Munger,Warren Buffett’s long-time investing partner at Berkshire Hathaway, recently expressed his disapproval of the business model of Robinhood. As I understand it, he has two complaints: the app encourages users to trade stocks and options in reckless ways that harm to the traders’ economic health and that this recklessness itself is the main source of Robinhood’s profits. Robinhood’s reply is that the ultra-wealthy 97-year-old is an elitist.

Robinhood has a point. Traditional “full service” brokers charge high prices and deliver, in my experience, very little either in service or superior investment performance. That’s presumably because these firms get paid on some combination of assets under management and the amount of trading done in an account–not on investment performance. They’re also a dying breed.

Discount brokers, the new and improved model, make their money in similar fashion–margin accounts, stock lending, bid-asked spreads and payments for order flow. This is by and large invisible to clients. Again, profits are mostly a function of how much trading is done, not investment performance. In fact, discounters go out of their way to underline that the colorful charts and technical tools they provide are not investment advice (which of course they aren’t) for fear of being sued. Robinhood is arguably the same wine in bottles more attractive to younger investors.

Munger may have a point as well. I signed up for a Robinhood account a few months ago but haven’t used it. Preparing to write this I went back for another look. What impressed me first time around was the bright colors, the speed at which I was whisked through the regulatory formalities and the way I was pointed toward options trading, the product that history says is the most lucrative for a broker and the least so for the client. The vibe reminded me of the time I saw a long line of people in the Luxor Casino in Las Vegas waiting to pay a dollar (five dollars?) for an employee to guess their weight. A guess within two pounds meant the weighee lost all his money. A guess outside that still meant losing the money, but getting a stuffed animal worth about $.25.

When I went back the other day the bright colors had been replaced by a more sober white and there were simple charts and other market information available that was either new or I wasn’t able to find on my first visit. There’s no information about how much money Robinhood makes for directing trades to third parties for execution, or the care it takes to ensure that the executions are at reasonable prices for its clients. But that’s basically the same as for any other discount broker.

The only information I can see that might have triggered Munger’s comments–Munger may have more–about how Robinhood regards its customers’ welfare vs. its own profits comes from its declining to take customer buy orders for “meme” stocks during recent runaway Gamestop trading. Its reason? it didn’t have enough assets to post collateral for new trades during the two-day clearing process. After the fact, however, Robinhood raised several billion dollars almost instantly. To me, this says the owners of the company chose the path they took. They judged it was better for them personally to avoid paying for extra capital and run the risk of having to suspend trading, rather than incur the cost to obtain new capital that would ensure customers’ trading would be uninterrupted and not need it. Munger’s point would be that for Robinhood the idea is not that we’ll all grow rich together but instead that a dollar in my pocket is a dollar not in theirs.

None of this explains why Merrill Edge, a part of Bank of America, refused new buy orders as well.

deflation is the worst

Deflation is the situation where prices in general are falling. It’s a strong candidate for the biggest factor behind the economic devastation of the 1930s Great Depression.

The general idea is this:

I earn $1000 a month. I borrow to buy a house. The interest on my bank loan is $900 a month.

Prices, including the price of labor, are falling by 5% a year.

Three years in I’m making $857 a month and am forced to default on my mortgage.

My employer has borrowed to open the business where I work. The same thing happens to him–operating margins are squeezed by falling prices, meaning bank loan payments eat up an increasing amount of operating income. At some point, operations don’t generate enough to make loan payments and my employer declares bankruptcy.

Voila …depression.

1970s runaway inflation in the US

A decade of excessively loose money policy in the US in the 1970s created inflation (prices generally rising) that was high at 7% a year, and accelerating, with 11% in prospect, when Washington was forced, kicking and screaming, to address the problem. People and firms were doing all sorts of crazy things–hoarding, buying any sort of physical asset… The Fed Funds rate rose from 6% to 16% by 1981, when inflation was 14%, and did not return to 6% for a decade. It took that long to change the inflationary mindset. Inflation didn’t stabilize at around 3% until the early 1990s.

what came next

What’s less talked about is that the economic establishment began to think that the country, while clearly past the danger of economic distortions induced by hyperinflation, would be better off with inflation at 2%, a goal that was achieved by the late 1990s.

Two problems emerged:

–during the financial crisis of 2008-09 economists began to have second thoughts when they worked out that there wasn’t much scope to lower rates to counter anything more serious than a garden-variety slowdown (which this was way worse than) and that the move to 2% inflation might have been a horrible mistake; and

–perhaps more worrying, they couldn’t manufacture a rebound no matter how hard they tried. In vintage form, Congress was little help.

why this matters now

Although economists won’t say acknowledge this, they realize–and are acting on their belief–that we’re in uncharted waters with little growth, no inflation, the external shock of the pandemic and the traditional economic toolkit not working so well.

We do understand inflation and how to tame it, however. So there’s absolutely no percentage in the Fed raising rates until we’re clearly in a part of the pool we can navigate in. Yes, a surge in inflation–not that one is on the horizon so far–might do some harm. But at least this is a problem we know how to fix. But the alternative might be to turn into a new version of Japan, whose economic stagnation is in its fourth decade. This is not a side of the bet anyone wants to take.

An economist I knew years ago made an exhaustive study of the real and nominal returns generated over long periods of time by both stocks and bonds in OECD countries. His conclusion:

–stocks return inflation +6% yearly

–government bonds return inflation +3% yearly.

In today’s world, of low and hard-to-affect inflation, the +x% are probably too high for bonds. It’s harder to figure what to make of stocks, since their returns have been considerably above the +6 pretty steadily since the 2008-09 financial crisis.

Let’s say that the return on a 10-year Treasury should be inflation +1% annually. That would fit 2018 and 2019 experience, when inflation was running around 2% and nominal yields were around 3%.

Where we are now: inflation at, say, 0.6% and the 10-year at 1.45% today. That’s up from 0.6% last summer. However, if we could wave a magic wand and return the US to a pre-pandemic state, inflation would likely be 2%+. That would imply the 10-year at 3%.

If so, we’re a little less than half way back to normal. Given the competence of the current administration, it’s hard to think that the pandemic won’t be increasingly under control as the year progresses. The removal of the prior administration’s growth-inhibiting measures will presumably add an extra tailwind. So my guess is that the bond market will pretty steadily head for 3%. This is a headwind for both stocks and bonds. In the case of stocks, though, the anticipation of strong profit growth will act as a counterweight. This is another reason the stock market is gravitating toward consumer cyclicals, where the greatest positive growth surprises are likely to come from.

what I’m doing

I think a day like yesterday is important to study carefully for what it will tell us about how this year’s stock market will likely evolve. For one thing, yesterday suggests that intraday volatility will likely be extremely high as investors respond to higher interest rates on long-dated bonds.

It would be useful to form an idea of how high the 10-year Treasury yield might get. If we were to suppose that inflation ends up being 1% and the real yield ends up being 2% then the 10-year nominal yield will end up–maybe some time next year–at 3%. I have no confidence that this is anywhere close to correct. But it’s a point to start at and to refine from. It would imply that the PE on the S&P should be somewhere around 33x.

On portfolio structure, my guesses are:

–as evidence mounts that the domestic economy is strengthening more quickly than expected since the beginning of the year, the market is moving away from secular growth names to cyclical recovery beneficiaries, where earnings gains will be the strongest. A shorthand version of this would be to say that the Russell 2000 will likely continue to outperform NASDAQ.

–this doesn’t mean abandoning last year completely. After all, IT + Communication services + Healthcare together make up half the S&P. I see three kinds of stocks among last year’s winners, though: companies that are wholly or mostly beneficiaries of quarantine, and whose growth will shrivel as the country opens back up; companies with new ideas/services whose adoption has been accelerated by the pandemic and will remain important features of life when quarantine ends, but whose growth rate will slow; and companies that are flat-out growers, for whom the pandemic hasn’t made much difference.

My most important task is to get rid of the first group and lighten the second, to shift money into cyclical recovery stocks.

–we can sort recovery stocks into groups as well. There are: the left-for-dead, like airlines and cruise ships and possibly hotels; the immediate beneficiaries of reopening, like bricks-and-mortar retail and restaurants; companies like Lowes and Home Depot, where an end to the pandemic may be bad for business; and firms whose prospects have been damaged by pandemic-induced rethinking of priorities–like the line of ultra-tall, ultra-expensive condo buildings crossing Manhattan just below Central Park.

Personally, I’m most comfortable with retail and dining, but I also hold shares of MAR. I’ve also held a large position in an R2000 etf for a while

–most banks are pure beneficiaries of higher interest rates. Real estate is more complicated, but generally higher rates are not it’s friend.

a starting out note

Less than two months ago the then-sitting president of the US summoned an armed mob to Washington DC in an unsuccessful attempt to intimidate Congress into reversing the results of the November election he lost by a wide margin. Almost as startling, there national Republican luminaries who, although victims of this assault, continue to refuse to affirm that Joe Biden won the election and is the lawful president–dismissing the voices of veteran Republican state election officials who assert the election results are accurate.

As an investor, what I find most notable about is that I don’t see the slightest sign of worry about the coup attempt in any subsequent trading of US equities. Quite the opposite. To my mind, the capital flight trade is no longer the main concern of Wall Street.

My standing assumption is that of all the professional investors I’ve ever known–that the market is always right. So I conclude that Trump is, and will remain, a non-issue for stocks. Why doesn’t matter. The important thing is stock prices have spoken.

think commodities

Typically the stock market shifts from worrying about an economic downturn to anticipating expansion about six months before the economy hits its low point …something government economists will confirm several months after the event.

During the initial phase of a garden-variety up market, the closer a company’s products are to being commodities, the more likely its stock is to have a sharp initial bounce as soon as the market begins to give the “all clear” signal. This move is followed by flattish trading for a while. A second upward movement kicks in only once there’s strong evidence that earnings growth is resuming. That could easily be nine months or a year after the first bounce.

I think that this pattern may hold true for a much larger part of the market than just commodities as the domestic economy begins to recover from covid. How so? I think the pandemic has overwhelmed cyclical downturn defenses, such as having a brand name or appealing to more affluent customers, for virtually all companies.

rising interest rates

Another peculiarity of the economic upswing we seem to be on the cusp of is that interest rates are already rising, to an extent that typically happens only after corporate profits are in full cyclical bloom. The two main issues surrounding rates that I see are: at some point Treasury bond yields will reach a level where individual investors will allocate away from stocks and into fixed income. Where is that level? Not at 1.35% on the 10-year. But at 2.5%? …higher? I don’t think this is a current worry but at some point it will be. Secondly, there’s a kind of rough inverse relationship, in the minds of both the academic and real worlds, between the interest rate on bonds and the inverse of the PE on stocks, which academics all the earnings yield. The idea is that a shareholder’s portion of the current year’s corporate earnings can be looked at as the equivalent of the interest a bondholder gets (even though the earnings remain in the hands of corporate management).

I think the important thing to observe, assuming (as I do) that there’s a germ of truth in this, is that the long bond at 5% is the equivalent of a PE on the market of 1/.05, or 20x. At 4%, the PE is 25. At 2%, the PE is 50. More generally, when interest rates are falling, the market PE expands; at times like now, however, when rates are rising, the market PE contracts.

So unlike the typical bull market situation where rising earnings and falling/steady interest rates reinforce one another, in the current market earnings and rates will likely act as cross purposes.

consider what to sell as well as what to buy

Every major shift in market leadership–and that’s what I think is happening now–should be looked at from two perspectives: who the new leaders will be and how to play them and which former market darlings will be left behind most badly.

On the plus side, it seems to me that the hot spot of growth this year will be the US consumer. Three reasons: fiscal stimulus, Washington acting to fight the pandemic, and a government move to more pro-growth macroeconomic policies. Yes, Americans have been spending a lot while in quarantine, but there’s also considerable pent-up demand, I think, for what reopening will bring. This last is where the the most favorable combination of low valuation and the possibility of surprisingly strong eps growth lies, in my opinion.

Reopening has a flip side, as well. This is the issue of what stay-at-home beneficiaries have passed their best-by dates and should be sold. Prospects for, for example, Etsy, Zoom, Peleton?

In theory, we should all be working on both sides of the portfolio. In practice, we all have different skills and different levels of conviction about potential winners and losers that tell us where we will find the most profitable area to work in.

More tomorrow.