2022 Annual Memo
This memo marks a sea change in our view for the future of markets in the coming months and years as compared to past years. 2021 was possibly the easiest year to make a capital gain on investments of late, as we got all of the benefits of loose Modern Monetary Policy (i.e. quantitative easing) without having to worry about inflation. We took full advantage, handily outperforming all indexes, but we attribute the performance mostly to good luck. We believe the time has come to expect a lower total return on investments, perhaps for several years to come. Keep in mind that the Dow index was roughly unchanged during the period of 1965 to 1995, with a large drawdown of 73% from 1965 to 1982 caused primarily by inflation.
In a public statement 3 weeks ago, Jerome Powell, Chairman of the Federal Reserve (The Fed), changed course regarding his long defended stance that inflation has been transitory. The next day Powell emphasized, for the first time, that the US needed to taper its bond purchasing quicker than planned and switch from a loose policy to a tight one. One could almost feel the disappointment in his tone.
Moreover, The Fed’s historical target for inflation has been 2%, which Powell suggests may not be achieved for years to come. Because of that admission, the return required by an investor to overcome the inflation hurdle becomes higher. At higher enterprise valuations relative to earnings, the needle is harder to move in both directions.
For example, the earnings yield of the majority of the US stock market is currently under 3%. When compared to a 2% inflation target, valuations have been fair or even undervalued, but decidedly overvalued in comparison to a 3% inflation rate. Note that the inflation rate going forward is unknown and could be higher or lower than 3%. The difference between the inflation rate and the net cash flow yield is an investor’s ‘real return’. If you require a 1% real return (without factoring in taxation), a business would need to increase operational earnings by 33% without the enterprise values changing. Or the enterprise values could adjust downward by 25%. Sounds dramatic, but those numbers are rough estimates of what may happen if we consider a 3% inflation rate. Also, interest rate levels (currently near record lows) are inversely proportional to the magnitude of valuation corrections, because at lower interest rates, more money is in play than at higher interest rates, as we will emphasize later.
We find it troubling that no assets (including stocks) have consistent positive real returns. We assign figures in the table below to be very rough estimates of the major asset classes. Nominal yield is the return before factoring in inflation, the real yield (real return) factors in inflation, and capital gains refers to appreciation due to market factors.
What this means is that if you invest in [nearly any asset], you should not be able to buy the same hamburger a year from now that you could today, without considering capital gains. If the capital gain turns negative, you quickly lose purchasing power. In the above scenario, a drop in stock valuations of 2.5% erodes their advantage over cash. Stock prognosticators will call on a ‘real option’ to argue a bull case. Real options describe the unknown upside of an economy, such that the buzzwords “5G”, “Big Data”, “AI”, “EV”, et cetera can provide. If the fundamentals are not present for an asset, guessing at the future is clearly a dangerous game for reasons we discuss later.
Alternatively, you might choose not to buy hamburgers. Frankly, if assets can’t consistently keep up with inflation, we don’t see the utility that they provide. For us, buying stocks as long term investments is an implicit admission that the underlying business (in its entirety) will not lose money over that investment period. If we expect hamburgers to drop in price and rise in utility, we should expect businesses to as well.
The S&P 500 index has earned a negative real yield twice since the 1950’s, according to our research.
Surprisingly, the first instance was 2001 when inflation was 3% and the S&P’s nominal yield was 2.5%, delivering a real return of negative 0.5%. If you review that period, the S&P began dropping in the second half of 2000. Cisco Systems (CSCO) flew high during the period, returning operational income to investors slightly more than 1% of its valuation. Today, CSCO is down more than 40% from its 2000 highs, adjusted for stock sales, 22 years later.
The second instance of a negative real return was 2008. Our view is that 2008 did not result directly from inflationary pressures, but from a collapse in mortgage-backed securities. Therefore, from a negative yield perspective under otherwise normal conditions, the only historical precedent that we found occurred in the year 2001.
Nonetheless, Negative Interest Rate Policy has only grown in global popularity, taunting the respective economies to inflate. The holders of such bonds not only lose on the bonds held to maturity, but also get hit with any inflation that arises; our opinion is that buyers of such bonds expect newly issued bonds to earn lower nominal yields and lower real returns. By design, bonds, with a fixed nominal yield, are less risky than stocks, whose nominal yields are fluctuating operational earnings. This strategy of ‘praying for lower real returns’ seems to be catching on in all markets, especially in the United States lately.
So we posit that 2022 will be a quagmire for logical thinkers who think that an investment should, by definition, allow you to increase purchasing power. Speculators, however, will continue buying that which has the highest return, even if that return is negative. A war will break out between stoic logical thinkers and wildcatting speculators, and intense volatility will be the result. We now venture into dangerous territory, trying to gauge market results by the fallibility of mankind with a question of ‘who is right?’ Interest rates will rise in the coming years, reducing profitability and theoretically reducing funds available to be reinvested.
First, businesses buy things too.
The investments that businesses make are not unlike the investments that consumers make – the return on investment (ROI) must be higher than the cost of capital (WACC) for the investment to make financial sense. This means that over the finite investment period (AKA “useful life”) of the asset, the business must turn a profit, net of all factors. We don’t envy managers making forecasts into 2022 and beyond.
Times have been great for many years; managers of asset intensive businesses must be wondering how the good times can keep rolling into a higher rate environment. If you decided on an investment in equipment last year, the cost to replace that equipment now is much higher. So when a business goes to adjust the price for wear and tear (depreciation), it does so based on the cost paid last year. Most businesses in the US base depreciation on original cost and not replacement values. This means that, despite the value of the equipment rising significantly, businesses recognize a low figure to write off against taxes, even though the replacement cost of that equipment will be higher when it needs replacing. When the equipment is replaced at the new higher price, the depreciation expense will be significantly higher, leading to higher operational expenses and lower earnings.
Furthermore, Cost of Goods Sold is another hurdle similar to WACC. To produce a profit, a business must sell items for more than the cost paid for that item. An extreme example – say I go to a widget manufacturer today and buy 1,000,000 widgets for an average price of $1 over the course of a year, beginning at a price of $0.10, increasing until the final unit cost is $2.00.
Under only GAAP (i.e. US) accounting standards, I could sell that last unit before the rest (LIFO accounting); in the first year in business, my widgets can be sold for $10 each. Demand is just as high and even increases into the next year. That year, I can sell those widgets for $20. However, the price to replace my inventory at the manufacturer level is now $15 at the end of the second year as opposed to $1. Say I sell half the first year, and the other half the next year. The profit for the first and second year is roughly $9 and $20 per unit, respectively. The next year’s profit should be at least $5 per unit, assuming demand for the widget has mostly been stable. Such a situation is abhorred by economists, as such a drop (67%) in profitability would also mean a 67% drop in investments like wages, inventories, and general equipment. Keep in mind that the gross profit margin gets incrementally smaller at higher levels of revenue. Yet again it is hard to move the needle.
So if we combine these realities – increased depreciation expense, higher replacement costs, increased inflation – a business manager has a very big challenge. He must transfer all of these new costs to the customer to continue earning similar profits and stay in business. That means those higher depreciation costs plus the higher replacement cost need to be baked into the price of those widgets. We have a disrupted supply chain as we enter 2022. If you have inventory, you can now price it very high because nobody can get new inventory to meet demand. If that demand evaporates, “Just in Time” becomes “Just in Case” and inventories may pile up. If this happens, earnings will turn into losses as the depreciation and costs of goods sold balloon at the same time revenue decelerates.
Closing out 2021, asset heavy businesses are for sale at a positive real return, based on trailing twelve month (TTM) results. Asset light businesses, on the other hand, are for sale at a negative real return based on TTM results. Asset light businesses have a much higher probability of transferring inflation costs to customers. In both situations, we find the largest hurdle to overcome is uncertainty. An investor facing a 3% inflation hurdle and a current operational profit yield less than 3% earns a negative real rate of return on that investment. If businesses overall find they can’t transfer all of those new costs to customers, earnings may drop with real returns.
Higher rates on newly issued debt will result in similar effects as higher replacement cost for equipment: paying more. As rates rise, businesses issue new debt and refinance current debt at higher rates. This increases interest expense, and reduces earnings yet again. That debt is incredibly important to enable businesses to buy equipment and inventory, so naturally the WACC will increase with rates. In turn, those businesses will require a higher return to overcome WACC, and, all else equal, a manager will pull the trigger less often. A decrease in business investment and overall demand could result.
Will a lower demand and lower earnings be enough to cause a market correction? We believe both bonds and equity should drop in price, but cash will not move in either direction. If demand stays elevated or increases, both bonds and stocks will continue outperforming cash, but opportunities may abound in the case that demand slows. We don’t have a forecast on demand, but historically rising interest rates has led to drops in demand.
Peak demand is often characterized by demand overcoming supply, which is also referred to by The Fed as an “overheated economy”. We are seeing that play out today in supply chains (and asset markets) all over the world. It is a seller’s market – if you have the inventory, you can name your price. We find it painful to imagine that demand (and inflation) increases further. The lower levels of society would need increasing help to buy normal goods. Further increases in inflation would probably be met with even higher interest rates. Our question – when will consumers refuse to jump through hoops to buy luxury items?
To illustrate, a friend of mine can’t find wood domestically to build his home in Dusseldorf, Germany. German lumber, he discovered, is being sold nearly exclusively to the US, so his build-out is stalling. The decision of German lumberers to export to the US instead of sell domestically seems to factor in the relative net profit margin on the export (which I hear has been more than 100% in 2021) and also the currency exchange rates. The dollar has scarcely been stronger against a whole host of currencies, a side effect of flooding the global economy with our high-demand US Dollar (the world’s “Reserve Currency”). We do not have a forecast for the US Dollar, but we expect that those net export profit margins of non US countries will cease to be higher than their domestic margins. US builders will refuse to pay so much to import and the US Dollar will drop in value.
Despite increases to the supply of US dollars, demand is probably flat – the dollar remains strong. Most transactions are still performable in the US Dollar, even after all of the quantitative easing over the last 20 years. Quantitative easing in countries without that “Reserve Currency” stamp cannot print money without experiencing drops in demand: we encourage you to review the perils of 1920’s Germany. Because the dollar is stronger than ever elsewhere and US citizens have trillions more of it to spend, not only have all US denominated assets shot up, but those assets denominated in other currencies haven’t experienced the same relative gains. Thus, US citizens have enjoyed unparalleled increases in global purchasing power.
We suspect that lumber isn’t the only item being net exported out of countries into the US. Because it’s a seller’s market, the supply of myriad products and services is being met consistently by willing consumers; Americans will consistently pay these historically outrageous prices. But the dollars paid for imports are leaving the country and not being reinvested domestically. We get things and they get dollars.
Which of those has a higher utility?
At higher interest rates, Americans will find the return (utility) of cash more desirable than something that returns nothing, like lumber. However, higher interest rates make it more difficult for businesses to take out debt. At very low interest rate levels, very small increases have outsized impact on the liquidity of the system, which is precisely why The Fed capitulated in 2018: liquidity evaporated more quickly than expected.
Our next question – can The Fed raise interest rates, and what happens if it cannot? Suppose that earnings begin drawing down in the first quarter of 2022. The Fed would find raising interest rates difficult since businesses, with lower earnings, will have enough trouble paying back current debts, let alone refinancing at higher rates. Runaway inflation could result, which could lead to the utility of the Dollar decreasing, which could lead to exchange rates dropping, which could then lead to US imports slowing. Next, we would expect to see a broad sell-off of US based assets by both US citizens and businesses, but inflated prices on normal goods could remain. Businesses in the 1970’s period of inflation kept prices high to remain solvent. Perhaps US dollars flow to foreign countries where they have a higher utility, or they stay in the US and prices go even higher for normal goods. We believe the boycotts, rationing, and tax indexing of the 1980’s is far away, but possible nonetheless.
More liquidity may not be a solution. A $2 Trillion bill is being debated amongst US politicians, known as the “Build Back Better” bill. The bill’s passage may cause more job openings and higher prices, but we have difficulty seeing how even higher prices in the US will ameliorate inflationary effects. In the event that businesses cannot convert job openings, we see that bill’s passage as more destructive to businesses in the US than helpful.
Is now the time to invest in emerging markets like China? Yet again, the risk of uncertainty is simply too high. If the US market experiences waning liquidity causing price drops, could foreign exporters lose profit on sales to the US? Will political pressures in China continue to threaten domestic asset valuations? Challenging as it may be, lack of liquidity in credit markets is fraught with dangers for investments around the world.
Of course, business executives will find other ways to raise money other than issuing debt, such as issuing new stock, which dilutes the earnings that current shareholders receive. Contrariwise, annual net buybacks hit a record high in 2021. Buybacks should slow as earnings slow, but, of course, demand for buybacks could stay high. Similar to the demand outstripping supply in supply chains, there has likewise been a high demand for new issues of growing businesses, including initial public offerings, which likewise hit record highs in 2021. Investment banks have raked in extraordinary returns on equity.
However, financial businesses such as banks and insurance companies are in business to borrow short term (liabilities) and lend long term (assets). The rate these institutions borrow at is set daily, meaning that the rate they borrow at fluctuates while the rates they lend at are mostly fixed. When rates rise, the bonds are either held to maturity or immediately sold for the higher yielding bonds. In the former scenario, the spread earned by that long term bond compared to an increasingly higher short term rate will narrow, and earnings will drop. If earnings drop, book value drops along with third-party ratings on the institutions’ strength, and customers shift from weaker institutions to stronger institutions.
In reality, those weaker institutions historically don’t throw in the towel, but raise the interest they pay on customer deposits to stay competitive with stronger institutions: earnings drop even further. If longer bond yields stay the same or drop while shorter yields rise, financial institutions will experience drops in core profitability, and may be forced to mark those assets to market instead of valuing them at cost: we encourage you to review the US economy in 2008. We also know from historical precedent that there is a demanding incentive among executives at those institutions to ‘chase yields’ in rising rate environments. We believe financials are increasingly risky in higher interest rate environments.
As described above, purchasing power for investors will probably drop unless demand for products and services grows sufficiently to offset higher costs of goods sold, higher depreciation expense, higher interest expense, and higher input costs. Revenues must increase in proportion to rising expenses. This increase is difficult to surmise, leading to heightened speculation. Such speculation could encourage higher asset prices over several upcoming quarters, even if it means the stock market must correct for numbers to make fundamental, logical sense.
First, there may be a lag before we see demand start to wane and earnings impacted by inflationary forces, so bullish behavior around markets can continue until the lag occurs. Furthermore, speculators continue to buy money losing assets in expectation that real rates will continue to drop. Speculators may continue demanding money-losing assets, keeping markets up or even driving them higher in 2022. This is a dangerous game, and one we don’t advise our clients to play, even if the only alternative is cash. We find it very hard to consistently throw money at bad, especially when the probability of a drop in demand is higher for all investments and assets alike.
In the long run, we see the next few years resembling the early 1980’s and the early 2000’s. The P/Es for the 1980’s and today are below, respectively, represented by the vertical axes. We assign inflation of 13.5% in 1980, and 3% today. The figures for the early 2000’s are described earlier in this memo.
With inflation at a peak in 1980 of 13.5% and dropping thereafter, a P/E below 7 equates to a 15% nominal yield: a positive real yield of 1.5%. With inflation projected to be higher than 3% in the long term, the 38 times P/E provides a loss of purchasing power for investors. This can be resolved if P/Es come down, with higher earnings or a drop in valuations. If prices stay exactly the same, operational earnings must increase by 52% to earn a positive real yield. If earnings grow at 10%, which is what we expect in a ‘best case’ scenario, the stock market would decline 28%. This isn’t a recession, nor a bear market, but a ‘correction’. If neither of these happens, investors must continue earning negative yields forever. To illustrate the situation, according to longtermtrends.net, the current real yield of a 1 year US treasury bond is -6%, down from -1.5% in January of 2020 and down from 0% in 2019.
The conclusions above are heavy-handed, but at these high valuations, moving the needle takes unbelievable feats of strength (or weakness). This explains another 2022 theme we wholeheartedly expect:
Volatility like we have never experienced before
During 2021, we owned many thinly traded, illiquid public stocks. At Powell’s capitulation in early December, we decided to avoid the risk of owning thinly traded stocks and we sold them. Though the outlook of those individual businesses continues to be promising, thinly traded securities experience violent swings relative to highly liquid counterparts. A cadre of thinly traded businesses may be undervalued, but the forces of inflation could be unpredictably systemic. Thinly traded securities are prone to fire sales and are terrible stores of value in highly volatile periods; we prefer having more liquidity in the case a correction occurs. A heavy dose of highly liquid, consistent, asset-light stocks combined with a big wad of cash is our medicine to avoid ulcerous market swings. We call this strategy “Ignorance Insurance”.
To Summarize, the risk of investing in equity has never been higher as we may have a 50% higher inflation hurdle to overcome than last year (i.e. 2% becoming 3%). Inflationary pressures promise to cause lower earnings in upcoming quarters, the timing of which we make no attempt to estimate. A continuous feat of enormous strength is required for earnings large enough to overcome costs of capital going forward. As a reminder, the top of any cycle is when products and services can’t be sold to earn a sufficient profit margin, “Just in Time” becomes “Just in Case”, and there are fire sales.
Although we believe the market is overvalued, momentum and yield chasing may cause markets to continue moving higher. Over the coming quarters, we see steady to growing revenues with decelerating earnings hit by inflationary factors. Negative real returns are not sustainable in the long run, but the short run might secede to the “greater fool” theory. All of us are told that near-infinite liquidity is waiting on the sidelines, ready to steady any drop in demand for all assets. Very few things have as much an influence on buyers who don’t want to miss out on today’s low prices when that liquidity continues driving prices higher. Our question from earlier – when will consumers refuse to jump through hoops to buy luxury items? The answer – when businesses (and consumers) make less money. And also when those items don’t have as much utility to them.
Thus, we expect a correction should occur, but estimating the magnitude, breadth, or duration of the correction is hard to do. We intend to wait with a big wad of cash until income statements fully reflect inflationary effects like replacement costs, and we welcome a correction to address prices we find are mostly unpayable. The downside is greater than the upside.
You only flinch if you don’t expect it coming.
James M. Esler
CEO, High Flows