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“We learn from history that we do not learn from history.”– Georg Hegel
Reflections and Takeaways
A Review of a Letter Written to my Clients in the Fall of 2018
On October 23, 2018 I sent the following message to my clients. The content from the message is shaded in grey and I will leave further commentary below.
General Market Update and Investment Allocation Concerns
If you have been working with me for any length of time you know that I spend most of my time and attention in our meetings focused on areas outside of investment management. That does not mean that I don’t feel this is a critical area of your plan or that I don’t pay attention to what is going on in the markets. I am in constant pursuit of insights, knowledge, and understanding of the financial markets.
For quite some time I have subscribed to an investment philosophy and process that is very consistent with very popular academic work and even Nobel Prize winning research surrounding economics and financial markets. Some refer to this approach as “evidence based” because the historical stock market data clearly shows that the approach that I have been using works over time. Of course there have been bumps in the road along the way with the early 2000 tech bubble and 2008 global financial crisis being the most recent and severe in recent history.
Looking at the S&P 500 Index which is used as a broad measure of US stocks, the March 2009 low was near 750. Since that market bottom less than 10 years ago, the index has rallied by over 350% to over 2700 as of the market close on 10/23/2018. When looking at index funds that seek to track the performance of the S&P 500, the trailing 10 year returns are North of 14%. Performance outside of the US has not been quite as strong, but has been positive. In observing these data points along with others, the question that I find myself asking is the following:
“What has fundamentally changed in the US and / or globally at the government, corporate, or household levels for the better that could possibly be driving this? Are we more productive and creating substantially greater revenue and profits? Are we spending less? Have we reduced our debt? What is it?”
The truth is that I have found very little encouraging data to support the market trends that have taken place. More than anything my observation is that financial market performance has been largely driven by money printing by the federal reserve, low interest rates, debt expansion, and creative “financial engineering” by corporations to make themselves look more attractive on paper without actually doing anything that would materially increase revenues, decrease expenses, or boost profits.
In seeking out answers to these questions I have found myself in a state of confusion, denial, anger, and cognitive dissonance about what this all means and what I should do about it in my own life, in my business as a financial advisor, and ultimately in regard to the advice and services that I provide to you as a client.
In some ways I feel less competent and prepared to deliver financial and specifically investment advice than ever given the distorted state of our global economy. I can feel it in my bones that something is not right and the deeper I dig into objective and factual data the worse it looks to me. At this point, there is no doubt in my mind that we are on an economically unsustainable path and that market prices are irrational. After all, today’s market prices reflect all known information combined with future expectations and those prices are telling us that the expectation is for a rosy future. Based on my observations so far the math simply doesn’t add up to support the market’s current opinion.
The problem is that markets can stay irrational for a long time and the reality is that I don’t know how long prices will stay propped up. Benjamin Graham, known as the “Father of Value of Investing” famously quoted:
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Said differently, what matters in the long run is real and measurable productivity and profitability. To the degree that a company or group of companies demonstrate favorable or unfavorable performance over time will eventually be reflected in their price. I am uncertain of how market prices will move this week, this year, or even over the next few years. What I am certain of is that I am not at all comfortable with knowingly participating or encouraging my clients to participate in a game of musical chairs that must at some unknown point in time come to an end.
So I apologize if you were having a good day and this is an inconvenient message to receive. On the other hand, I don’t apologize for being as transparent and truthful as I can be on this topic.
Some of the big things that have changed since I wrote this is that globally we have printed more “money”, gone deeper into debt, and demonstrated how fragile our just in time, fragmented, global supply chain is thanks to COVID-19. As I continue to probe deeper into economic and monetary history and theory I find myself both disgusted and exhilarated. Disgusted because of what we have done to ourselves, and exhilarated because I know it will end and I get a front row seat to maybe the most pivotal moment in our brief US history. Yes, I said brief. In the context of the timeline of recorded history, 244 years is a blip on the radar.
If we narrow the context to US economic, financial market, and monetary history some people might even argue that a few key milestones in the 1900’s mark key points in time in which the rules of the game were so dramatically changed that we really can’t look back to 1776 and call that the beginning.
1913 – Federal Reserve Act: I’ve done a lot of reading, listening, and learning, but The Creature from Jekyll Island: A Second Look at the Federal Reserve is a must read if you want to gain literally unbelievable insight about what absolutely sounds like conspiracy theory. The definition of a conspiracy is “a secret plan by a group to do something unlawful or harmful”. Based on that definition, the only difference between the Federal Reserve and a conspiracy is that it is not a secret. It is actually a quite blatant tool that is owned, operated, and used by the banks that own it – no the Federal Reserve is not a government entity. It is a private entity owned by and for the Wall Street banks. More to come on this soon.
1944 – Bretton Woods Agreement: How else were we supposed to pay for World War II other than creating money and credit out of thin air? At this point we didn’t eliminate the gold standard, but weakened the integrity of the dollar by pegging it to gold at $35 per ounce and then pegging all other currencies to the US dollar. The hazard here was that there was no actual reserve requirement. Dollars were redeemable for gold but the actual gold stock could not have possibly covered a wholesale redemption based on the dollars in circulation. The obvious risk with this arrangement was a “run” on gold.
1971 – Nixon Take the US off of the Gold Standard: And this, my friends, marked the end of anything that resembled sound money and integrity in the US dollar. That “run” on gold I mentioned above? It happened, or started to until Nixon stepped in and took us off of the gold standard altogether. Somehow everyone went along with it? From this moment forward we have seen massive monetary expansion and total US Debt grow at approximately twice the rate of total US income.
Once you start opening your eyes to this stuff, you can help but just keep going. It’s like a juicy, scandalous novel that you just can’t put down. Speaking of which, I highly recommend The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble by Bonner and Wiggin. It’s a satirical economic history accounting and is loaded with awesome information and data, and I have read very few books that have made me laugh as hard. I actually haven’t read it, but rather listened to it on audible several times over and plan to dive back in again soon.
By the way, as pessimistic as I am on all of this I am actually pretty optimistic about how the future could turn out if enough people wake up quickly enough to turn this thing around.
Thoughts, questions, comments on this one? Hit me up on my contact form.
Ray Dalio on the Economic Impact of the Coronavirus Crisis
I have listened to two excellent interviews with Ray Dalio of Bridgewater Associates via TED and Bloomberg. Both interviews are worth the listen. I have a lot of thoughts on all of this that I would love to cover at some other time, but for now here are some quick notes from the Bloomberg conversation.
- Survey: when do you expect normal business conditions to return in your industry (2020-Q3, 2020-Q4, 2021, later than anyone thinks)
- What has Bridgewater been doing to understand the pandemic and what conclusions have been reached?
- Everything has happened before including this
- We are in an economic downturn
- Every individual, company, and country has and income statement and balance sheet. This pandemic has created holes in nearly all income statements and balance sheets.
- In the financial world the central banks can create money and credit of thin air to fill in the holes in these income statements and balance sheets.
- Analogous to other moments in history including 2008, but more like the period of 1930 – 1945
- What holes will be filled in, and whose holes will be filled in?
- 70% of global currency is denominated in US dollars
- How big are the holes?
- $5 Trillion in the US economy
- $20 Trillion in the global economy
- Point of reference: Per the Dimensional Funds Matrix Book 2019, As of 2018 the global equity market capitalization was $50.5 Trillion and global bond market capitalization was $42.7 Trillion, so a total capitalization of $93.2 Trillion
- Expecting a reduction in the global real economy of 4-5% which is more significant than 2008. It is more like the 1930 – 1945 economic period.
- The capacity of creating money and credit is unlimited, so we can make this work but we will be in an entirely “new world order”. The changes in wealth will be very big and different.
- How long will it take?
- Is what we have seen this far in the way of fiscal stimulus and monetary stimulus appropriate?
- At this point there is no choice.
- In 2008 we had a choice, but chose to save the banks. This time we have to save not only the banks but the entire economy.
- We need to think about the consequences of creating all of this money and credit
- What are the consequences that you are thinking of?
- He is thinking about the real economy, financial markets, wealth gaps, etc.
- There were things that we did in 2008 to help us get out of the financial crisis that are not repeatable in this scenario:
- Corporate tax cuts helped with earnings and therefore stock prices
- Interest rate cuts caused all asset prices to rise and an PE expansion but they can’t go down away
- Stock buy backs
- Rising stock prices increase wealth gaps
- How is this going to play out in regard to inflation, interest rates, and yield?
- There is inflation of goods and services, and then there is the value of money and financial assets
- One type of inflation is driven by supply and demand. The other is monetary inflation. This will be the latter.
- Polling Question: What quarter will the US economy return to positive growth (2020-Q3, 2020-Q4, 2021, later than anyone thinks)
- Is it surprising to see equity markets enter what looks like a new bull market in the midst of one of the worst health and economic crises in history?
- Not at all. Financial markets and the real economy are not the same thing.
- Economic activity and stock prices are not the same thing. When he was a kid he would see the economy get stronger while the financial markets were going down and vice versa. It was all driven by the amount of money and credit. The real economy lags that financial economy. You have to follow the flows of capital.
- We are going to see a big shift in wealth. We have to anticipate the flow of money.
- Brought up Nixon coming off the gold standard in 1971 and discussed the impact it had on financial markets because of the way that money flowed.
- Who will be the beneficiaries of this wealth transfer?
- Not bondholders…he thinks you would be pretty crazy to hold bonds. How much wealth is in bonds and where is that money going to go?
- Geography is also a consideration. This flood of money will not reach all countries.
- How will some gain or lose based on changes in corporate income taxes?
- We are likely to move away from the globalized efficiency and lowest cost model and will be rebuilding our basics rather than exporting all of them overseas.
- What about climate change and innovation opportunities in that arena?
- Ray’s concerns about equality and flaws in the capitalist system…is there going to be a fight over wealth?
- We may handle it well, but that has not been the case most of the time historically
- New world order in 1945
- We have to intelligently engineer how to increase the size of the pie and divide the pies of wealth and productivity in a wise way
- Should the federal reserve be going in and buying corporate stocks and bonds rather than government debt? Aren’t they determining who will become the winners and losers?
- The current central bank leadership has inherited a lot of problems created by its predecessors and have some tough decisions to make