trading on “fundamentals” in the first place. They are not. Enough said…
Which now brings us to an updated (and still very simplified) ranking of our asset classes (or strategies). Again, for the sake of your time, we will boil it down to just a few, as well as indicate where they have moved on our list since this time last year:
- Gold (up one spot from #2)
- Short (inverse) US Stocks (up one spot from #3)
- Broad Based Commodities (down two spots from #1)
- Emerging Market Stocks – Kind Of… (new addition)
- Ultra Short-Term Bond / Cash (same spot as last year)
Hugely important note – this is our rankings taking a long-term view. Yes, “long-term” is arbitrary. But it is most certainly not the next week, next month, or even next year. We will call it an arbitrary “next 10 years” – fair enough?
This is now where I insert another hugely important note – that being, I still have no better description for the overall state of the economy/financial markets than a “gigantic, Fed-induced casino”. This applies to every asset class listed above, as well as the hundreds that remain off the list. To be fair, I would use that same description (less the “Fed-induced”) in more “normal” market conditions – assuming I was only talking about the next 12 months. But I unfortunately now view markets in this light even using a long-term view – for all the reasons I have (hopefully) made clear in my ranting so far.
Let’s start with gold. I am convinced that gold will be the death of me. I still can’t believe that I am even talking about gold, and am now convinced that I am in fact living in some sort of matrix when it makes its way to the top of our rankings. Gold makes zero sense – yet at the same time – it’s the only thing that makes any sense. Let me explain…
I have one perceived certainty for the next ten years. That certainty is that the Federal Reserve – and central banks around the globe – are going to continue to print previously unthinkable amounts of money. They simply have no choice. Now, the “gold bugs” (those that believe gold is the be all and end all) will be quick to tell you that gold has been the “store of value for 4,000 years”. In other words, if you want to protect against “J-Pow Gone Wild”, gold might just be for you. This is why gold remains one of the few asset classes that make sense to us today, looking long-term.
What the gold bugs don’t tell you, is that for some 3,950 of those years, gold was either the actual currency being used, or at least backing all of the paper currencies out there. That is no longer the case. It’s no longer the case anywhere. So, I like to call it instead the “perceived store of value” in its current state. But let’s be clear – for this reason alone - gold shall remain considered “part of the casino”. There remain many risks and uncertainties surrounding this asset class to be sure…
Still, there are several reasons it belongs in one’s portfolio in our view. The printing presses are indeed running overtime. Central banks around the globe still do hoard the stuff. It can act as a hedge against tail risk in currency markets. And, historically, it has tended to do well when stocks are imploding. All things considered, and given the state of everything else, it’s made it to the top of our list. When we analyze the potential risk/reward profile of any asset class over the next ten years, nothing else comes particularly close. How we reached this point still baffles me however…
Moving on to number two on the list – short US Stocks. As a reminder, “short” means betting against stocks – in other words, making money when they fall in price. Simply put, we believe that there is more money to be made – from today’s valuations and with a long-term view – betting against stocks rather than owning them.
That said, we will readily admit that it is near impossible to short stocks directly in this type of environment. Doing so can get painful in a hurry. There is a way to do it more responsibly, which we will get to later.
On to broad-based commodities. They were tops on our list last year - mainly due to our fear of inflation. Inflation arrived much hotter and quicker than we would have expected – and commodities spiked as one would assume. Already discussed our longer-term view that deflation will ultimately set in – at which point commodities will almost certainly not be your friend. Still, we can’t rule out a “stagflation” environment (Fed refuses to act) where inflation and commodities continue to rise – while the economy and other asset prices fall (see the 70s). As such, they remain in the mix.
Emerging market stocks. Upside is in how much more favorable their valuations are vs the US. Still, show me a period where emerging markets stocks did well while US stocks fell in significant fashion. You can’t. And you certainly know our view on US stocks long-term from their current valuations. So they are on the list, but not as high as they otherwise might.
As for cash – let’s put it this way. If/when the house of cards falls, cash will likely be your best friend – regardless of how low the interest rate. Of course, the more inflation sets in, the more cash (with no interest) is your enemy. Deep down, because of our long-term views as discussed, we would prefer cash or (preferably) other ultra-short-term income be higher on this list. However, the lack of interest rates – along with the significant inflation that may or may not persist – pushes is it down. There just isn’t any return to be had, while the risk of persistent inflation remains substantial.
Now, I don’t think I need to reiterate this, but I will anyway. The reason we don’t rank asset classes based on what we think they will do in the coming year - is that we have no flipping idea what they are going to do in the coming year. Nor does anyone else – even though most all of these “outlooks for the year ahead” in our industry spend their time trying to convince you otherwise. This year, we were insanely lucky in that our #1 ranking (broad-based commodities) actually performed as such (at least until the last few weeks) this year. We were insanely unlucky in that our #2 ranking (gold) might literally be the only asset class that actually lost money in 2021.
What any of these asset classes did over the past 12 months – or what they do over the next 12 months – is not our primary concern. That said, what we are always concerned with is whether or not something has changed that would cause us to re-think our long-term view of any asset class. A quick example in hopes it will further clarify this point:
You will note that #2 in our long-term rankings is “short US stocks”. As you know, this is due mainly to concerns around valuations and their sustainability. Now, let’s hypothetically assume that the S&P 500 were to drop by 50% over the next 6 months – do you think that would change our long-term view of that asset class? Of course it would! At that point, not only would “short stocks” be off the list all together, but it would most likely be replaced with owning stocks for the long-term instead. At that point, valuations in that asset class will have gone from “historically expensive” to “historically cheap” – or at the very least “fairly valued”.
So yes, what happens in the coming year (or the rest of today for that matter) is of critical importance to us – but only to the extent it alters our long-term view of the economy, markets or any particular asset class. And this is the reason that we spend all of our time in these updates discussing our views on the overall environment – and zero time (with very few exceptions) pretending that we know how any market or asset class will perform in the year ahead.
So, with that, we move on to our final – and most important – piece of this update…
What to Do?
For those still reading along, you’ve almost made it to the end – I promise. All that is left to discuss are some thoughts on what we can do in the face of everything we have described herein. Take too much risk, you are overly exposed to the bubble bursting – and hoping the Fed has any tools left to make said bursting a quick experience. Take too little risk, and you are left exposed to inflation eroding away your purchasing power – especially if it persists. This is an almost impossibly difficult investment environment – and it requires some serious creativity in our view.
Rule number one in this exercise:
Remember why you are investing in the first place.
I’ll go ahead and answer this one for you – as it is near-universal. You are investing with the goal that your monies allow you to live your life the way you choose, for as long as you are on this earth. It is that simple. Having higher returns than your neighbor next year might feel good, but it is irrelevant in the long-term if you are taking on too much risk to get there. Similarly, losing money with your investments next year might feel painful, yet again irrelevant in the grand scheme of things – assuming of course that you don’t lose more than you can afford.
Every single investor in the world has their own, individual “investment profile”. Your profile is made up of your goals, resources, timeframe, tolerance for risk, etc. Understand your own “profile”, and don’t let short-term noise cause you to deviate from it. Focus only on the long-term.
Rule number two:
In a world of maximum uncertainty, refrain from pretending otherwise by making large, concentrated bets.
Diversification of one’s assets has always been important – though I would suggest never as important as it is today. The range of outcomes at this point is massive, while the potential magnitude of each has never been greater.
So, what does it mean to refrain from “large, concentrated bets”? We’ve made clear our long-term assessment for stocks at this point. At the same time, we have not completely removed stock exposure for our clients (our ourselves). Why? Because doing so would be us making a large, concentrated bet that stocks have nowhere to go but down. But what if valuations remain elevated for another decade? What if the Fed and politicians are able to print money endlessly, without consequence, and stocks continue to get even more expensive as a result? And all of this occurs while we sit in cash - earning nothing - with our money being eroded by the inflation all the while. Even with everything I have expressed so far, we can envision that scenario. We find it extremely unlikely, but we can envision it nonetheless…
All of that said, I certainly do want to reduce our straight equity exposure – based on our beliefs as described. And by reducing our stock exposure, we can then add exposure to the other asset classes that make more sense to us – such as commodities and gold. But those assets carry their own risks and uncertainties as previously described – and may or may not be correlated to stocks if/when the house of cards finally falls.
So, we also need the “stability” piece built in – which would traditionally be filled with bonds. The problem here (as discussed in previous updates) is that the interest rates are so low, they not only lack sufficient protection in terms of interest earned – but they too are at risk of significant loss should the Fed lose control of interest rates. Never mind the fact that inflation is currently running significantly higher than any interest rate you can find on even the longest duration treasury securities. That’s not good.
Ok, so we overweight cash. Cash won’t lose money no matter what stocks or interest rates are doing – so we get our stability, right? Of course, you also get exactly zero return. So, if inflation stays running hot – and we are sitting in cash – we are in fact losing money. It just doesn’t look that way on a statement.
Hopefully, the casino analogy is making more and more sense at this point…
Thankfully, there are additional options available to us. They are not an “asset class” per se, so they don’t show up on our rankings. Even if we added them to the list, it wouldn’t fit as their use is more short-term – at least for as long as the casino analogy fits. And much like I cannot believe that gold has somehow made its way to our number one, long-term asset class – I’m equally shocked that the strategies I am about to discuss have become our preferred manner of investing at the moment. Every time I think I’ve seen it all…
The strategies to which I refer are “long/short” and “market neutral”. In essence, both strategies involve being long (owning) asset classes or securities that a money manager may like, while being short (betting against) those they view unfavorably. It is most commonly associated with stocks, but can also be deployed with bonds, commodities or other asset classes. Long/short money managers will tend to overweight either their long or short positions in an effort to maximize return, while market neutral managers tend to take equal sides long and short to remove “market risk” (directional) all together.
As an example, a long/short manager who might share our views on US stocks – while believing that there is long-term value in emerging market stocks – would short (bet against) US stocks while being long (owning) emerging market stocks. Depending on his views, he might be more short than he is long or vice versa.
A market neutral manager who believes that growth stocks are significantly more expensive than value stocks might own a basket of value stocks while at the same time shorting growth stocks. Unlike the long/short manager, the market neutral manager would be long and short his positions in equal dollar amounts.
Additionally, there are long/short strategies designed to take advantage of “momentum”. These managers tend to not to take stances on the state of the economy, and don’t give things like “valuation” a second thought. Instead, they simply follow “the trends”. If an asset class has been trending higher, they will own it. If it is deemed to be trending lower, they will short it. That’s it. That’s the strategy.
To be sure, as enticing as they might seem given the current state of things, none of these strategies are some sort of magic wand in the face of an otherwise impossible environment. For traditional long/short managers, they need to be right in their decisions of what to be long and what to be short – in addition to how much to weight each. Market neutral managers are left with the same decisions, just without the weighting issue. And long/short managers basing their decisions on momentum can get whipsawed by a market that makes violent, short-term swings without a clear trend ever developing.
If you are following along so far, one of the main benefits of these types of strategies – in light of all that we have discussed today – is that they can (potentially) make money in both up and down markets. At the very least, these strategies should offer significantly less downside risk than comparable “long-only” funds due to their short exposure. Of course, the trade-off is that you are also giving up potential upside for the same reason.
In summary, strategies such as these might be employed when nothing really “makes sense”. When we are extremely mindful of downside exposure, but also seeking upside potential to protect against current and future inflation. When we see value in being short certain asset classes, but don’t want the risk associated with calling a market top in an insanely speculative environment. Or when interest rates are so low, that traditional fixed income has largely lost its utility.
So, there you have it – our playbook for navigating the current environment, and doing so while maintaining a long-term view. It involves “max-diversification”, and not making large bets on any one outcome. To be sure, the arrival of inflation – especially in such significant fashion – has surely made everything more complicated in the short-term. At the same time, I hope that I have sufficiently explained how our longer-term views have not changed – and most important – how those views might apply to each of your individual circumstances…
Final note before I wrap this up – and I’m speaking for myself here. If you find yourself sensing a certain level of cynicism in these updates, your senses are correct. For better or for worse, I’ve always called it like I see it, and I tend not to mince words. At the same time, please do not mistake my cynicism – or its redundancy at times – for tunnel vision. We spend far more time seeking research and data that would contradict our views than we do looking for confirmation bias.
Furthermore, regardless of popular opinion, I am not some old curmudgeon waiting for the world as we know it to end. Well, an old curmudgeon maybe – I will be 50 next year after all. My point being, if we ever find reason to believe that our long-term thesis is flawed – or that valuations and recent monetary policy are truly sustainable without consequence – we won’t bat an eye at changing course, and quickly communicating as much. Unfortunately, as of this writing at least, we remain unconvinced…
In the meantime, please understand that any cynicism you detect is simply my version of “honesty”. I have no desire to sell narrative – fear, greed or otherwise. In fact, I have no desire to sell anything. As far as I am concerned, the world could use a lot fewer salespeople at the moment – and a lot more people willing to think for themselves. So that cynicism – seemingly growing by the day, and hardly limited to financial markets and the Federal Reserve – is nothing more or less than my honest assessment of the topic at hand.
Yet I cannot sufficiently express just how much I love my job. Yes, there are more days than not that I want to throw that now more expensive brick through that now more expensive TV - or find myself staring at the “BITFD” displayed prominently in my office. Still, I arrive at the office each morning full of energy and passion – with the challenge of navigating these crazy times with and on behalf of all of our clients.
Speaking again on behalf of our whole team, that energy and passion around our work truly is a gift that many do not enjoy – a gift that never goes unappreciated. And we have the trust and confidence that each of our clients have placed in us to thank for it. We can never sufficiently express our gratitude for the opportunity.
And speaking again of navigating this crazy world, we remain confident that we will do so successfully - and promise to always give you every ounce of our energy toward that end…
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are not guaranteed to continue in the future.
All performance referenced is historical and is no guarantee of future results. Investments mentioned may not be suitable for all investors.
Equity investing involves risk, including loss of principal. No strategy – including tactical allocation strategies - assures success or protects against loss.
Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time. There is no guarantee that any investment will return to former valuation levels.
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