I normally begin writing these updates with a title in mind first, as it serves as a guideline for what I hope to ultimately accomplish. After a full week of contemplation, I still haven’t arrived at an appropriate title for this piece. So, I’m going to work backward and simply start writing – hoping that the title makes itself obvious as I proceed. As such, I can’t tell you upfront if what follows will be short or long in length – or simple/overly technical in content. Guess we will have to find out together as I start typing literally whatever comes to mind. All good stories start with an element of intrigue, right?
I must admit, I currently find myself in a “funk” - which has presented itself in varying degrees over the past couple of weeks in particular. It is not a mental state I find myself in often, and definitely not one I enjoy. My personality normally lends itself to the “let’s take on the world at 500 MPH” – and it’s usually very easy to identify and eradicate whatever might be getting in the way. But this feels foreign, and I can’t seem to put a finger on it.
It might be that we just finished the process of rebalancing accounts. This year was particularly challenging due both to the time sensitivity as well as the detail in what we were trying to accomplish – made more difficult in that we customize portfolios for each client individually rather than running “models”. But while short-lived funks often follow the completion of major tasks, they tend to evaporate near-immediately as I quickly immerse myself into the next project (scheduled to be this letter). Surprisingly, this time was different – so I don’t think this is my answer.
Another real possibility was the overall environment that I discussed with each of you in our review call. As I mentioned then, and reiterate today, I have absolutely zero interest in gambling with the monies you have entrusted to us. So, when the Federal Reserve turns the entire financial system into some glorified casino – and they have – it becomes disheartening to say the least. Still, the Fed and their corrupt mismanagement mainly triggers anger for me – and anger has always been a motivator. Additionally, this didn’t just happen overnight – we’ve been analyzing it to death for years now. Thinking through, it can’t only be this.
As I type this, I’m looking across at my son Logan (9) and daughter Reagan (11) doing their “schoolwork” – of course staring at a Zoom session on their laptops, as they have been for nearly 12 months now. The looks on their faces these days during “school” are truly indescribable. No, not indescribable – it is heartbreaking. I just told them to shut the screens off and go outside – I’ll deal with their teachers later. If this was truly happening because of the virus, as it was last March, then we deal with it and move on. But that’s not what is happening now – this is happening because the supposed “adults in the room” are incapable/unwilling to act as such. We have truly reached a point where it seems our self-interests as adults rank above the well-being of our kids. Think I am getting closer to my answer….
And now I think about all of you – our clients. I think about how many stories I have heard from you about being couped up at home. How many trips I was looking forward to hearing about, long-ago cancelled and still unsure when they might be made up. I haven’t seen the vast majority of you in-person for over a year now. Selfishly, I will say that I miss seeing everyone – and it is surely taking a toll. Much more importantly, my heart hurts knowing how this is affecting many of you in so many different ways.
Often the case when transferring thoughts to paper, I think I may have just put my finger on what is causing this funk – and come up with the title of this update at the same time….
Ok, I think I’m now ready for warp speed again. So, for those of you more interested in my psycho-analysis of myself – you can stop here (please don’t). For the rest, buckle up – and let’s have some fun!
I think I may have mentioned somewhere before, one of the most rewarding items for us that came about as result of COVID was the installation of a giant, glass dry-erase board in my office. There, we can record all sorts of random data, thoughts, etc – and have them staring back at me 24/7. One item we decided to add was quotes that we found particularly poignant. Stealing a page out of Grant William’s playbook – which we think is fair as we are now convinced he’s stealing from ours (the title of his latest podcast is simply “casino”) – we will be sprinkling all quotes currently on said board into this update where they fit most appropriately.
(Side note – for those of you who truly enjoy following along – I cannot recommend strongly enough Grant William’s work. He is now behind a paywall (though inexpensive), and can be found at www.grant-williams.com . I do not know Mr. Williams, nor are we affiliated with him in any way – it’s simply fantastic, independent and entertaining analysis of all things finance…)
Another addition (or subtraction) this time around – we are officially finished with the short-term “prediction” segments that we have reluctantly included in past outlooks. As we have explained previously, short-term predictions are, in no particular order of importance:
- Dangerous in that they cause one to focus on short-term noise rather than what really matters – that being long-term objectives.
- Utterly ridiculous – no one has any idea what is going to happen in the short-term.
- Used by Wall Street as a sales tool to have you believe that they have a crystal ball that simply doesn’t exist.
Now, does this mean we don’t have opinions that we will share? Come on now. But while we will miss the entertainment value of comparing our own short-term forecasts with those of the coin-toss, we believe the removal of such predictions will serve both the authors and their audience well in this case. Much more on this surely to follow, as we reiterate the importance of long-term planning vs. short-term psychology – especially when being forced onto the floor of a casino by Jay Powell and his band of merry morons at the Federal Reserve.
And while speaking of the Fed, I can think of no better time to introduce our first quote of the day:
“When plunder becomes a way of life for a group of men in a society, over the course of time they create for themselves a legal system that authorizes it and a moral code that glorifies it.”
- Frederic Bastiat (French Economist), 1848
With that, let’s get into it…..
Bubble or No Bubble – Do Valuations Matter (and will they ever again)?
“Men, it has been said, think in herds. It will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
- Charles Mackay (author/poet), 1841
Before I start babbling on the topic, let me reiterate a very important and redundant point. My job requires that I not be an optimist, nor a pessimist. To do my job effectively, I must do everything in my power to remain a realist. Please believe me when I say it would be much easier to simply bury my head in the sand, and view all things through rose-colored glasses. It would be easier on my brain (I am not a pessimist at heart), it would make our conversations with you more enjoyable and uplifting, and it would be much more financially rewarding when speaking with prospective clients. Let’s face it, everyone wants to hear good news – especially these days….
There are many days when Dave and I find ourselves wanting to say “f&*k it”, and just move everyone into a 60/40 model like “the rest of the world” – then simply blame the markets or the Fed when reality finally sets in. But honestly, I would sooner close our doors and quit. We made a promise to each and every one of our clients to be honest, transparent and – most importantly – put your long-term objectives above all else (including our own mental health). Importantly, a very significant aspect of doing so involves managing risk(s) - and that is exactly what we will continue to do, with as much transparency as our clients will allow.
So while much of what is discussed in this section might be viewed as pessimistic in nature, my hope is that everyone reading will instead view it as intended – a realistic discussion. And I promise, not all of what you are about to read is negative in tone – there are always opportunities along with the risks, and we will spend significant time on those as well.
With that out of the way, let’s examine a few important metrics – presented in historical context and without opinion:
Price to Sales – S&P 500
Price to sales (P/S) is one of our favorite individual metrics to look at. As the name suggests, it is derived simply by dividing the “total price” of the index by the total gross revenue produced. We view it as a more “pure” metric of studying valuations, as revenue cannot (legally) be manipulated, whereas “earnings” (used to calculate price to earnings, or P/E ratios) can (and are) manipulated through accounting gimmicks. The higher the ratio, the more expensive (or over-valued) the index might be perceived.
Source: www.multpl.com/s-p-500-price-to-sales
Price to Earnings – S&P 500
Price to earnings (P/E) is the most commonly referred to valuation metric by a large margin. Same calculation as the P/S, except net earnings is the denominator. As mentioned, it is more easily affected/”manipulated” by taking “creative accounting measures”.
Source: https://www.multpl.com/s-p-500-pe-ratio
Shiller P/E Ratio – S&P 500
We have discussed this metric many times before, and it remains our favorite by a large margin. The Shiller P/E is essentially the same as the traditional P/E ratio, with two important differences. First, it incorporates the previous 10 years’ worth of earnings – rather than just the past 12 months. This better accounts for the cyclical nature of corporate earnings. Second, it adjusts the readings for inflation.
Source: https://www.multpl.com/shiller-pe
US Market Cap to GDP (Gross Domestic Product) – US Total Stock Market
Commonly referred to as the “Buffett Indicator” due to Warren Buffett’s affinity for it, market cap to GDP simply measures the total “value” of the US stock market to the GDP of the US.
If you’re following along to this point, we can start to form an opinion on the topic. You now all have visual evidence supporting my repeated statements to you that “depending which metric you use, stocks are either as - or even more - expensive than at any other time in history”.
But the question is whether or not we are in a bubble – “expensive” and “bubble” are not necessarily one and the same. Having been fortunate (I guess) enough to have seen the “dotcom” and “financial crisis” bubbles up close and personal – and as pointed out by many others much more intelligent than I - we know that true bubbles will tend to have almost unthinkable speculative aspects to them. Think Pets.com for those old enough to remember, or simply recall the real estate frenzy of just over a decade ago.
Do we have this today? Well, we will let you decide:
- As of January of this year, Tesla’s market cap was greater than the market cap of Toyota, Volkswagen, Daimler, GM, BMW, Honda, Hyundai, Fiat Chrysler and Ford…..combined (Reuters). Let me say that again – COMBINED. Now compare revenues…
- A bunch of “kids on Reddit” were able to almost bankrupt a multi-billion dollar hedge fund by forcing the price of Gamestop from a 52-week low of around $2.50 to a high of $483 per share. (see also: message boards in the late 90s)
- Many penny stocks (low-priced and/or unlisted shares of mostly near-bankrupt companies) are regularly rising by hundreds and thousands of percentage points.
- Bitcoin….probably.
- And if you question any of the above and whether or not it is sustainable, you are immediately attacked as a “Boomer”. Note - I am in fact NOT a Boomer. I’ll be 49 in October, which puts me squarely in the “Gen X” camp. Though I happily accept the label as a compliment, given who I see doing the assigning. I digress….
So yeah, I’d say the speculative bid is alive and well these days.
“This is not speculation – this is now desperation.”
- Me (hater of the Fed), June 2020
But let’s not get ahead of ourselves. If we all agree that – at the very least – stocks are expensive, there are two ways they can normalize. One is that the bubble bursts, and the numerator (price) crashes back to earth. But the second – as JP Morgan, Goldman Sachs and any other Wall Street salesperson will immediately point out for self-enrichment purposes – is that the denominator (sales, earnings or GDP) can grow into the numerator. Fair enough – that is true, though extremely uncommon historically I might add.
To gauge the likelihood of the latter, we will go back to our own “headwind/tailwind” analysis for corporate earnings into the future – updated since we posted last, and listed in order of importance as we see it:
Headwinds (negative for future earnings)
- Interest Rates Already at Zero
- Margin Compression due to Higher Commodity Prices (new)
- Higher Taxes Going Forward
- Geopolitical Risks (China)
- Elevated Unemployment Rate (also a tailwind in reverse)
- New COVID Variants / Vaccine Ineffectiveness
- Removed – Reduced Share Buybacks (no political will remains)
Tailwinds (positive for future earnings)
- The Federal Reserve (no chance at rate hikes – maybe ever)
- MMT (Modern Monetary Theory - or, fiscal spending of money that we don’t have)
- Re-Opening of Economy due to Vaccine or Politics (short-term)
- Lay-offs / Cost-Cutting (also a headwind for economy)
- Artificial Intelligence / Technology (also headwind due to employment)
Taking a peek, just realized I’m on page 7 already – so I’m going to over-simplify analysis of the above as there is still much to discuss (and no, this is not the “mother of all updates” that I promised). I think one could make the case that in the short-term, the tailwinds might even outweigh the headwinds. I say this because I don’t think tax increases are politically feasible in the short-term, while stimulus and all the other free goodies the politicians can provide given their adoption of MMT is in fact feasible (though not certain).
That said, two very important points to consider. The first is that in order for earnings growth to justify current valuations, stock prices would have to stay stagnant from here, while best-case earnings growth materialized. In other words, it wouldn’t justify further gains for stocks – it only justifies current levels, at least until earnings catch up. If stock prices keep climbing at a much faster pace than earnings, then valuations become that much more extreme.
More importantly, our second reminder – it is not the short-term that we should be focused on. In our view for the longer-term, the headwinds far outweigh the tailwinds. We entered this year with broad-based commodities as our highest long-term investment conviction. Long-term the operative word. Commodity prices in general have exploded higher already this year (will discuss in more detail later), and a further runup would push margin compression (reduced earnings due to higher operating expenses) forward in terms of risk to earnings.
All of this said, when you are in the midst of a speculative period (we are), valuations don’t much matter. Gamblers are gonna gamble and markets are gonna market. But since we are only concerned with long-term objectives – in our view – there are significantly greater headwinds than tailwinds for earnings going forward. This is on top of equity valuations at or near all-time highs. That’s a dangerous combination.
So yes, you will not be surprised to learn that – in our view – we will at some point in the future look back and realize that we were in fact in the midst of a bubble. I don’t know when “that point” will occur, nor does anyone else. That said, valuations are not a great market-timing tool (I don’t believe such a tool exists). Instead, as you know, we use valuations as a guide to tell us when we should lighten up on risk – or when it is time to get more aggressive. But never all-in, never all-out (though admittedly, I got close as I have ever been to the latter during last year).
So, what does all of this mean in less technical terms? There are many that study valuations in a historical context to try and project future, longer-term returns. Personally, I think it is an exercise in futility – especially in light of an over-active Fed causing us to use the word “unprecedented” so often. Still, I thought it worth sharing a couple of examples from individuals who have spent significant portions of their professional lives analyzing such things.
We will start with Dr. John Hussman, who has done about as exhaustive work on the topic as any I have seen. From his latest commentary, which can be found on his website sourced below:
Source: www.hussmanfunds.com/comment/mc210201/
In his view, a portfolio comprised of 60% S&P 500 and 40% treasury bonds/bills should expect to earn an average nominal return of negative 2.15% per year over the next 12 years – based on today’s equity/treasury valuations. That’s 12 years, and with only 60% of your money invested in stocks. And that’s negative 2.15% per year.
Similarly, our old friend Jeremy Grantham (he’s the “G” in “GMO”) and his firm publish their “7-year annualized returns” for various asset classes on a monthly basis. Here is the latest in their view:
Source: www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-january-2021/
GMO breaks it down more specifically for us by asset class. In their view, holders of large-cap stocks here in the US could expect to lose 6.2% per year over the next 7 years, while holders of small-cap stocks could expect losses of 7.9% per year.
And you all thought I was the pessimist…
So, to summarize, am I 100% convinced that we are in the midst of a giant bubble – which is about to burst – and all of us owning equities are about to be left holding the bag? Not exactly. There is one very significant player that we have not yet discussed in this section. Discussion of this organization has been known to cause extreme nausea. They bear responsibility for the two prior bubbles – and most certainly will be to blame if we do ultimately learn that we are living in the midst of a third. Ignoring this player in trying to determine whether or not we are in a bubble would be a most dangerous game to play. Any guesses who this player is?
You are correct – The Federal Reserve.
I’m going to do my absolute best to summarize this succinctly, simply and with as little sarcasm as I can muster. If you are a gambling type – and can find odds – I’d suggest betting against my successfully following through on that goal…
First things first. Financial markets used to react to (or foreshadow actually) the economy – stock prices and interest rates would react positively or negatively to prehistoric measures such as earnings, GDP, employment levels, etc. Not any more you Boomer – the script has flipped, and you better get with it! Now, the economy is increasingly a function of financial markets – rather than the other way around.
The two best examples as to why this is the case are pension funds and Baby Boomers themselves (just can’t escape the Boomers these days). We are all aware of how criminally under-funded so many of pension funds in this country (hello Illinois) are these days. Meaning, they won’t have enough assets to meet their future obligations – and it grows worse by the year. As such, they are incredibly reliant on their investment returns to remain solvent.
Now, you don’t need to be a financial wizard to conclude that managers of pension fund assets should have a strongly conservative bias. After all, the funds need to be there to meet the ongoing obligations. Anyone know what kind of interest you can get on a 10-year Treasury Bond these days? Thankfully, it has ripped higher in the past few weeks – to about 1.5% as of this morning. One. Point. Five. Percent. Uh oh, that’s not good. Pension funds that are already massively under-funded are going to have to survive on returns of less than 2%? That’s not the best part however…
Most pension funds assume an average annual rate of return of somewhere between six and seven percent – to arrive at their already underfunded projections – with a ten-year treasury returning 1.5% (never mind potential losses on those positions should interest rates rise). Riddle me this: how exactly are pension funds going to average 6-7% returns with interest rates where they are? Well, the stock market of course – stocks only go up, you Boomer!!
What about all of the retirees in this country, largely relying on their 401ks to supplement income now that corporate pension funds have all but disappeared. They can’t get any more interest on their cash or bonds than the pension funds can – so what are they to do? Damnit Doug – you Boomer – we put it into stocks of course! You’d have to be a moron to earn nothing on treasury bonds, when you can get 10%+ every year in stocks (potentially of course)!
You might see where I’m going with this, and believe me, this is the simplified version. I’m going to stop here and pat ourselves on the back – followed by ripping our own heads off. We have been 100% spot-on in our analysis of what the Fed would be doing – down to even predicting the purchase of corporate bonds when the liquidity finally dried up (that occurred last year). It’s all there in our previous updates for anyone to see.
But we got one thing very, very wrong. We incorrectly assumed that the Fed was unaware of just how reliant the entire financial system and economy was on keeping asset prices inflated. This was proven last year when, in just 2 weeks, they had a plan to (illegally in the view of many) purchase corporate and municipal debt to stop the collapse. The fact that they were able to move that swiftly means one very important thing: they were already well aware that if they lost control of the stock (or bond) markets, the consequences would be dire.
The point, you might ask, is this: The Federal Reserve - in all of its glory - will do anything that it takes to keep financial markets propped up. Free-markets and capitalism be damned. And this is a hugely important consideration in trying to determine whether or not this is a bubble. There ain’t nothing wrong with a bubble, if it’s never allowed to burst. At least, that’s the way they see it…
“Every time there is a failure in the market economy, the government wants to step in and protect us from failure – to get votes. But if you don’t have failures, you don’t have winners. If you don’t have winners, you don’t have a market economy.”
- Scott McNealy (co-founder Sun Microsystems), 2002
Now, can the Fed ultimately ensure that stock prices rise forever without consequence? I don’t have that answer – though I will state that I have very serious doubts. I would like this on paper in case I haven’t before: there is little doubt in our minds that the Fed will ultimately (and again illegally in our view) begin buying stocks directly (by printing more money, but of course). Japan has already given them the playbook, as they have been doing so for years. Of course, we are not Japan and the Yen is not the world’s reserve currency – so a direct comparison in projecting success is difficult. But we are damn certain they will try when deemed necessary…
“…but it is equally beyond doubt, that every speculative mania which has run it’s course of folly and disaster in this country has derived it’s original impulse from cheap money.”
- The Economist, 1858
After 10 or so pages of analysis and discussion, we get to our conclusion. We do believe that we are in fact in the midst of a bubble. Yet, as always – and particularly with the Fed involved as described – it would not be wise to go “all-out” in terms of equity exposure, as we could be very wrong. Instead, we believe the proper course of action is to reduce (not remove) pure equity exposure. At the same time, and leading to our next topic (yep, not done), look to alternate asset classes for growth/inflation protection.
Thanks A Lot Mr. Happy-Pants, but What Now?
Ok, that was a fun discussion, but what do we do about it? This section was supposed to be discussing the second most important question of our financial times: inflation or deflation? But I’ve already discussed that at length in previous updates (which can all be found on the website in the blog section), and this is already running past the risk of too lengthy. Instead, we will incorporate that discussion into examining how we are choosing to deal with the current environment as described.
We’ve already analyzed the landscape for stocks, so let’s switch gears and move to bonds. This will be much simpler. There are two main problems with bonds at the moment. First, they don’t pay any interest. Add to that the fact that they will lose value as interest rates rise – which they have rather dramatically to begin the year (if we can call 1.5% on a 10-year bond “dramatic”) – and you end with what some have aptly described as “return-free risk”.
The second problem with bonds is actually a much more troubling one. Because rates are so low, they are unable to act sufficiently as a “hedge” to growth assets as they have in the past. There simply isn’t enough interest left to lower, meaning there is also little room for appreciation in price. We remain concerned that the investing public at large will learn this lesson the hard way in their static 60% stock/40% bond portfolios. Previously, the 40% would somewhat offset periods of equity weakness by increasing in value. Taking that inverse correlation away might well prove a shock to the system of many the next time around. In fact, we have already seen it this year – as many of the model portfolios are showing negative YTD returns due largely to their treasury exposure as rates rose, even in the face of equity weakness. Stagflation anyone? That’s another update…
Moving outside of treasuries, most all other bond types are – like their equity counterparts – at or near all-time low spreads in comparison to treasuries. Simply put, they are as expensive as they have ever been. Municipal bonds in particular looked attractive to begin the year, as they were one of the few bond classes which had not completely “normalized”. But alas, the pleasant bump to returns enjoyed by holders of municipals in January became frustrating drags in February, as they too had become overly expensive.
Needless to say, bonds are not the answer that we are looking for. Our preference in the “income” – or what we now call the “ballast” – space is cash or short-term bonds (removing more of the interest rate risk). But now, we have to inject inflation into the equation. Important reminder from the last update – hypothetical and over-simplified. If you hold cash at 0% interest, and inflation runs at 3%, you have in essence lost 3% on your monies – even though it appears on paper that you simply have what you started with. Remember, money is nothing more or less than the products and services you can purchase with it. Unless of course you plan on using dollar bills to make art pieces, or to spark up the fireplace. But let’s hope we don’t get to that point….though the Fed and politicians are trying their very best (sorry, couldn’t resist).
So, taking a long-term investment view – remember, we are not concerning ourselves with short-term - we have come to the following conclusions. Bonds will likely suck. Stocks very well may suck more. Cash pretty much sucks as well. Thankfully, this is where I get to take a more optimistic stance – albeit not a stance I ever dreamed I’d be taking after near 30 years….
When creating a long-term investment plan, a good place to start (after identifying goals, timeframes and tolerance for risk) is by ranking your long-term convictions (hopefully not criminal) by how strongly you hold them. Some traditional examples might be “stocks should provide the best long-term returns”, or “cash and bonds should provide income and a measure of safety”. If I have done my job properly so far, I’ve at the very least made you question whether or not those two examples are good ones at this particular moment in time. After hundreds upon hundreds of hours of conversation, research and reflection – I can generally boil our highest conviction list down to these two (in this order):
- The Fed – and central banks around the world – will be printing unthinkable amounts of new money, with virtually no end in sight. They have no choice.
- (A distant second by the way) Generally speaking, stocks (especially growth) and bonds are as - if not more - expensive than at any other time in history.
There are others on the list, but hardly worth mentioning as our level of conviction in them pale in comparison – though they certainly play into how your portfolios are currently allocated.
As you might assume, we then start looking at which types of investments would most directly benefit from our list being proved accurate. In this case, we land on one in particular – with another a distant second.
Broad-Based Commodities / Commodity-Producer Stocks
Coming into the year, this is the asset class that checked virtually every box. Fed devaluing the dollar? Check – and commodities traditionally do well when the dollar is weakening. Fed actively trying to force inflation (and stating as much daily)? Check – one definition of inflation is literally “rising commodity prices”. There are other reasons for optimism – mainly the prospect of fiscal stimulus globally, along with the fact that commodities are one of the few asset classes that have struggled over the past several years – making them one of the few historically “cheap” asset classes.
It has worked out well so far this year - maybe too well. Our goal was to have an initial position, and then add during periods of weakness (those actually occur when free markets are allowed to work). As of this writing, commodities are the (or one of) best performing asset class so far this year. What we would prefer not occur, is for commodities to become the “new hot trade” in this period of speculation – though we should have known better the second we heard Goldman start touting it. Either way, beggars can’t be choosers as they say…
Gold / Stocks of Gold Mining Companies
If my math is right, this is my 26th year in the business. For the first 25 years, I would chuckle when someone mentioned gold as an investment. First and foremost, there is currently no currency in the world that is any longer backed by physical gold. This fact alone led me to sarcastically respond to many a question about gold with, “who’s to say that my office chair is not the alternative currency of choice”? Of course, the obvious answer to my question is that there is an infinite supply of office chairs, they are not indestructible, and – most important – they have not been considered the “ultimate store of value”, protecting against governments gone wild, for hundreds of years and counting.
Still, the point is a valid one, and also the reason that gold ranks a distant second to broad-based commodities overall. In fact, it is the gold-mining stocks in which we are more interested. While gold itself is hardly “cheap” (it’s not that far off of historical highs), the companies that mine for it remain largely cheap from a valuation standpoint. And since the price of gold has risen significantly over the past 12 months, we expect more tailwinds than headwinds to future earnings – unlike many other sectors of the economy.
Oh, and one more thing. If the Fed does succeed in crushing the dollar - while producing the wealth-gap-widening inflation they so desire – the long-term upside for these companies is significant to say the least…
Our Current Rankings of Asset Classes
Think I’m up to the fourth or fifth time reiterating this point: What we are about to discuss is from a long-term perspective. While on the topic (again), we are often asked what “long-term” really means. It’s a very good question, as it definitely depends largely on one’s perspective. Ten years is a widely-used rule of thumb, but I’d rather offer a definition of what it is not. It is not the next 18 months, not the next year, definitely not the next 6 months and definitely, definitely not the next 6 weeks. Hopefully that helps.
Most of you will be glad to hear that I am not about to rank hundreds of different asset classes in this section. The worksheets that we use internally are 4 or 5 pages long, and it is a rather painful process to be honest. Our discussion here so far has given you enough backdrop to where we can simplify this list down to five – as follows and in order of preference:
- Broad Based Commodities
- Gold / Gold Miners
- Short (inverse) US Growth Stocks
- “Value” Stocks
- Short-Term Treasury / Cash
If there is one part of my job today that takes its toll on my mental state above all others, it is definitely number three on the list above. For anyone unaware, being “short” stocks simply means making money when they drop in price. There are several reasons that having "short stocks" rank number three on your highest conviction, long-term list is mentally exhausting. The most basic reason is that having a negative attitude toward anything tends to be exhausting, and certainly not great for one’s mental health. But by far the biggest reason it causes angst is that you simply can’t do it in this environment. Some might remember, we attempted that last year – not even as an investment, but simply as a hedge against some of the existing positions as a way of mitigating risk. Even then, it was a disaster – and I don’t blame the chosen manager one bit. There was simply no way a manager could successfully manage being fully short in that environment – an environment which largely still exists today.
That said, and thankfully, there are strategies and vehicles out there which allow us to blend being short US growth stocks with being long “value” (number 4 on the list, and discussed next). The way to do it is by employing “Long/Short” or “Market Neutral” strategies. The strategy is simple in theory – own the investment categories that you believe represent the most favorable long-term investments, while at the same time betting against the areas of the markets that you view most unfavorably. In doing so, you own what you like – go against what you don’t – and largely reduce or remove “market risk” in the process. We are employing such strategies on your behalf, consistent with our long-term thoughts as described.
Last but not least, a quick discussion on “value” (#4 above) vs. “growth”. Just to make it more complicated than it needs to be, let’s start with this – ask 10 different money managers what “value” means, and you will likely get 10 different responses. A way oversimplified and hardly sufficient definition might be stocks that are “cheaper” vs. their peers – assuming (a big one) that it is not “cheap” because the business is broken. Growth, on the other hand, is exactly what the name would suggest – companies expected to rapidly grow their earnings over time. Everyone wants companies that rapidly grow their earnings. The trick is determining how much you are willing to pay for that expected growth. Over the last decade or so, the answer is “a lot” – explaining the valuations discussed previously.
Generally, we think that growth valuations have gotten out of control (the bubble) – and that “value” represents much better long-term investment prospects. That said, one super important fact to note. “Value” (as defined by most) is cheap only relative to growth. In other words, many value stocks appear cheap when compared to valuations on growth stocks – but remain expensive historically when looking at them individually. It is for this reason that we rank betting against growth stocks ahead of owning value, again while taking a long-term view (have I made that clear yet?).
What Can Go Wrong?
We are getting close here, I promise. We have discussed in updates past - and hopefully explained why in the commentary above – that we are cautiously in the “inflation camp” when analyzing whether inflation or deflation is the more likely outcome in the years ahead. Yet we can easily make the case for deflation, and I will attempt to do so in one paragraph, rather than the 2 or 3 pages needed for a full discussion.
We spent a lot of time today talking about a possible bubble. One would have to go back to the 1970s to find a time when a bursting bubble was not also accompanied by significant deflation. That said, the similarities between today and what we saw in the 70s are many – though proper discussion of said similarities would require I break my one paragraph mandate. Still, if we are correct in our belief that markets will now dictate the economy, rather than the other way around, that itself should give one pause in their confidence for inflation. Most heavily indebted, asset bubbles end with deflation. This one, if it is in fact a bubble, may or may not be different.
I also want to revisit another topic that I discussed with each of you in our review. Hopefully, everyone remembers this quote verbatim from our discussion:
“The more we deviate away from the major indices (referring mainly to S&P and NASDAQ), the greater the potential disparity between what you see on TV, and what you see on your statements – for better or for worse.”
Now I’m happy to report that as of this this writing, and generally speaking (again, we don’t run models), our clients have indeed experienced a disparity between the two so far this year – and it has largely been a pleasant one. Though I will admit, I hope that it has gone unnoticed as it means no one is wasting their days watching CNBC, and – more importantly – means that, like us, you are indeed only focused on the long-term. The pleasant disparity to date is largely attributed to our preference for commodities and value vs. growth in the “risk” space, and our significant reduction of duration (interest rate risk) on the income side. Conversely, gold and gold miners have remained a drag – though we are contemplating additions to the space as a result. All of that said….
It is important to note for the past decade or so, the disparity as described would not have been a pleasant one. As we have discussed, it has been the high-growth, high-multiple names that have remained largely the only game in town over that period – and we have little interest in this segment of the markets, for all of the reasons discussed.
Yet believe me when I say, good ole J Pow could jump on TV any minute now and completely reverse the recent rotation – though it would not concern us in the least. Please note that I said “concern” and not “frustrate”, as the frustration is more than you know. Still, hundredth reminder, we have no interest in gambling with your money…
“You are your own sight!”
- Billie Joe Armstrong (Green Day), from the song “minority”
In case I haven’t mentioned this yet, we are only concerned with the long-term. Unless something material has occurred causing us to change our long-term views, we will not change course based on short-term noise. I assure you, disingenuous comments from the Federal Reserve concerning their short-term plans are nothing more than that. Instead, we will continue to add to preferred asset classes on weakness – or take profits in asset classes where the speculative bid may have caused them to get ahead of themselves.
A Final Note – Managing Risk in the Face of “FOMO”
There are two critical reasons why every investor in the world should have a solid understanding of risk management, before ever investing a dime. The first is understanding how much risk one can afford. This is accomplished every time we update your cash flow analyses. The results paint a numerical picture of how much risk you can afford to handle, without affecting your long-term goals. The universal goal remains – to ensure that you do not outlive your money.
The second reason is more arbitrary, and even frustrating. It involves truly understanding your psychological tolerance for risk. One might assume that the former is more important, but I would argue that they are of equal significance. Reason being, psychology is a nasty, nasty word when it comes to investing. It can cause one to do things they never otherwise would, and even know deep down that they shouldn’t. At its worst, not understanding one’s true tolerance for risk can lead to financial ruin.
It is not coincidence that I spent so much time in our latest conversations reviewing risk tolerance, or that I am speaking to it again today. If I have done my job properly, the first reason should now be crystal clear. That being, the current environment presents maximum uncertainty at best, and the prospect that we are in the midst of a massive bubble at worst. The other reason is trickier, as it slips from consciousness the longer the speculation continues. All of us, including those of us that do this for a living, suffer from recency bias. The longer and harder financial markets move upward and onward, the tougher it becomes for us to remember what the other side feels like. Conversations around risk tolerance elicited much different responses from clients in 2010 after the financial crisis (and a 50% decline in the S&P 500), than they do today. That should tell you something.
So, while I am not as concerned with how much risk you can afford (for our clients, it is my job to already know), I would encourage everyone to run through a simple exercise again themselves. Start by taking the value of all of your investments – you can simply use your last statements. Then imagine it was lower by 10%, being careful to imagine in dollar terms instead of percentages. Then 20%. How about 30%? You can stop at 50% (or 70%, if you want to believe Dr. Hussman). Be honest with yourself. What number would cause you to lose sleep? What number would cause you to drastically change your lifestyle?
Importantly, understand that the answer to that last question is avoidable for many – all it takes is properly managing your risk upfront….
At the same time, since we all now OFFICIALLY share such long-term mindsets, risk is not only measured by how much one could lose with a given portfolio. Far from it. In fact, most of us need a certain level of long-term return in order to meet our objectives. As I have mentioned countless times before – usually interjecting R-rated words of which I will refrain today – this is where you should despise the Federal Reserve even more than I. In the absence of interest rates, it is extremely difficult to achieve acceptable returns, while at the same time sufficiently managing downside risk. This is especially true with all that we have discussed today.
But I want to assure you, we are working tirelessly to come up with that “perfect balance” for each of our clients individually – allowing for adequate return while at the same time sufficiently mitigating risk. And I promise that we will continue to do so - to the absolute best of our ability, and again with as much transparency as you will allow (ie: reading these letters).
With that, I am finally done – and leaving you with my favorite quote on the board, given all that we have discussed today:
“Too many people do not recognize when they’ve won the game. They risk what they have and need for that which they don’t have and don’t need. As Buffett (Warren) always says, that is a stupid thing to do. When you’ve already won the game, your only priority is to never return to ‘GO’…”
- Rational Walk (via Twitter), August 2020
In other words, often times - enough is truly enough….
As always, to all of our clients, we can never thank you enough for the trust and confidence you have placed in Round Hill.
Sincerely,
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.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major indices.
The NASDAQ Composite Index measures all NASDAQ domestic and non-US based common stocks listed on the NASDAQ Stock Market. The market value, the last sales price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the index. You cannot invest directly into an index.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
The prices of small-cap stocks are generally more volatile than large-cap stocks.
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