trying to rotate (iv)

If I were still working as a professional money manager, my thought process would be very clear. I’ve had very strong outperformance of the benchmark my customers measure my performance by. I’ve probably long since maxed out the bonus payments I’d receive for my work . Therefore, the most sensible course of action, based on the instructions and the incentives my employers have laid out for me, is to make my portfolio look much more like the index I’m measured by. I wouldn’t gain any more performance. But I wouldn’t lose any of the relative gains I’ve made already. In addition, if I generate too much good performance (yes, there is such a thing in the institutional world), clients may begin to think that I’m taking on too much risk.

I’m only working for myself, however, so I’m not going to do that.

Implicitly, I’m betting that the current economic situation–the pandemic and its aftereffects–will persist for a longer time than most other stock market participants expect. That’s ok with me, since I think that’s what’s going to happen.

I’m also finding it hard to imagine what ordinary life post-pandemic will look like.

In this regard, I’ve already written about the easy part–what’s not going to work. By underweighting the clunker sectors and making my portfolio look like the rest of the market, I stand to gain performance against my benchmark. This is not nothing. Over the 25+ years I’ve worked for others, this high-level portfolio layout has accounted for about half the outperformance I’ve achieved. Individual stock selection, which is much more time-consuming and all about detailed accounting statement analysis and projection, makes up the other half.

Conceptually, I’m trying to divide Consumer Discretionary stocks according to how interesting they might be as investments:

–direct beneficiaries of the pandemic whose appeal will likely endure, like food delivery services, online gaming, entertainment streaming, suburban real estate, outdoor dining, drive-throughs. Amazon, Microsoft. Peleton (?) Etsy (??)

–beneficiaries of the pandemic, but with limited appeal as/when life returns to normal. sellers of sports/ exercise equipment, like bicycles, kayaks, backyard swingsets…

–losers today with unclear potential for recovery. high-rise offices and apartment complexes, densely packed city areas, department stores, big malls, restaurant chains, supermarkets, movie theaters (?). hotels, cruise ships. Traditional value investors will live here

–already big companies that are adapting quickly to new circumstances. Target, Nike, dollar stores Walmart (?)

Feel free to share your ideas

trying to rotate (iii)

Well, it’s longer than two days. Sorry.

I’m really puzzled, though, about the current state of the stock market, and how to transition away from this year’s winners by broadening out into the Consumer Discretionary sector.

For one thing, I think the election matters a lot. We can see in detail from Trump’s leaked tax returns what everyone in New York already knew–that although he excelled at playing the role on TV of a stereotypical heartless businessman, he was a genuinely terrible real estate investor who lost his shirt during a raging bull market. He has brought this “talent” to bear as president: reducing real domestic economic growth to zero, damaging business relations with the rest of the world and refashioning the image of the US from the land of the free to a white supremacist police state (not a look to inspire purchases of US goods by foreign consumers (to me, this is an important reason LVMH wants to wriggle out of its commitment to buy Tiffany, which has a huge Asian business)). If Americans sign up for four more years of this, Consumer Discretionary will look a lot less attractive, particularly high-end goods and services.

(An aside: the financial press doesn’t see things this way. To some degree this may be a result of the Rupert Murdoch strategy of trading highly partisan media coverage in return for political favors. But for whatever reason, commentators seem stuck in a pre-Reagan world where Republicans represent big business and Democrats organized labor. Also, a key facet of Trump operations also seems to have escaped his supporters’ notice (ex farmers)–that invariably the people who believe in and trust him are the worst-hurt victims of his actions. think: his limo ride yesterday or his NJ golf club meet-and-greet with fundraisers, knowing he was infected.)

In an unclear situation like this, where the areas to overweight aren’t evident, the first step, I think, is to identify areas to avoid.

I divide the areas to avoid into three types: left-behinds from structural change, accelerated by Trump’s coronavirus mishandling, like department stores, autos, cable TV, fossil fuels, financials (because they do best when interest rates are rising)…; coronavirus victims, like restaurants (and their suppliers), high-rise urban real estate; and casualties of the loony-tunes way Trump is waging his trade wars, like farmers and farm equipment.

The second step is to look at what’s left and comb through that for positive ideas to invest in. More about this tomorrow.

the Fed’s new inflation stance

Fed Chair Powell, speaking virtually at what would otherwise be the annual monetary policy conference in Jackson Hole, Wyoming, set out a new protocol yesterday for what the Fed would do if the US ever had inflation (a sustained period in which prices in general rise) again.

The old policy was to begin to choke back economic growth by raising interest rates once price increases started to roll, with the objective of holding inflation at or below a 2% annual rate. The new policy is basically to not be so eager, but rather to sit back for a while and see what happens.

Why the change? What does it mean?

some context first

The late 1970s was a baaad time for the US economy. Politicians had successfully arm-twisted the Fed into running an extra-loose money policy for most of that decade. This ended up creating runaway inflation, an economy-killing disease thought to only be found in the worst third-world countries (and Weimar Germany, of course). Prices were rising at close to an 8% clip in 1978, with 11% in prospect for 1979 and progressively bigger figures after than.

Families began to turn their paper money into physical things as fast as they could so that inflation wouldn’t eat into value. They accumulated large inventories of everyday items, on the idea that they’d only be more expensive later on. This hoarding itself drove prices up more. Companies began to borrow heavily, thinking they’d make money just by repaying fixed-rate loans in inflation-diluted dollars. They used the funds to acquire hard assets–real estate developments or gold mines or cement plants or ships–that had absolutely nothing to do with their core businesses but which they told themselves would be inflation-proof and maybe even rise in value.

To shatter the belief in ever-rising prices, and the loony-tunes behavior it sparked, Paul Volcker raised the fed funds rate to 20% in early 1980 and kept it ultra-high until mid-1981, causing a deep recession. This also made prices fall, breaking the inflationary spiral that had developed in the late 1970s. This left families trying to figure out what to do with eight years’ worth of canned goods and corporate boards stewing about their brand-new gold mines–just as the gold price began a fourteen-year swoon.

a 2% target

As inflation and nominal interest rates both continued to decline for decades (the 10-year Treasury yieldid about 5.7% in 1999), theoretical economists began to discuss what the ideal inflation rate might be. They arrived at 2% as their ultimate goal. The Fed decided to see if it could accomplish this with the real economy.

And it succeeded. Some years ago, however, it and other national central banks began to realize that while they’d done a bang-up job getting interest rates down, they had somehow lost the ability to get them, even temporarily, to move in the other direction. What was once an aspirational downside goal had suddenly become an unattainable ceiling.

How so? Who knows. The result is that the world has been constantly been flirting with deflation–the bane of the Great Depression of the 1930s. Whoops.

back to Powell’s statement

I think he’s saying two things:

–given the gigantic amount of government debt run up by Trump administration bungling and its questionable decision to fund the lion’s share in very short-term instruments (which disguises the extent of the damage but puts the country at risk should rates begin to rise), he is not about to create a new crisis by prematurely raising short rates

–given that monetary theory has trapped us in a place where traditional policy tools don’t work so well, Powell would like to see us well above the 2% line before he begins to tighten

Yields went up by a mere 0.05% on the announcement, meaning Wall Street had been assuming the Fed would remain an island of calm in a sea of administration economic madness.

end game (ii): Keynes, Kondratiev and Schumpeter

The nineteenth century in Europe ushered in a deep change in the metaphor used to explain how the world works. The earlier (Enlightenment) view was that the universe was like a magnificent watch, made in the dim past and kept running by God, the ultimate craftsman. What you see is what you get.

By 1820, the metaphor was already moving quickly from mechanical to biological–evolution; conflict, sometimes violent, driving the process; the unconscious nature of much of what happens, both on an individual and a social level.

Yes, more stuff changes in the 20th century, but what’s important for us as investors is that these are creative fictions created to explain the world of 200 years ago continue to live in economic theory.

cast of characters

The nineteenth-century thoughts enter 20th century economics in a number of ways:

–Nikolai Kondratiev (1892 – 1938). His take on Hegel, formulated in the 1920s, was that the western world follows a 40- 60-year economic cycle. The first half exhibits robust growth. That’s followed, however, by a secular decline and, at least in the version I learned as a young analyst, the destruction of existing production apparatus through world war. Rebuilding from the rubble would start a new long cycle in motion. Some Kondratiev theorists also suggest there’s also a “super” Kondratiev cycle lasting a century+, the high point of which was reached in rebuilding from WWII. (In other words, my whole life would be on the downslope. Very depressing)

–Joseph Schumpeter (1883 – 1950). His version of Hegel is “creative destruction.” In his view, entrepreneurs ultimately use loose credit as a way of continually expanding their businesses to the point where supply of goods/services completely outstrips demand. This causes severe recession–a mini-Kondratiev experience. But like a phoenix rising from the ashes, a new upcycle emerges from the destruction of the old.

In both these cases–as with Marx–the precondition of the new cycle starting is the utter collapse of the old. Recessions are bad, but the cleansing they do is important for progress to happen.

–John Maynard Keynes (1883-1946). Keynes’ interest was more practical, and perhaps more modest, than his Continental contemporaries’. His main focus was on the Great Depression of the 1930s and how to prevent a recurrence. In other words, his intent was to use monetary and fiscal policy to forestall the economic peaks and valleys that the others thought was the inevitable price to be paid for evolutionary progress.

relevance for today’s stock market

A preliminary point: Trump’s incompetence in office, both before the pandemic (his tariff and immigration policies had reduced real GDP growth from 2%-ish when he took office to near zero), and especially during it, is the main reason the US is in so much worse economic shape than other OECD countries. Getting him out of office would seem to me to be the #1 economic goal for the country.

The nearer-term question is whether Washington should go all in with fiscal support to blunt the negative effect of the pandemic on the domestic economy. Here’s where the clash of economic theories comes in (as well as another Trump blunder).

Conventional economics, represented by Keynes, argues that stopping the economic bleeding is the top priority. Among Trump’s financial backers, especially on Wall Street, however, Kondratiev/Shumpeter seems to me to be the prevailing view. I think the idea that greater destruction now will lead to better growth later is why the Senate is balking at providing further financial support.

What complicates the issue somewhat is Trump’s income tax “reform” enacted in 2017. That bill did a good thing by reducing the highest corporate tax rate from 35% (highest in the world) to 21%–something that was necessary to stem the flood of US companies fleeing to lower tax-rate regimes. But it did harm by failing to offset that loss by eliminating special interest tax breaks, and it lowered personal income taxes for the ultra-wealthy. The result was a $1 trillion federal deficit expected for this year, pre-pandemic. As things stand now, the deficit will likely hit $4 trillion.

Under Trump, the national debt has already increased by almost $7 trillion, to around $27 trillion, making the US one of the most indebted countries in the world. At some point, creditors will begin to worry that the country will not be able to repay. In the signature fashion that led to his companies’ multiple bankruptcies, Trump made this situation worse by suggesting the US is willing to default on debt held by foreigners. Typically, worry shows itself first of all in currency weakness of the type the dollar has seen over the past few months.

my take

First of all, you should realize I’m really out of my comfort zone with the politics here. For what it’s worth, though, I think the Kondratiev/Schumpeter crowd believes that withholding government help and letting people fend for themselves is conceptually the right move. This group seems to have the ear of Senate Republicans. The fact that their personal wealth will suffer most severely from currency weakness probably colors their thinking as well. Trump says he’s in favor of more government aid and could probably persuade Republican senators to change their minds. But he chooses not to.

So we’re kind of in no man’s land. I think this means that we’ll remain in the current “capital flight” stock market, no matter how long in the tooth it appears, for a while yet.

two common market fallacies

market cap/GDP

I was reading an article on Yahoo Finance the other day that cited what it claimed was a Warren Buffett rule to gauge whether the US stock market is under- or overvalued. The idea is that if the total market cap of US stocks exceeds annual GDP (of the US) then stocks are overvalued. If market cap is less than GDP, stocks are undervalued.

On the surface, this sounds like it might make sense, since it is the US stock market, after all. And the health of the Treasury bond market is tied to the vigor of the US economy. Also, the idea was big in the 1980s, when market cap/GDP was used by Americans and Europeans as a rationale for not becoming involved in the Japanese stock market during a decade-long domestic economy boom there.

Two issues this idea ignores:

–multinational companies. In the case of the US, a good guess is that half the earnings of the S&P 500 come from outside the US. In fact, a very simple but effective way of approaching structuring a portfolio in the US market is to ask whether the US economy will likely do better than the rest of the world in the year ahead or worse. In the first case, the portfolio should overweight domestic-oriented stocks; in the second, internationally-oriented.

–how much of the domestic economy is publicly traded. In the case of the US, big sectors like real estate and housing have little representation. Germany, whose market cap has seldom, if ever, exceeded half of the country’s GDP, is the biggest counterexample for the cap/GDP idea. Two reasons: almost nothing is listed in Germany, and German citizens have historically had little interest in stocks.

For the record, I can’t imagine Buffett thinks this.

strong stock market = strong economy

Typically, this is the case, in my experience. But there are exceptions, like Mexico in the 1980s–and Germany almost always. In today’s US, it’s easy to see, by comparing the global NASDAQ with the US-centric Russell 2000, that stocks are strong in spite of weakness in domestically-oriented issues. In fact, somewhat like Mexico back then, the US market is underpinned by the near-zero interest rates made necessary by our extreme economic weakness.

A side note: over the past three months, the R2000 (+22.7%) has held its own with NASDAQ (+24.5%). Both have far outdistanced the S&P 500 (+17.5%). Why the R2000 strength? Three possible reasons (translation: I don’t know): counter-trend rally; the worst of the pandemic is already baked into R2000 prices; anticipation that Trump will not be reelected. My guess is some combination of the first two. I think it’s too early to be trying to figure out the election, although belief in four more years of Trump dysfunction should translate into shorting the dollar and the R2000.