Amateurs talk about strategy and tactics. Professionals talk about logistics and sustainability.
Robert Hilliard Barrow (1922-2008), a former United States Marine Corps commandant and general, interview published in the San Diego Union on November 11, 1979.
A year that started out gangbusters in terms of market appreciation, without regards to valuations, has subsequently started having hiccups on and off. That begs the question as to whether it is now recognized that valuations are stretched? Or perhaps it is a recognition that no matter how many stimulus packages are passed by Congress, flooding the market with money and programs will not necessarily resuscitate the economy.
President Obama found himself in a similar set of economic circumstances when he entered office, absent a pandemic. He elected to focus on what was his signature (and perhaps from the view of history only) achievement – Obamacare. Likewise, President Biden has come into office with both some needed and lofty goals. He has started off with a flurry of executive orders representing motion if not necessarily progress. And while there is a temptation to look upon the last four years as something of an aberration, for many Americans, up until the pandemic became widespread and the economy tanked (or was tanked, depending on your political point of view), they were years of apparent economic prosperity. The question remains to be determined down the line whether that was true, or whether we were in effect living in a Potemkin village.
What I would like to raise here are some things we should be concerned about (and for those who would like a greater in-depth read as to some of the issues raised, I refer you to the excellent 4th Quarter Commentary from Horizon Kinetics, which can be found on their website). First, we have the question of inflation, both the Federal Reserve and our new Treasury Secretary Janet Yellen (a labor economist by training) talking about a target of roughly 2% inflation in terms of the Consumer Price Index. What does that do to cash and bonds in terms of a return certain? Well, it guarantees a negative return in those asset classes if the Federal Reserve achieves its monetary policy goals.
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If the Federal Reserve is targeting inflation at or above 2% for an extended period and you have a 10-year U.S. Treasury Bond, yielding at purchase today just about 1%, your investment will decline in value or purchasing power by 2% each year, so at maturity, you will have earned about negative 1% a year. You say, well that is not too bad all things considered. But as is often the case, it is not considering all things. Rather, in the pandemic year of 2020 the domestic money supply, that is the supply of dollars in circulation, increased by 24.4%. Given that the amounts of goods and services in the economy did not change much in 2020, and if you had cash sitting in a CD or money market fund, that cash also did not change much, YOU HAVE ROUGHLY 20% LESS PURCHASING POWER TODAY THAN YOU DID A YEAR AGO.
(And those of you who do the grocery shopping will have noticed that the packaging sizes and weights continue to shrink – look at a Rice Chex box of cereal). In the sixty years in which records have been kept about such things, the money supply’s worst increase over a year was about 13.4%, during the decade from 1972-1982. In that period, the Consumer Price Index increased by slightly more than two-fold. Put differently, if you started 1972 with $10,000 of government 10-year bonds, at the end of 1982 you would have needed $23,000 of government bonds to buy the same amount of goods and services.
Now, of course, we are entering into unchartered territory, since having expanded the money supply by that amount in 2020, President Biden wants to “go big.” That suggests that the creation of an excess money supply will have a hyperbolic impact on increasing inflation. And that is at a time when we are at a rather dangerous tipping point. According to the National
Debt Clock at the St. Louis Fed and the Bureau of Labor Statistics, in 2000 Debt per Taxpayer was $55,750; Interest Expense per Citizen was $8,053, and Real Median Personal Income was $32,032. In 2021, we are at $222,191 Debt per Taxpayer; Interest Expense per Citizen of $14,939; and Real Median Personal Income of $49,217. During that time, Debt has changed annually by 6.81%; Interest Expense on that debt changed annually at 3.00% (a very low interest rate period), and Real Median Personal Income grew at 2.07%. One last point to scare you with – 20 years ago Federal Government debt was 60% of Gross Domestic Product. Today it is 130%. That is not money that we just owe to ourselves. Rather, other countries have purchased our debt and have a call on it.
Asset Allocation in An Uncommon Time
So, where not to invest? Cash and money market funds should probably be limited to insured certificates and government/treasury money market funds. You will probably not find the best certificate of deposit rates at a bank. Seek out to get membership in one of the federal credit unions, which also offer insured accounts, not by the Federal Deposit Insurance Corporation but rather by the National Credit Union Association, a government agency. And often, one can become a credit union member by joining an affinity group, so do not just assume the door is closed at a particular institution. A good example of that would be the Digital Federal Credit Union, one of the largest credit unions in the country, with multiple ways to become a member of the affinity group.
Bonds present an interesting set of problems. Given what we have said above, you want to avoid interest rate risk (rates ultimately rise with inflation), duration risk (long maturities are out), or credit risk (given the finances of states and municipalities, municipal bonds need to be owned by those who understand the credits). And the issue of currency raises its ugly head in the face of the possibility of monetary debasement. If the dollar is no longer the sole reserve currency, holding dollars alone may beg the question of whether a diversifier is needed. As this is the point where some would raise the subject of crypto-currencies such as BITCOIN, I will suggest there are others far more qualified than I am to have an opinion in that regard.
Which brings us to equities, index funds, and the mega-cap equities that represent such a large portion of the S&P 500. I have indicated in prior writings a preference for active management, value, and smaller capitalization companies than those represented at the top of the S&P Index. A slightly different perspective is perhaps worth looking at. The number 1 and 2 companies in the S&P 500, Apple and Microsoft, represent almost 11.5% of the market value of the index. The bottom 251 companies in the index represent a little more than 11.7% of the market value of the index. Do the top two companies represent the same exposure and slice of the economy that the bottom 251 do? How diverse really is an S&P 500 index fund, given the weightings of the companies. I will leave this by saying, do not assume that the other metrics regarding the largest companies at the top of the index have not been deteriorating in terms of operating margins, return on assets, and sales revenue growth.
A couple of observations from Jeremy Grantham’s recent piece, “Waiting for the Last Dance” are appropriate. Mr. Grantham recognizes, and I would agree, that we have reached a point of extreme overvaluation in terms of equities, especially in the United States, that there will be a bad ending. Grantham believes that career incentives in the investment banking and investment management industry as well as basic human greed will succeed in drawing investors into the markets at the worst possible time. Now investors in equities are relying on easy money policies by central banks around the world coupled with the promise of extremely low real interest rates for the foreseeable future. And those two things can prevent a decline in asset prices for now and the future as far as one can see. Really?
How will the current bubble end? Well, perhaps in the late spring or early summer, as the pandemic wanes somewhat in the face of increased vaccination, we will see the end of central bank stimulus, the economies of the world will still be struggling, and valuations will still be extreme.
Here’s the thing, to quote Mr. Grantham exactly, “The great bull markets typically turn down when the market conditions are very favorable, just subtly less favorable than they were yesterday. And that is why they are always missed.”
Ask yourself why, if stocks are rising not for their fundamentals, but just because they are rising, what that means? And what it probably means is that that bell tolling, which will be ignored, is tolling for a reason. For the brokerage firms, it is a matter of making a bet against their basic business, which they will not do. Being bullish always works best and appeals most to the innate optimism of customers. And it offers the benefit of everyone being in the same leaking boat when it all ends.
In future months, as I puzzle through some of the non-correlated asset classes that I tend to favor, I will try and make some more specific suggestions as to areas to focus on. In the interim, Mr. Grantham suggested that two areas worth exploring should be value stocks, which had their worst ever decade of underperformance through December of 2019, followed by their worst-ever year in 2020. He also suggested emerging market equities, which are at one of their lowest periods of performance against U.S. equities ever. And a corollary to that would be an exploration of the overlap between the two areas.
A separate question which I believe plagues investment consultants these days is China, and where to categorize it in terms of groupings and assets. Surely it is no longer an emerging market? Or is it? But that too is another discussion for another time.