10/27/2020

Good Morning! Blessings to you and yours as you get through these trying times. 

 

None of the following is investment advice.

 
Over the past month, sentiment has certainly shifted in a big way. Prices have gone from exuberant to hopeless in record time. Of course, experience is defined by Emerson as not what happens to a man, but how a man reacts to what happens to him. So in this email, I’ll give you more on what I’m doing and what I’m thinking today and into the near future. In the past month, I have finished 4 books:
  • Life Imitates Chess, by Garry Kasparov
  • Lessons in History, by Will Durant
  • Memos to Clients, by Howard Marks
  • Art History, Volume 1, by Marilyn Stokstad
 
First, how about an allegory. Mr. Market is a famed imaginary character from Graham and Doddsville, but I feel he is and was underappreciated. The market is like a grandiose swap meet, where investors walk in, look around and take items to Mr. Market and ask what he prices them at. At this point, a few things are important
  1. You should be able to determine if that price is accurate based on your own form of valuation
  2. You should not necessarily price in factors that are not likely
  3. What other people are doing in the store should not affect how you buy things
  4. You should expect to hold the items for a long period of time, or else why would you buy them at all?
  5. You will find more bargains on items that scare people or that they find difficult to price
  6. It is preferred to have Mr. Market try to sell you an item out of a depressed mood because the price will be in your favor, rather than you buying an item when he is exuberant.
So we have a storefront full of stocks, bonds, and all assets, where Mr. Market will always have a price for you. The intelligent investor buys based on available knowledge and a defined value system that he/she is comfortable with. When investors buy items, there’s not much else to do but wait on the items to appreciate, and when you feel enough time has elapsed, you can sell them to Mr. Market anytime. 
 
Lately, the “available information” category has seemed more like a 3 stooges comedy, where nobody can figure anything out. 
 
Many people say that active investing isn’t possible because the future can’t be known by anyone more than someone else. This has been proven mostly false during 2020. As record amounts of debts amassed over the last several years, many would-be bankrupt companies found that the Federal Reserve would bail them out, meaning that when the black swan event happened, instead of tail risk manifesting negatively, the opposite happened. What is most fascinating, though, is the audacity of the bailout, that the government can prop companies (and their prices) up infinitely. Trees truly can grow to the moon! C’est La Vie.
 
From this, the storefront alluded to above can never be the same, as valuation systems now require coordinating bailout information and other miscellany. As new as all this is, investors now find that bailout information can’t be easily known and that politics can play an enormous factor in the bailouts. After several months, I determined that this is the way of the future, and that massive bailout talks will probably move markets in magnitudes much larger than operational results can. I base this on how markets have bounced back since March lows, which, in my mind, could have gone much lower without a stimulus package. Importantly, we as investors are at the complete mercy of bailouts and we have no direct vote on them (that I can discern). 
 
What happened earlier this month shows how difficult knowing these things can be. On October 6th, The President said he would not provide bailouts until after he was reelected, and then provide massive stimulus. To me, it seemed like he was transmitting to us that his advisors suggested that Americans needed more stimulus money, but he would not grant anything until he secured another four years of a term. Since he didn’t say he would not provide bailouts due to how busy he was or the like, I assumed that bailouts are now political weapons. This is a very dangerous precedent, and so I immediately took a bearish stance, hedging bets significantly. The reason – if dearly needed bailouts can simply be postponed at the whims of one person, what’s to say that the postponement can endure for many years. Perhaps there are more to these negotiations that we are privy to, which makes me even more nervous and brings up questions of communication. 
 
Unfortunately, the next day, The President announced a 180, saying he wanted a massive bailout. Adding $2 Trillion of liquidity to the market would likely cause prices to rise much higher, meaning that things at the final announcement would be relatively undervalued. So I removed the hedges after only a day. It didn’t bother me, because the facts had changed. 
 
Only a week later, The President continued the narrative of a massive bailout, but the Senate blocked the bill and said they would block it until after the election. We were back at square one, where we as investors can’t determine the state of the economy, nor can we determine the likelihood of the government supporting a massive stimulus to prop up the economy. The phrase, “Don’t hate the player, hate the game” comes to mind – civil law probably shouldn’t allow such things. What’s more, the government this weekend announced that the virus is not controllable. I don’t think anyone can be certain of what that means for our present and for our future, but the future must be very bleak if our leaders are indicating that they are giving up the fight. 
 
In my entire career, I’ve never felt more in the dark, and anyone saying otherwise probably has even less of a clue. How did we go from working harder as a country through the World Wars and the Great Depression to get through tough times, to rely on free money given out? None of this sits right with me, and my intuition tells me it will end very badly in ways we can’t presently comprehend. There is no such thing as a free lunch.
 
I tend to believe that because of the supreme emphasis placed on the stimulus, it is needed and will probably happen. Keep in mind that it will not be passed until probably the end of January, which is quite some time. Because of that, I think any productive asset prices before the announcement of the stimulus are relatively lower than those after, but also that those prices could drop significantly until that time. So, I am looking at companies’ operational results with a tablespoon of sugar. As mentioned, operating results are much less important in the face of massive stimulus packages. Make no mistake; equities are overpriced, but the effect of a stimulus makes them look cheap today. The irony is not lost on me.
 
Is it better to leave the country?
 
Big Hit Records of Korea went public this month, harkening back memories of US record companies in the old days. Over the last two weeks on my 6am beach walks, I’ve been listening to BTS, which is Big Hit’s biggest hit. While I don’t understand the lyrics in most of the songs, the songs rhyme with American music. Much of the world enjoys exploring new cultures, but the greatest successes probably come when the deviations from your own culture aren’t too radical. As you probably guess, I extrapolated this thought to markets, insofar that the companies in Asia and other societies are starting to rhyme with those of America. So the question becomes, why would we not begin to appreciate (and invest in) those countries? This from a man that grew up in a one-stoplight town in the Bible Belt: we need to really consider inviting more culture into our investing lives, and not simply by adding an ETF. You can make money off of international plays, but as Ray Dalio will say, “One of my favorite things about investing is learning about the world.”  
 
Moreover, in any society, what businesses will do well when people are about to be completely depressed during the winter? People are deluged daily about the risks they take even stepping outside, the media headlines talking both about the tally in cases and our leaders’ unwillingness to communicate effectively, the economic downfall, the growing wealth divide, the potentially cold weather, and the mental fatigue continuously developing around all of these things. So while there may not be a depression in markets, people may become depressed. If we see continued market drops in the coming weeks and months, we chalk it up to these hardships, and that people will need money for other things rather than investments in markets. It has been said that money is pulled from the market for pessimism or for cash flow needs; I would expect much of a pullback in Q4 can be contributed to cash flow needs.
 
So what am I doing? I am counting my blessings, and they are numerous, I have discovered! 
 
Garry Kasparov says that intuition can be learned with discipline and application, and I’m using many of his techniques in an effort to produce better returns in the future. I’m also saving all the money I can and investing it. I am not doing that out of a facility for greed, but because the dollar may get weaker soon. Case in point – only a few years ago, a burrito at Cafe Coyote in San Diego was $8. This week I paid $14 for one, and it frankly wasn’t as good of quality. So does that mean inflation over those 5 years has equated to 75% or is a mediocre burrito at a restaurant a luxury good? In either case, I don’t feel it’s prudent to sit around in cash when trends point to a $20 burrito in short order (God help us!). 
 
Of course, compared to the ROI in equities, you find about a 4% annual spread, where cash is probably -2% real return and equities have a 2% real return. 4% doesn’t sound like a lot, but compounded over time, it really is. Note that I’m assuming that these real returns will continue forever, which sounds unlikely, but interest rate changes can never be predicted accurately. Compared to bonds, I think cash is relatively similar on an inflation adjusted basis, meaning that investors should be indifferent between bonds and cash from a return basis, but the risks in bonds make me believe that the risk-adjusted return is much lower than cash. This is an instance of me being selectively lazy – there are always good opportunities in any market, but the effort to find any in the bond market is simply too high for too little return.
 
In relation to bonds, observers will notice that the longer end of the treasury yield curve (issues over 5 years) has gotten steeper in the last couple of weeks. Meanwhile, the Federal Reserve maintains that the Interbank rate will be 0% for several years. That 0% represents the short end of the curve, and the longer end we see rising correlates to inflation. Keep an eye on that long end, because higher inflation causes all assets to drop as discounted cash flows have an increasingly higher hurdle. This is actually something that I would like to see, because it signals that the recovery is succeeding. Maybe if interest rates get high enough we will start buying bonds issued at higher rates. That would be very welcome to many of our investors.
 
As in any market flooded with liquidity, much capital is not being used productively, but rather to consume luxury goods. Consumers own expensive things like art, music (i.e. Big Hit Records), jewelry, various vehicles, antiques, fine liquors, etc. – these things have no possibility of producing a cash flow outside of simply appreciating in price, making them ‘storeholds of wealth’. Three thoughts on this 1) can cryptocurrencies fall into this setting out of sheer scarcity, 2) these attributes historically have been seen more at the ends of business cycles, and 3) are the price rises in consumable luxury goods highly correlated with inflation? 
 
This third point is one I have considered in great detail. Consumable luxury items cannot be valued based on cash flows, rendering logic moot, so anyone thinking about buying it must completely rely on the emotions to come to a price. The emotion that I think dominates all others in that world is, “If I don’t buy it, the price will rise, or worse, someone else will buy it and it may never be sold again at a price I can afford.” After deliberating for some time, I come to the conclusion that inflation certainly aids price gains in luxury consumables, because inflation generally means people feel wealthier. This is also something that I am continuously watching. 
 
But is it something else though? Is the world just becoming increasingly gaudy? Another question I can’t answer, but I think it can’t be good for society. At the end of Athenian democracy, the leaders were faced with a choice – tax the social elite and in effect redistribute the wealth, or put society at risk of revolution and in effect redistribute poverty. We all know how that turned out, and all because the wealth divide grew to too high a magnitude. 
 
However, I am emboldened, because more corporations have been formed this year than ever before. Hopefully this translates to new entrepreneurs and different levels of thinking. We need more people to take advantage of the American system that seems to favor corporations more with each passing year. Not only that, it is exciting to run a business and learn corporate law for yourself. I have found it to be nearly another language entirely.
 
Lessons from the greats:
 
What a great lesson I took away from Kasparov, who says the greats don’t complain, they just get better. When you get mad or otherwise emotional, your opponent has you, and often this is the reason why chess is so hard of a game, because your opponent plays you more than he plays the pieces. And so patience is very important – reduce unforced errors. A lesson for this year – markets can change more quickly than ever. The yoke is definitely put on the investor to understand both how and why it has changed and if those changes lead to vulnerability. 
 
Kasparov explains that the best strategy is constant offense, which is fine if you minimize mistakes. As affable as he is, Kasparov fails to recognize that most people’s offense looks surprisingly like defense, because they have not been taught the difference between the two. The thought is more, “If I make this move, I won’t make a mistake” than “If I make this move, I am closer to an uncontested win”. This is very common in investing, where I read of investors that can’t get themselves to go for the jugular, even though that’s exactly what they should be doing. Clients pay professionals not to make low risk, low return bets, but low risk, high return bets. This is not only possible, but has been achieved over and over and will continue well into the future. Not making mistakes at a low level is nearly exactly opposite of not making mistakes at a high level.
 
Howard Marks, top communications director at Oaktree is living proof that leaders should mostly be voices of reason and set the tone. Among his lessons, he extols that when others are acting imprudent or prudent, you should be doing the opposite. The negative sentiment of late may indicate that we are close to a bottom. So does that mean we are in a bull market? I’ll let you decide by looking over Marks’ three stages of a bull market.
 
The three stages of a bull market
1) Few forward looking people begin to believe things will improve
2) Most investors realize improvement is underway
3) Everyone concludes everything will get better forever.  
 
Both Kasparov and Marks will agree that change is inevitable and the person not trying to adapt will be left vulnerable. You must develop your intuition to know when the facts have changed and what you thought you knew is now irrelevant, and when there is only noise and what you knew is still relevant. 
 
So while we are at a global crossroads economically, I feel change is natural. Nature has a funny way of always keeping us guessing, doesn’t she? C’est La Vie.

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