February 18, 2021
My Friends,
I seem drawn, like a moth to a flame, to distressed markets. My first job after business school was trading municipal bonds in New York, as The Big Apple teetered on the brink of bankruptcy. In the 80’s, I was trading mortgages at Salomon Brothers when inflation was raging and the current coupon GNMA was 17%. I was sitting on the trading desk at Drexel on Black Monday October 19, 1987 when all 23 of the world’s major stock markets crashed simultaneously, and on Valentine’s Day in 1990 when Drexel went out of business and the junk bond market collapsed. I was investing in Russia in January 2000, when the largest energy company in the world, Gazprom, had the same market cap as a grocery delivery company here called Webvan. And I opened my investment advisory business in 2008 just in time for the Great Financial Crisis. In December, I re-opened On Keel Capital. What could possibly go wrong?
I think we’re near the brink of the next great apocalypse.
If this were solely my opinion, it would be entirely reasonable for you to ignore this message. But I’m just sharing the thoughts (attached) of some of the greatest investors alive today. They’re a bunch of old guys – maybe they’re all clueless and just don’t understand “future shit”, as my son calls it. Or maybe, since they are all billionaires, they know exactly what they are talking about. My money’s on the latter.
I believe in buy-and-hold investing and I don’t think anyone can time the market successfully, but it is possible to be positioned correctly for a howling bear market. Doing so will require forsaking the final paroxysms of the bull market, which will seem expensive, painful, and lonely. Do it anyway.
Please take five minutes to read the attached summary. Then I will have done my duty to God and my country, and to my friends.
Cheers!
Rick
The Current Market Environment
February 18, 2021
I don’t believe in trying to time markets, but I think that being positioned properly is critical. We are almost 12 years into a bull market, the average duration of which since 1941 has been 8 ½ years. And there are a lot of people investing in the stock market today who have never experienced a bear market, weren’t investors for the tech bubble of 2000, and weren’t even alive during the high inflation years of the 70’s and 80’s.[1]
I confess that I am drawn to the counsel of a group of guys my own age, who have been successful investors for a long time. Howard Marks of Oaktree Capital has been writing about the escalating acceptance of risk and the deteriorating quality of private equity and leveraged loan deals since September 2018, and his June memo from last year succinctly explains the impact that negative real interest rates have on equity prices and risk (page 3). Ray Dalio has published a full book on Linkedin, The Changing World Order, in which he argues that the U.S. is on step 5 of a 6-step process whereby the dollar could conceivably lose its reserve currency status. One interesting graph from Chapter 1 of that book:
Echoing Dalio’s observations about the U.S. and China, Stanley Druckenmiller had an interview with Goldman Sachs two weeks ago:
“Just to frame things a little, the recession we had last year or whatever you want to call it, the economic downturn, was 5X the average recession since World War II, but it did it in 25 percent of the time. More bizarrely, during the year while 11 million people more were unemployed, we had the largest increase in personal income in 20 years during an economic downturn that's occurred. And of course, as you know, that's because of the massive policy response we got.
The Cares Act added trillions of dollars in fiscal stimulus. How big was it? In three months, we increased the deficit more than if you took the last five recessions combined. And those were big ones. That was '73, '75, the '82 recession, the early '90s, the dotcom bust, and then of course the great financial crisis. If you added the increase in the deficit in all those five periods and combined them, we increased the deficit in the US more in three months in 2020 than we did in the cumulative total.
The other thing I would say is the juxtaposition of the various policy response is somewhat breathtaking… since 2018, M2 in the US has grown 25 percent more than nominal GDP. So, we've had a 25 percent increase in liquidity. In China, M2 to nominal GDP is where it was three years ago. So, they haven't borrowed anything from their future. We've had a massive liquidity input. And frankly, very low investment. It's primarily been transfer payments and Fed stimulus. And we've done a horrific job with the virus. The Chinese, basically Asia in general, the Chinese, the Taiwanese, Hong Kong, they've pretty much defeated the virus. They haven't borrowed from their future.”
At the end of the third quarter 2020, this ratio of government debt to GDP stood at 127%. Presumably, Round 2 of the Cares Act will push it higher.
Then there’s Warren Buffet’s favorite marker for stock valuations:
And for a capper, Jeremy Grantham:
“The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.
My best guess as to the longest this bubble might survive is the late spring or early summer, coinciding with the broad rollout of the COVID vaccine. At that moment, the most pressing issue facing the world economy will have been solved. Market participants will breathe a sigh of relief, look around, and immediately realize that the economy is still in poor shape, stimulus will shortly be cut back with the end of the COVID crisis, and valuations are absurd. “Buy the rumor, sell the news.”
It is a privilege as a market historian to experience a major stock bubble once again. Japan in 1989, the 2000 Tech bubble, the 2008 housing and mortgage crisis, and now the current bubble – these are the four most significant and gripping investment events of my life. Most of the time in more normal markets you show up for work and do your job. Ho hum. And then, once in a long while, the market spirals away from fair value and reality. Fortunes are made and lost in a hurry and investment advisors have a rare chance to really justify their existence. But, as usual, there is no free lunch. These opportunities to be useful come loaded with career risk.
The combination of timing uncertainty and rapidly accelerating regret on the part of clients means that the career and business risk of fighting the bubble is too great for large commercial enterprises. So, don't wait for the Goldmans and Morgan Stanleys to become bearish: it can never happen. For them it is a horribly non-commercial bet. Perhaps it is for anyone. Profitable and risk-reducing for the clients, yes, but commercially impractical for advisors.
However, for any manager willing to take on that career risk – or more likely for the individual investor – requiring that you get the timing right is overreach. If the hurdle for calling a bubble is set too high, so that you must call the top precisely, you will never try. And that condemns you to ride over the cliff every cycle, along with the great majority of investors and managers.”
It's definitely worth ten minutes to read Grantham’s entire article.
________
[1] Two months ago, discussing the tech bubble of 2000, a friend of mine, a long-time technology investment banker, sent me the following, which now seems prescient after the GameStop saga:
“Yep – I had a ringside seat to that bubble, and believe me, most of the companies paled in comparison to the size and established business models of today’s bunch. Not that the valuations aren’t crazy –we just took C3.ai public (ticker: AI) on same day as Doordash. Filed at $31-34, priced at $42, and now $102! It’s a terrific company, but there is no valuation discipline once the Robinhood crowd gets involved.“ (Note: C3.ai closed on 2/15/21 at $153.)