Adjusting To New Realities In A Changed World

Some 20 months have passed since my last posting, so a review is in order.

Living outside the bubble was, and continues to be, the strategy. The mantra? It is not how much money you make during a bull market, but how much money you keep once the tide turns.

Living outside the bubble led to radical advice. Like zero allocation to bonds and bond funds. In other words, abandoning 60/40 a year before even questioning the time-honored strategy became cool.

Despite a bear market in bonds, with prices down some 30%, long term bonds remain unattractive. Remember, in 2021 stocks were at bubble levels with some historical precedence. Think 1929, 1968 and 1999.

Bonds, however, were at bubble levels never seen in 3,500 years of recorded history. They remain expensive and bond prices will remain a headwind for investors. Perhaps for decades. It is an integral feature of the long-term debt cycle.

Although it is too early to buy long-term bonds, there is now some income in fixed income. Shorter-maturity investment-grade-corporates are yielding over 4.75% and seem a reasonable alternative to cash.

A lattered fixed income strategy could make sense. Say, every 4-6 months over the next 3-5 years, you could have some bonds maturing. Liquidity to take advantage of possible bargains. A prudent way to manage interest rate risk.

Selectively, there is opportunity in non-investment grade intermediate bonds, but you must be picky. A topic for another posting. Inflation-protected US Treasuries offer a paltry, yet positive, real return for the first time in years (before taxes). That’s welcomed news.

Last year I posited traditional Index Investing, passive investing, could lead to investor disappointment for a decade or longer. That view is unchanged and unchallenged by recent market behavior.

Fascinating that this view is the one people find most radical. When I point out the S&P 500 was flat for the 16-years ending in 1982 and, again, for the 14-years ending in 2013, it’s like people don’t believe me. Such is our tendency towards recency bias.

It did not take a PhD in finance to see the bubble in 2021. Only a disregard for the Efficient Market Theory, the ruling business school orthodoxy. Markets are not rational all the time, particularly during periods of extreme liquidity, as has been and continues to be the situation. Remember there are 30% more dollars today than was in existence in January 2020. The Fed Funds rate, in real terms after inflation, remains as deeply negative as it was at other times of extremely loose conditions such as in the 1970s.

Living outside the bubble did not mean hiding under the mattress. I mentioned owning quality businesses selling at reasonable prices—and still do. Defense contractors Lockheed Martin, General Dynamics and Huntington Ingalls were mentioned. Stable demand stocks Coca-Cola, Kellogg’s, Kimberly Clark and Pepsi. Investment grade pipeline companies Kinder Morgan and Enterprise Products for income.

I believe pipeline businesses remain attractive and continue to buy the two names above. I still own a reduced position in Lockheed Martin, but I no longer own any of the other companies. Topic for another posting, but stable demand companies will have the headwinds of adjusting to new realities, the topic of this posting.

Finally, I made fun of the mania in Bitcoin
BTC
and received rude comments as thanks. Though some appreciated the joke. It is off some 60%. Digital currencies remain a speculation with no intrinsic value, and I remain on the sidelines. Yet the technology enabling crypto is for real and if digital currencies have staying power, there are ways to participate in an incidental manner, with a margin of safety. Topic for yet another posting.

Enough review!

If 2021 was the year-of-seeing-the-bubble, 2022 is the year of accepting-new-realities. My thesis is simple. The tide has turned!

A paradigm shift is taking place in the global economy because our current form of capitalism is not only unsustainable; it is failing to meet society’s needs. Consequently, trends that investors may think are set-in-stone, and which have propped-up asset prices for a generation, have run their course. They are spent.

Assumptions built over a generation will be of no use in navigating the new realities. It is time to understand these realities, but it requires some context. A history lesson.

As is the case now, in the 1970s there was an emerging consensus the ruling form of capitalism, a variant of Keynesianism, was not working. Partly it was in response to an oil-embargoed recession but mostly, regulation was too intrusive. Balance sheets too conservative. Monetary policy too liberal. Taxes too high. Businesspeople too parochial. All leading to what was later called economic sclerosis.

In response, a new form of capitalism emerged. It advocated a reversal of the trends mentioned above. Its first effective champion was Jimmy Carter. He deregulated several industries including airlines, beer, railroads and trucking. Future Presidents continued to de-regulate and added free-and-open trade, laissez-faire economics, and ever-lower taxation to the mix. Debt-fueled expansion of government.

This variant of capitalism is called neo-liberalism (as in a liberal economic system. Democracies and totalitarian governments alike can have a neo-liberal economy). It has been instrumental in lifting billions out of poverty globally. Thanks to cheap foreign goods from low-cost labor markets, it has led to disinflation and historic corporate profit margins in the West. It has been accompanied by ever lower interest rates and ever lower taxes paid. A golden Age of Globalism helped by the slow death of the Soviet Union, enabling both Pax Americana globalism and cheap commodities.

In addition to the global poor, neo-liberalism has been particularly good to two entities: Western multi-national corporations (and their investors); and, of course, China.

The neo-liberal era was marked by disinflation, ever lower interest rates and ever lower taxes. This trinity of features enabled a ballooning of debt, both public and private. It is an integral feature of neo-liberalism. For example, when Carter left office, Government debt-to-GDP was roughly 0.3X. It is now about 1.3X GDP. On a bipartisan basis government expanded in real terms and it was funded by borrowings.

Uncle Sam is not the only profligate. Total corporate and personal debt has ballooned by roughly the same amount. Debt creation has had no small role in driving economic growth and asset price inflation since 1980. By growing some 4X in real terms, debt has obviously enabled a generation to live beyond its means. Less obvious is its role in driving asset price inflation.

Think housing prices. Low interest rates meant people could afford bigger mortgages. Bigger mortgages meant more money to buy houses. As is the case always, more money sloshing around means higher prices.

The same debt dynamic propelled stock returns. A generation of business school grads were taught corporations needed to be efficient. An efficient supply chain meant cheap and typically foreign goods. An efficient labor force meant outsourcing to a poor country, if possible. An efficient balance sheet meant loads of debt. As debt works like a seesaw, it juiced return-on-equity metrics. Outsized profit margins ensued. Stock prices thus juiced, remain historically expensive. Recency bias.

Popular bond strategies were also hopped-up by leverage. There is an entire closed-end asset class of levered bond funds devoted to what could end in total ruin for investors. People may again learn why debt became a four-letter word in the Depression Era. Topic for another posting.

This major feature of neo-liberalism, debt, is on an unsustainable trendline. If the trajectory remains unchanged, common sense tells us a society’s debt-to-GDP cannot be 16X. That is what will happen when 20-somethings become 60-somethings. Surely a case of that which is unsustainable will eventually end. But when? Down the round? Mañana baby!

Or not.

A concrete example of how debt is a massive headache now. Every day there is talk of the Fed’s current fight against inflation. Powell would love to channel his inner Volker, no doubt, and jack up rates to whatever it takes to kill inflation. But here’s the rub. Say Powell raised interest rates to the point where the cost of funding the Federal debt rose by just 2.5-percentage points. Easily done except the yearly extra cost to Uncle Sam would equal the annual budget for the Department of Defense.

Just one example of how policy options are constrained by debt and the trade-offs that await us: fund the Army or fight inflation? Comparable trade-offs await corporate America and over-indebted individuals. In the real-world binary trade-offs might not be as binary as my example, but the point is made.

Now, conventional wisdom says the bond market is smart. Signals from the bond market point to optimism. Long-term bonds are priced as if, though it may take many months, ultimately inflation will be somewhat transitory. Pandemic disruptions, Putin’s War, etcetera will end. The golden age of 2% inflation will return.

Rejoice! We can continue to kick-the-debt-can down-the-road. The Wizards of Finance are not Wizards of Oz.

Then again, signals from the bond market could be wrong. The end of neo-liberalism is inflationary. De-carbonizing the world is inflationary. Ballooning the money supply is inflationary. We remain in a 50-year economic lab experiment called paper money-not-based-on-anything. The outcome remains inconclusive. But there is precedence, and the ending is always inflationary.

Anecdotally, know that, at the start of neo-liberalism, the bond market was considered where the dumb money went. Its reputation for smarts only started in the 1990s. I believe any observed ‘prescience’ is simply a case of confusing brains with a bull market.

That said, I do hope we are not at a long-term tipping point in the credit cycle. Hopefully, the bond market’s reputation for smarts will not prove to be an example of an assumption that needs to be jettisoned.

Otherwise, to paraphrase a Woody Allen speech from 1979. Debt is facing a crossroad. One leads to despair and utter hopelessness, and the other to total extinction. Let’s hope Powell chooses the right one!

Another feature of neo-liberalism is globalization. Think cheap labor. Cheap goods. Cheap commodities. The losers in such a system include medium-skilled and low-skilled workers in rich countries. Think Opioids. Think Trump Country. The people living there, for the most part, have been its victims. They are the human face of what happens when multi-nationals are successful in what business school profs call exporting wage-inflation. It is the reason wages in the Western world, on balance, have been mostly stagnant for the better part of this century.

The wage deflation side of neo-liberalism has reached a tipping point with respect to its political implications. Namely, neo-liberalism’s sacred cow, globalization, is being sacrificed on the altar of bipartisan consensus. The resulting de-globalization has implications for investors and will be covered in future postings. Look no further than the President’s recent chip ban, akin to FDR stopping the flow of metals to Japan in 1941, should you doubt this thesis.

Globalization’s greatest beneficiaries will logically find the new realities the most challenging. China for numerous reasons will not be an engine for growth. It is Fortress China now. U.S. companies that comprise most of the S&P 500 Index’s market cap will no longer be able to export wage inflation. Efficiency in supply chains will give way to security in supply chains. Input costs raised due to a lack of cheap commodities. Profit margins squeezed.

The biggest risk to investors in the S&P 500 Index is that the Index is priced as if De-globalization and the Cold War with China are not things. The markets are in denial. They think Uncle Xi cares about them. They think investing is easy. They believe in fairy tales…

Big picture summary. The world is changed. Everything needs to be questioned. Tailwinds are now headwinds. Inflation will be sticky. Fixed income investors should opt for a laddered strategy with 3-to-5-year maturities. Keep a high level of liquidity.

Stock market investors should have a curator’s mindset. Deglobalization and inflation will eventually squeeze profit margins. Highly indebted corporations will suffer. No zombies allowed in the new reality. Bankruptcy experts get rich.

Opportunities will abound for common sense investors with a business-buyer mindset. Think cash generators. Think small domestic manufacturing companies. Think service providers to said entities. Think businesses not subject to input-cost inflation and wage-cost-inflation. Think friend-shoring. Think royalty business models. Think toll-takers with virtual infrastructure. All subjects of a future post.

This post is not gospel. No one knows the future. It is simply a philosophical construct in which to frame your investment journey over the next decade. History as our guide. The future path for inflation will be up. The future path for stock market indices, multinational companies, the long-term bond market and the real estate market will be down. But remember, those paths will be irregular. For instance, it is not unlikely the stock market could rally in the months ahead to a point where pundits are calling for the end of the Bear Market. It may even look like inflation is finally being defeated in a year or so. Just don’t be fooled.

The great investor and teacher, Benjamin Graham, later in life summed up what he learned. To paraphrase: any time you can buy a quality business at around 10X earnings, do so. Otherwise, do nothing. So, even if my thesis is baloney, investors heeding his advice—as I mostly plan to do—should do OK. So long as they are patient…