My musings are current thoughts, somewhat fluid, but not always structured. I do not write to develop a story or thesis. I write with the hope that my musings spark a new idea or refract a different light. Independent thought is becoming rare. I suppose I write to assure myself that what I think is of my own synthesis, and not a media mimic. As unfinished as this or any piece may be, I hope it gives you something to ponder and synthesize into your very own views.
April 15, 2021. Today is normally tax day. But nothing is normal anymore. We all know this. Yet lately, I keep circling that refrain. I’ve been musing that the bond market is not normal. Valuations are not normal. Investor behavior is almost not normal. So much ‘not normal’ gives me pause.
When the closing days of 2017 brought us major tax reform (like how I bring this up on tax day?), I anticipated that the corporate tax windfall would be swept into capex projects and thus spark the smoke of inflation. It’s all a balance. Some inflation is a good thing in an expanding economy. Because inflation takes time to show up, I set my red flags for late 2019 into the first half of 2020. But companies didn’t put their new-found riches into operating growth or efficiencies. Instead, they bought back their shares. This increased the ownership stake of shareholders who, it turns out, did not cash out to buy goods and services. They kept it in the stock market. More money chasing fewer stocks. Not an economic inflation but a valuation inflation.
In fact, the Buffet Indicator clocked a stratospheric 201% yesterday (compare that to 107% in October 2007). Modifying the metric to include the Fed balance sheet still places the market in significantly overvalued territory at a 148% ratio. [Buffet Indicator = Total Market Cap ÷ GDP. Modified ratio = Total Market Cap ÷ (GDP + Fed Total Asset Fed)].
It is clear that these metrics are distorted by the historic money-printing stimulus packages and well over a decade of quantitative easing. If corporate profitability does not revert to its long-term trend of 6%, then the implication is that other factors are at work.
INTEREST RATES “ACT ON FINANCIAL VALUATIONS THE WAY GRAVITY ACTS ON MATTER. THE HIGHER THE RATE, THE GREATER THE DOWNWARD PULL. .... CONVERSELY, IF GOVERNMENT INTEREST RATES FALL, THE MOVE PUSHES THE PRICES OF ALL OTHER INVESTMENTS UPWARD.” – WARREN BUFFET
THE TECH EFFECT
I believe a key ‘other factor’ is the technology effect. It shifts the ‘rule of thumb’ and historical valuation metrics. More specifically, the tech-effect puts an upward bias on valuations.
Moore’s Law may have sunset for chip productivity, but its principles apply to the cost structure of the tech company itself. For years, tech devours capital and then, one day, breaks-even which is quickly followed by profitability. At this turning point, earnings seem to become a function of an exponential logarithm. [It’s a log because at some point the asymptote kicks in and the curve flattens.]
Alternatively, or perhaps additionally, productivity gains from our use of technology and novel applications cause the economy to scale to higher GDP in less time.
Both ways, the questions become “Can we do more? Create more? Be more productive with the same resources using new technology?” If yes, then what is that exponential rate and does it impute faster returns to support the upward bias? At what point is this new valuation metric overvalued? These may be simple questions, but the answers are not easy. I’ll revisit some of the complex relationships in future musings.
A flashing warning of bubblicious valuation is the swarming of night riders. This occurs when privately held stock floods public markets. Real businesses will be okay. [They’ll be caught in the downdraft but fundamentally will be okay.] It’s the half-developed models and empty ideas rushing to retail that tell the tale of greed. Stay away. Don’t FOMO. If you waited three years to buy any FAANG, you’d be congratulating yourself today. It’s okay to wait for the bubble to dissipate. The good ones will still be afloat. And you’ll congratulate yourself.
One last muse on valuations is that the new normal = social+finance. Flash mobs will continue and may even influence market behavior long term. It’s hard to regulate this to protect investors but I’m certain we’ll see a few high-profile cases soon. In essence, flash mobs are sentiment momentum on steroids. This is day-trading. Not investing. It can be fun, though, which means tap only your play money. Keep it to an amount you’re happy to lose as payment for a wild-ride entertainment.
FISCAL & MONETARY
Getting back to fiscal and monetary support: It can be hard to keep track of how much money the government has pumped into the Covid crisis. Here’s a snapshot of the $10,400,000,000,000 money-bump year.
Fiscal stimulus grabs the headlines. [Politicians like limelight.]
- CARES Act March 2020 $2.2 trillion
- Heroes Act October 2020 $2.2 trillion
- Stimulus Bill December 2020 $0.9 trillion
- Covid Relief Bill March 2021 $1.9 trillion
Monetary stimulus may be quieter but its impact shouts loudly. The Federal Reserve added $3.4 trillion to its assets in the last year alone. For some perspective, it took the Fed eleven years to increase its balance sheet by $3.2 trillion since 2008 - and even that was a time of largesse. Currently the Fed is buying $80 billion/month in Treasury and corporate bonds as part of quantitative easing (QE). The first time the Fed could ever buy corporate bonds was in June 2020. This is an important shift in policy. Do not underestimate the implications.
Funding monetary expansion is part of the reason that government debt sits around $28 trillion this month. That’s 129% of GDP. Come on, tech, we have a lot of scaling to do!
Interest rates are at historic lows but not all $28 trillion are fixed rates. Let some inflation kick in and pretty soon it's interest on interest. If you’ve ever looked at a compounding graph, not much happens for about 20 years. Pretty level stuff. Then it happens. The value (if you save) or cost (if you borrow), turns nearly vertical as the compounding effect gains traction. We’re just past year ten.
Einstein called compound interest the eighth wonder of the world. Those who get it earn it. Those who don’t, pay it.
Index investors have had a stellar ride the past 15 years or so. This is changing. Valuation inflation is sustainable only if the underlying companies in the index outperform the current outperforming valuations. And, interest rates are required to stay low. Neither of these is likely. That’s the wake up. It doesn’t mean rush to active management. Even in the best of times, active rarely beats passive. It does mean to look at shifting from index tracking to a more flexible and responsive passive strategy.
In addition, we are experiencing the early waves of radically new technology that is building a future infrastructure with profound impact. Yes, I refer to crypto. Understanding and being part of the future is why we have delved into this large, dynamic market in a big way. The crypto ripple will be a tsunami very soon.
Investors should not languish in the complacency of the past. In turbulent times, money moves. Times are turbulent.
Thanks for reading!
Beckett Collective:: Fee-only :: Fiduciary :: Thoughtful
Not your normal financial planners and investment managers
 I refer to public companies on the assumption that listed companies generally have economic hurdles of success to prove in order to list. I exclude the current SPAC craze which does not meet the lofty baseline of being an established company with a proven business model.
THE ALL-IMPORTANT DISCLAIMER
My Musings are informational and are intended for educational and entertainment purposes only. All content contained in this article is just my own opinion and experience. Nothing I state, share, express, or allude to should be considered professional advice or recommendations of action. In other words, do not rely upon this article in connection with any purchase or sale of any security or other asset. Everyone should take investing seriously. Do your research. Consult a professional (or two ... or more) for any tax, accounting, legal, or investment questions you may have. If you would like to speak with us at Beckett in our professional capacity as financial planners and investment managers, please feel free to email or text us for an appointment. Sam@BeckettCollective.com :: 443 254 8980 (text only)