April 25, 2024
“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”
- John Kenneth Galbraith
What do we know?
We cannot know the future. Unforeseen events will take place. They may have a positive or negative impact on the stock market, interest rates, global currency, and commodity markets. We cannot know the next big event to occur (like Covid or the Ukraine war), but we know with certainty there will be another impactful event that will surprise us.
As my colleague Peter Grave said to me: “You never get hit by the bus that you see.” Wise words! So how do we prepare for unforeseen events:
Understand the constants and what we can generally rely on about the future.
Assess the current situation.
Assess probabilities about the future, and measure that against people’s expectations.
Build a portfolio that will hopefully provide wealth protection over time.
What is constant:
The United States and other western liberal democratic countries are governed by laws and property rights. Having faith in these systems is a prerequisite to invest with any degree of confidence.
The Federal Reserve targets 2% inflation over the longer term. It is their belief that this target is consistent with their dual mandate of maximum employment and price stability. What this means for your money is that the purchasing power of the US Dollar will erode over time.
Surprising future events will occur; they always do.
Human nature doesn’t change. Oscillating between greed or fear / calm or anxious.
We tend to extrapolate the recent past into the future (Recency Bias).
We tend to focus more on successful outcomes without incorporating enough potential for failure (Survivorship Bias).
Points 5 and 6 are very important considerations when it comes to investing.
My Subjective Assessment of The Past, The Present, and The Future:
The Past:
The Covid response by the Government and the Federal Reserve (free money and free spending) has created a lot of stimulus, economic growth, and private sector wealth. Inflation increased, and with it the Fed hiked interest rates from zero to 5.5% (the US government remarkably continues its fiscal expansion despite economic growth and inflation).
Fixed income and portfolios with a 60% equity/40% bond allocation have not performed well these past few years. The BlackRock Total USD Bond ETF (IUSB) has returned -2.19% annually (as of March 31, 2024) and the BlackRock target allocation 60/40 is +0.30% / year over the past 3 years (as of December 31, 2023). By comparison, the S+P 500 index fund ETF (IVV) is up approximately 11% annualized as of March 31, 2024.
House prices nationally have increased considerably since 2019 but have not increased much since the middle of 2022 (see chart below).
High interest rates are helping savers earn a nice rate of interest, but it is hurting borrowers that need cash. Credit card delinquencies are well above any level compared to the past 10 years (see chart below).
The Present:
Many commercial real estate loans will need to be refinanced in 2024 and 2025 at higher interest rates. Cash flows are already challenged because of high vacancy rates.
Although inflation has come down from the highest levels of last year, the Federal Reserve chair indicated on a recent panel that there has been a “lack of further progress so far this year on returning to our 2% inflation goal”.
Expectations of a Fed interest rate cut have been reduced. US 2 Year notes which were yielding around 4.20% in January, are now yielding almost 5%. This increases the financing rate for consumers, corporations, and real estate mortgages.
It has been 25 months since the Federal Reserve first hiked interest rates in this economic cycle. Normally there is a long lag between the first hike and an economic recession. The last 4 recessions have occurred 20 to 50 months after the first hike.
Inflation rates are falling around the world.
Chinese export prices have fallen dramatically, and there are signs of excess capacity in: Electric cars, batteries, wind turbines and solar panels.
Temporary Help Services in US payroll employment continues to fall, and the rate of people quitting jobs is also falling.
The US Dollar compared to other currencies (measured by the Nominal Broad Dollar Index) is near historically high levels.
Gold has increased cumulatively in price approximately 79% over the past 5 years. The stock market has increased by a similar magnitude (as measured by the S+P 500 index) over the period (GLD EFT tracks the gold price, see chart below).
My thoughts (The Future):
It must be pointed out that I view all future events as probabilities. If there is a 70% chance of rain, there is a 30% chance of no rain. Hence, if I weigh evidence that suggests there is a 40% chance of a recession in the next year, that means two things:
1) There is a 60% chance (in my estimation) of continued economic growth without recession.
2) Our investment portfolio will consider the significant possibility, but not the certainty that a recession will occur.
This is a very important consideration when reading my thoughts below. I am always cognizant of what I know and what I do not know. With that in mind, here are my current thoughts (solely my opinions).
As I suggested above, the relatively high interest rates in the economy are helping savers and holders of cash and hurting others that need cash. I do not expect rates to rise, but high inflation in the near term suggests Fed rate cuts are less likely to come soon. Additionally, whether the Fed changes rates (up or down) by 50bp or so is unlikely to matter materially to the current economic environment. The real change in rates from 0.00% to 5+% in 2022 and 2023 are having an economic impact.
Although higher than expected inflation in the near term is causing some market participants concern and causing the Federal Reserve to reconsider its potential desire to cut interest rates, I do not see inflation as an ongoing problem. Why:
It is important for the Chinese leadership to keep their economy growing and population employed. There are serious challenges for them in the near term for a myriad of reasons. The likely solution is to keep manufacturing growing in goods where international demand is high, and the Chinese are competitive (solar, wind, batteries, Electric vehicles), and this will likely depress prices of these goods globally.
In the USA, house prices feed inflation with a lag, and this is a factor in keeping inflation rates high presently. I do not see this as sustainable. High rates have caused people to stay in their homes because of their cheap fixed mortgages, and this has created a short-term supply constraint. Affordability of houses is a problem for first time home buyers (high prices and high mortgage rates). People cannot spend what they do not have. As the chart above shows, nationwide house prices have not risen much in the past 2 years.
Employers are slowly gaining the upper hand over employees. Less working from home, less “quiet quitting” silliness, and artificial intelligence is showing promise in reducing the need for labor. Quit rates are falling and temporary employment looks weak.
Inflation around the world seems to be falling. I continue to believe that inflation was caused primarily by Covid over-stimulus, and that should continue to wane. Covid savings appears to be depleted for most Americans.
Higher gas prices also raise inflation in short term but are likely to constrain discretionary consumption because energy is essential at any price.
Higher insurance costs are also a factor feeding inflation, but this is more of a regulatory issue than an economic issue. These costs will also tend to constrain discretionary consumption.
Interest rates have risen because of the recent inflation concerns but are unlikely to go much higher. Bonds are attractive again. Why:
Getting paid close to 5% return on US Government bonds when I expect inflation to fall back towards 2% makes sense. This will protect your purchasing power well with highly liquid, government guaranteed bonds.
If a recession were to materialize, the Federal Reserve will likely cut interest rates materially. Locking in high rates of interest on bonds at high yields today would cause the prices of these bonds to rise if rates were to decline.
Government bonds have lost money for the past few years as an investment, but they typically provide a guaranteed income stream and reduce portfolio volatility (they typically move higher in price when equities decline). Because they now are providing a significant rate of return, I now view them as valuable in all our managed portfolios.
If an adverse economic event occurs and forced liquidation of assets takes place, government bonds should rise in price. This allows holders to switch out of their government bonds to buy assets at discounts.
In general, assets with less certainty of cash flows and less liquidity (ability to sell the asset) are less attractive today than they were at the start of 2023. Why: I can earn close to 5% guaranteed on a liquid investment from the US Government, I want my expected return from investment in a company (from current prices) to be 10% or higher per year. That is not an easy task. If I have no ability to sell that asset, as in the case of some private equity or real estate, I want my returns to be even higher than that!
Prices of many companies and assets have risen materially since the start of 2023.Gold, bitcoin, equities, residential real estate, and others. I wonder how much of this was a monetary phenomenon due to the extremely accommodative monetary and fiscal policies of the recent past. The chart above shows gold and the S+P 500 producing similar price changes in percentage terms over the past 5 years. Gold produces nothing, and it costs you to hold it, but companies produce a return on your investment. Why are the returns similar? I’m not sure I have the answer, but I suspect that pumping large amounts of paper currency into the global economy was a factor. Given that this money accommodation has been removed (hiking of interest rates to 5.5% from zero), I must consider the possibility that prices of assets can decline over short periods of time.
With the above thoughts in mind, what have we been doing?
As many of our clients are already aware, we have been raising cash levels in many of our portfolios since the start of April. We have been selling many companies that we purchased back in the first quarter of 2023, we have reduced exposure to Brazil, corporate bonds, and we have reduced our gold exposure. We have increased our exposure to US Government fixed income. We remain invested in mining, energy, and utilities as we expect the
demands for energy (partly due to demand for computing power) to continue to grow faster than the available supply.
What are we reflecting with these changes?
We have increased our diversification across asset classes with the following goals in mind:
1) Reduce portfolio volatility (volatility is a measure of risk).
2) Continue to protect purchasing power and grow wealth.
3) Allow us more flexibility to buy quality assets at more attractive prices if others are forced sellers because they need cash.
What are the risks to these changes?
Less equity risk overall will likely mean less performance correlation to the S+P 500 index in the near term. We have a more balanced portfolio of equities and fixed income across most managed accounts. If inflation were to accelerate further and interest rates went even higher, the higher weight of US Government bond investments would likely weigh on short term performance.
What continues to intrigue me in the investment world?
Occasionally clients and friends approach us with questions regarding various “opportunities” they have been shown and are excited about their potential. Insurance products, annuities, structured notes, private small company investments, alternatives, private equity, innovative tech companies, real estate, and many others. Usually these are shown by salespeople that will make money if you decide to invest. This is a huge red flag
that you should not overlook. Salespeople understand recency bias because you want to sell what is hot and sexy. It may or may not work out well for you, but it will certainly work out for them if they sell it to you.
We hear stories of rags to riches, concentrated risk that went enormously well, but we rarely spend time on the failures we do not see (survivorship bias). Most fund managers understand that for every home run investment that makes 100 times your investment, you will have many more losers. It works out because the portfolio allows your big winners pay for the smaller losers. Often though, investors put money into the odd investment product here and there without thought to their overall goals.
At August Wealth
Poor investing strategies pervade the public markets too. Sticking with one company can bring great wealth, and then you can watch it evaporate. Tesla is an excellent example of a visionary leader, a great product, and it made many investors wealthy. However, for those with concentrated wealth in the company at the end of 2021 it’s been a disaster. Things change.
The ARK innovation fund ETF run by Cathie Wood really makes me wonder why some investors make the decisions they make. Cathie Wood is an outstanding marketer. She became a social media sensation by making big bets on disruptive technology companies with great narratives. Many of the companies she owns in the ETF are innovative and have arguably made our lives better. However, an incredible new technology company that provides amazing solutions often does not translate into a good investment return. I posit that she isn’t doing anything particularly unique on the investment front, but she is incredibly good at marketing. Read this from the WSJ:
“By the end of last year, ARK funds had destroyed more wealth than any other asset manager over the previous decade, losing investors a collective $14.3 Billion, according to Morningstar.”
ARK ETF charges 75bp for a portfolio of “innovative companies”; you can view the holdings in the ETF without even buying the fund. The cost of working with a fiduciary advisor that develops a strategic investment plan specifically for their family typically costs 1% (most charge 1% of assets). If someone could help me understand the value in paying for the ARK innovation fund ETF, I would welcome it. I suppose it is sexy and cool to be involved with great innovations, but I suspect you receive a lot more value from a caring and thoughtful fiduciary advisor. I welcome your thoughts on this topic; perhaps I am missing something.
At August Wealth, we are not very sexy (at least not me or my ideas). We try to develop simple solutions at a fair price for the families we work with. We emphasize the importance of asking: What does money mean to you? What are you trying to achieve? What liquidity is required? How do you feel about your wealth fluctuating? We then formulate a plan that reflects a family’s unique situation with the goal of making your wealth work efficiently for you within the confines of the available market opportunities. We believe that serving our clients should be at the forefront of every single decision we make.
Exciting investment opportunities:
Many investors have not lived through markets where interest rates have remained high for an extended time. These circumstances are different from the world of zero and negative interest rates of which we just came through. There are likely to be changes in technology, regulation, monetary policy, and other areas. These factors will likely cause changes to the investing landscape. Navigating these challenges should provide opportunities to grow wealth over time. We welcome change, and we believe we are well equipped to deal with them. We continue to scour the market for companies which produce high returns on capital, provide free cash flow, and trade at reasonable valuations.
I think the approach requires attributes of reflection, open-mindedness, humility, experience, and charity.
We are so grateful for your trust in allowing us to serve you and your family.
Joe
i Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor. Stratos Wealth Advisors, LLC and August Wealth Advisors are separate entities.
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