Wesley Chapel, FL
I am at a total loss for words. For those of you who know me well, that is saying a lot. Nothing makes any sense anymore. Socially, there seem to be very few (if any) objective matters of fact, these days. Instead, pretty much everything seems to be based on totally subjective matters of preference. It isn’t much different when you get to economics. Nothing (and I mean nothing!) makes any fundamental sense, and yet the market rises.
After the first “down month” for stocks in a long time (September,) major market indexes recovered nicely in October and went on to make new all-time highs in early November (before pulling back a bit as of this writing.)
It has been more than a year since we saw a real “correction” in the stock market – defined by a 10% drop from the highs. This is abnormal, to say the least. We are long overdue for a correction, and maybe even a real bear market (usually defined as a drop of 20% or more.) But that has been true for a long time, and it still hasn’t happened.
Stock market valuations are sky high, and prices of goods and services are rising faster than at any time since 1990, as measured by the consumer price index (CPI), the standard measure of inflation which is prepared by the United States Bureau of Labor Statistics (BLS). Energy prices are up about 30% since this time last year – an astronomical number. Usually, when prices start rising too fast and stock market valuations get too high, the Federal Reserve Bank (the FED) steps in and raises borrowing costs (interest rates) to reign prices in.
But today, it seems that no one in the government is willing to spend the political capital to raise rates.
In fact, in a recent interview, Larry Summers, a democrat and former Secretary of the Treasury (under Clinton) who is now a professor at Harvard University said:
“We have a generation of central bankers who are defining themselves by their wokeness… They’re defining themselves by how socially concerned they are.”
He went on to say:
“We’re in more danger than we’ve been during my career of losing control of inflation in the U.S…”
When Mr. Summers says “losing control of inflation” he probably means something like what was happening in 1979 (long before I was a portfolio manager and before Ken got his driver’s license.) Back then, inflation was almost 15%, roughly three times what it is today.
Today, the FED is not interested in raising rates. In fact, not only are they not willing to increase rates but they are unwilling to even stop stimulating the (arguably overheating) economy. That’s right, in the most recent meeting of the Federal Reserve’s Open Market Committee (FOMC) the body tasked with setting the overnight lending rate that banks pay for borrowing money from one another, decided that starting in November they will only buy $105 billion of bonds.
That isn’t a typo. $105 billion of bonds is what they are buying. This is down from $120 billion per month which they started doing after the market dropped 30% last year due to the COVID outbreak. They called it “QE4”. QE stands for Quantitative Easing. 4 means this is the 4th round of doing it since the Great Financial Crisis. To me, the 4 means “forever.” They just can’t stop themselves.
For those of you who don’t totally understand the implications of this tactic, let me briefly explain.
The percentage interest rate for a bond is a function of its price and its coupon. If a bond pays a $50 per year coupon, and that bond’s market price is $1,000, then the interest rate as a percentage is 5% (50/1000=0.05).
The bond’s price is established by supply and demand. The more demand there is for a bond (or anything else) the higher the price will go. So, when the FED uses money printed by their friends over at the Treasury Department to buy bonds, they are effectively increasing demand for those bonds and so the price of the same bond will rise.
To continue the example, let’s say they print so much money to buy bonds that they bid the price of the bond up to $2,000. And they know they are overpaying for this bond, but they don’t even care. If the bond still pays the same $50 annual coupon, the interest rate of that bond is now (50/2000=0.25) 2.5%.
This is how the fed reduces interest rates further than would otherwise be possible by simply changing the overnight lending rate that banks pay to each other. After all, the overnight lending rate is already at the rock bottom level of 0%. So, rather than dip into negative territory, they just print money and buy bonds.
This money printing is inflation. The impacts, or symptoms of that inflation are price increases. Those price increases start in bonds and serve to lower interest rates, but those symptoms soon spread to the price of everything else in the economy, as we are seeing today.
The only real way to combat these price increases are to force rates higher. When interest rates go up, the prices of everything else goes down. Why?
Well, in normal economic times (when the FED isn’t artificially manipulating supply and demand for bonds) investors generally use the interest rates that they could earn buying safe government bonds to compare relatively riskier investments, like stocks.
As a simple example, if you knew you were getting $1,000 of cash in each of the next 5 years, using a discount rate of 1% would mean that the present value (the value today) of all those future cash flows, is $4,853.
The five $1,000 payments are not worth $5,000 today, due to the discount rate. The future cash flows are worth $4,853 today, because if someone gave you $4,853 today you could theoretically earn 1% per year, and that would net the same $5,000 total over the 5-year period.
Now, what happens if rates increase to 2%? Well, the present value of those future cash flows drops by $140 (or 3%), immediately, from $4,853 to $4,713. You are immediately $140 poorer.
And this is essentially why I (and Mr. Summers) say that nobody in Washington DC has the courage to raise rates.
If you go back to 1979, when inflation was almost 15% and nobody could get it under control, it wasn’t that nobody knew how. It was the same thing – they didn’t have the courage. So, they found a new Chairman of the FED named Paul Volcker, and he did the unthinkable. He raised the interest rates virtually overnight, from 11% to 12% during the weekend of October 6, that year. By 1981, the overnight lending rate set by the FED topped out at 21%.
Depending on your view, this bold action probably cost Jimmy Carter his reelection to the Whitehouse in 1980, where he lost to none other than Ronald Reagan. And it would probably have similar effects to whichever party was in power if a similar action was taken again, today.
Now you can see why courage is required to take real action to stop inflation.
…prices were spiraling upward, almost out of control.
A vicious cycle was underway: Because prices had been rising rapidly in the recent past, workers demanded ever-higher wages.
As the nation’s central bank, the Federal Reserve was the agency best positioned to try to end that demoralizing cycle, but it would exact a cost.
To reduce inflation, the Fed would need to raise interest rates to choke off the flow of money into the economy, probably prompting much higher unemployment. For that reason, the previous two men in the job had moved only timidly in trying to combat inflation…
The above excerpt (with a few liberties to keep you guessing) is from an article in one of my least favorite national newspapers (owned by Mr. Jeff Bezos.) You might think it is describing the current economic environment… it could easily be. But it is not.
The article was written December 9, 2019 and describes the economic environment in 1979. It is essentially an obituary for Mr. Paul Volcker.
I think the entire obituary is worth reading, lest we forget history. As Aldous Huxley quipped:
“That men do not learn very much from the lessons of history is the most important of all the lessons of history.”
Maybe in this case the politicians did learn from history, and they are acting to save their own skin, not to be good stewards of our economy.
At any rate, because I think it is so similar to our current situation, I will share the entire section of the obituary related to the FED below:
Putting brakes on inflation
In 1979, when President Jimmy Carter was looking for a new Fed chairman, prices were spiraling upward, almost out of control.
A vicious cycle was underway: Because prices had been rising rapidly in the recent past, workers demanded ever-higher wages.
As the nation’s central bank, the Federal Reserve was the agency best positioned to try to end that demoralizing cycle, but it would exact a cost.
To reduce inflation, the Fed would need to raise interest rates to choke off the flow of money into the economy, probably prompting much higher unemployment. For that reason, the previous two men in the job, Arthur F. Burns and G. William Miller, had moved only timidly in trying to combat inflation. Miller left the job after a single ineffective year as Fed chair.
As Carter and his aides spoke with people in financial circles about potential nominees, Mr. Volcker’s name came up repeatedly. The president appointed Mr. Volcker, a decision that had been judged well by history but may well have cost Carter reelection in 1980.
Taking the job came at a personal cost for Mr. Volcker. He would have to take a 50 percent pay cut from his salary as New York Fed president, and his wife had to return to bookkeeping work to afford both their New York co-op and the small Foggy Bottom apartment. Mr. Volcker commuted back to New York on the weekends.
Just two months after taking office, Mr. Volcker was ready to make the boldest move of his tenure. He called his Fed colleagues from across the country to Washington for a secret, emergency policy meeting on a Saturday. After hours of argument and debate, he steered the Federal Open Market Committee to change the entire framework the Fed would use to control the nation’s money supply.
The Fed then, and now, set a target for short-term interest rates and then bought and sold securities to ensure that interest rates actually settled at that level. When the Fed wants to slow the economy and choke off inflation, it raises its interest rate target. Mr. Volcker concluded in October 1979 that the Fed needed to change strategies and start targeting the actual amount of money floating around in the economy.
Angry reaction
The media called it the “Saturday Night Special,” and it most certainly put a bullet in the U.S. economy. The unemployment rate that month was 6 percent. By the time Mr. Volcker’s campaign of monetary tightening was done, in 1982, joblessness would peak at 10.8 percent.
This, understandably, led to intense pressure on Mr. Volcker and the Fed to relent, to hold off on the tight-money policies that had caused the deepest recession since World War II.
With interest rates over 20 percent, home-building activity practically came to a halt. People who worked in construction trades mailed two-by-four pieces of lumber to Mr. Volcker in protest. Auto dealers mailed keys to the cars for which there were no buyers. Farmers drove their tractors around the white marble Fed building.
A man with a sawed-off shotgun and other weapons, who later told police he was angry about high interest rates, charged past guards at the Fed’s building and nearly made it to the boardroom of the central bank before a guard tackled him. (After the incident, Mr. Volcker was assigned a full-time security detail for the first time.)
Mr. Volcker’s routine appearances on Capitol Hill became an exercise in lawmakers of both parties attacking him. The economic downturn caused by Mr. Volcker’s tight-money policies was surely a significant factor in former California governor Ronald Reagan’s landslide victory over Carter in the 1980 presidential election. Both Reagan and Carter expressed public support for the policies, even as many of their aides assailed them behind the scenes.
But Mr. Volcker, confident in his analysis that this was the only way to rid the nation of double-digit inflation for good, ignored the calls. It was successful: Inflation was about 12 percent over the 12 months before Mr. Volcker became Fed chairman. By 1986, it was down to around 2 percent.
Once that vicious cycle of out-of-control inflation expectations was ended, Mr. Volcker relented and cut rates, unleashing an economic boom that would continue with few interruptions for more than a quarter century.
As a totally unrelated matter of fact, I also recently listened to Jimmy Carter’s crisis of confidence, or “Malaise Speech,” which he delivered on July 15, 1979. You can check out the audio or written transcript here. It is also totally worth it. It is truly amazing what we can learn from history if we are willing to.
Performance
In October, both our strategies (Appreciation and Income) were up nicely for the month. The Income Strategy beat its benchmark by a fair amount and is ahead of its benchmark for the year 2021, as well. The Appreciation Strategy was up more than the Income Strategy, but not quite as much as we expect in such a strong month for the S&P 500 (SPX) which was up 6.91%. The Appreciation Strategy is up nicely for the year, but we still have some catching up to do in the last 2 months if we are to match (or beat) the SPX return for calendar year 2021.
What would be helpful to our cause of beating the SPX (I know none of you want to hear this, but we tell you what we’d want to know if our roles were reversed) is for the SPX to drop hard and fast for a few weeks, or even a month. It would only be natural for that to happen, as it hasn’t happened for over a year now (the 5% drop in September doesn’t qualify as hard or fast.) And as I mentioned last month, the SPX drops an average of 14% every year, and this year, we haven’t even come close to a 10% drop.
The reason this would help us, especially right now, is that we typically outperform by a wide margin on the downside. So, we already tend to drop by less than the market when it goes down, but since we recently stopped out of two positions (INTC and PYPL) in the Appreciation Strategy and we haven’t fully replaced them yet, we are presently holding a lot of excess cash.
We were allocated to Intel (INTC) in the Income Strategy too, so we have some extra cash there as well. So far, our newest positions are Facebook (FB) in the Appreciation Strategy, and Cisco (CSCO) in the Income Strategy. We have purchased half-positions in each of those, so far.
Outlook
I won’t spend much time on the outlook, this month. Mostly because I have no idea what to expect given the inflation situation. I chose the newest stocks that we added to each portfolio largely based on their capital efficiency – their ability to grow revenue without increasing the amount they must spend to generate that revenue. These are the types of stocks that (based on history) I expect to do well in an inflationary environment where costs are rising faster than they have in decades.
That said, we are still in an uptrend. So, there is still no good reason to “sell everything” and hide in cash. The market is still extremely expensive too, but that is nothing new. As you know from previous commentaries, the combination of uptrend + expensive, still typically leads to handsome gains.
On that note, isn’t it amazing how many words I can come up with when I am at a “total loss for words?”
Until next time. I thank God for each of you, and I thank each of you for reading this letter!
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor
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