Market Commentary – May 2020
“It’s not about being afraid; It is about being prepared” – Christopher Cole of Artemis Capital
Every once in a while, I’ll read something that really blows my hair back and makes me think “Holy S^&t”, I have so much still to learn in this business after 17 years. Christopher Cole’s recently released paper The Hawk and the Serpent is a must read, especially if you’re looking build and protect multi-generational wealth as we are at Koa. This month, I will try pull a few choice ideas from this dense and informative read, but there’s just no way to dive in fully in just a couple of pages. The average advisor in our industry is 52 years old and was in elementary school during the last stagflationary bear market of the 1970’s. Most advisors have only been invested in markets where interest rates have been falling while asset values of Stocks, Bonds and Real Estate have been up and away.
Effectively the purpose of Chris’ paper is to build an outline for an investment strategy not for this year, or even this decade, but for a century. In it he shows pretty effectively how investors fall into the trap of “Recency Bias” – plainly we assume that asset classes will generate returns and produce similar volatility moving forward as they have in recent history. Fortunately for the sake of this paper, Chris has data on Stocks, Bonds, Real Estate, Gold, Commodities and Volatility that stretch all the way back to the 1920’s, so his points are not only thought provoking but backed up by what counts – data. His study of this data has led him to the conclusion that economies and markets pass through phases of Secular Booms (1947 to 1963 & 1984 to 2007) and what he calls Regenerative Eras (1929 to 1946 & 1964 to 1983). If you noticed above, he feels the most recent Secular Boom ended in 2007… an investor might question that opinion as the US Stock Market has continued to make new highs, regaining the 2007 highs back in 2013 and has since pushed to new highs. But Chris’ view is that Central Banks in trying to save the global economy from the abyss of the 2008 financial crisis have only delayed our march down one of the paths of tail risk – Deflation or Higher Inflation.
In our current predicament with the demand shock that has been caused by the Corona Virus, ZIRP (Zero Interest Rate Policy) would signal that the immediate risk is one of deflation. Under deflation, falling asset prices wipe out investor nest eggs as we experience falling rates, lower growth and debt defaults. Central Banks in turn move to negative rates and quantitative easing. However, periods of deflationary pressure can easily reverse depending on the actions of Central Bankers and Policy Makers and effectively yank the economy out of the ditch of deflation into the opposite ditch of higher inflation. Under this regime, rising hard asset prices also wipe out savings and the value of cash. These inflationary periods are marked by higher interest rates but still slow growth and ultimately end in fiat default and helicopter money.
The question investors have to ask themselves is – do you want to bet that the next 10 to 20 years are going to look like the boom times of the 1984-2007 time period or has the pendulum already started swinging the other way and we are in a 1964 to 1983 time period… we just haven’t realized it yet? While the history books will ultimately tell us, who was right many decades from now, my best guess is we are in a period of secular change that is going to require a Regenerative Era. We currently enjoy historically high valuations on all of the commonly held assets classes by investors – Stocks, Bonds and Real Estate. We have the highest Corporate Debt to GDP levels ever. We have 17 trillion in negative yielding Govt. Debt globally. We have the lowest capital gains rates and highest income disparity in American History. I hope you enjoyed the boom times, because they were good to the Boomers! Chris writes, “A new period of secular decline began with the great recession and will likely end in entitlement defaults, helicopter money and monetization of budget deficits”.
Boomers vs. Millennials the coming battle. While it seems odd to think grandparents will be in a war of wealth with their grandchildren, let’s run through some interesting ideas on the topic. Boomers (Defined as ages 56-74) will be drawing on 28 trillion in retirement assets to live on; assets grown during a 40-year demographic and debt super cycle. Boomers applaud the current actions of the Federal Reserve to buy just about any asset they want in the bond market which has effectively helped to prop up assets in the financial markets. Boomers represent the lion share of wealth in our country and 23% of the populace. Millennials (Defined as ages 24-39) who represent 26% of the populace by contrast will likely be the first generation to be poorer than their parents. With many carrying what amounts to mortgages to pay for their higher educations, they will be in support of populist policies like printing money and giving it directly to people (Rather than buying financial assets). Don’t be surprised if an idea like UBI (Universal Basic Income) gains a hold as the govt. has just recently been sending out $1200 “Stimulus” checks to the majority of the populace. In contrast to Boomers, Millennials are incentivized to support policies that redistribute wealth (Higher taxes on earnings and capital) which creates inflationary pressures which ultimately destroys the value of their debt.
While not knowing how the deflation/inflation debate will play out – what we do know is our clients’ primary holdings and building blocks of their wealth – Stocks, Bonds and Real Estate may be in for a rougher ride than clients have experienced during their period of wealth accumulation. As their financial advisor we will have some difficult decisions to make – do we keep them allocated as we always have during our/their investment lifetimes and potentially suffer dismal returns or do we build in assets/strategies that they are not familiar with and have not done well in recent history but have done better in other “Regenerative Eras” like the 60s through early 80s? Clients are not accustomed generally to owning large allocations in metals/commodities or owning volatility. We will have to do what we can in the months and quarters ahead in broaching these topics and having these conversations with our clients. It’s a difficult thing to get an investor to invest in something that hasn’t made money in recent history – but perhaps our clients will realize that we are in a period of sea change and investing in assets that are not yet broadly owned will be our ticket in trying to not only survive but thrive in the coming decade.
As we sit here at the end of April, we have seen quite a lot of volatility over the last 2 months. The S&P 500 touched a high to low trough of roughly 35% down in March  with comparisons being made to the 1987 and 1929 crashes to the tremendous bounce we have seen off those lows at the end of March into the end of April, again being compared to Bear Market Rallies that occurred in the 1930s! My oldest son Lincoln loves him some roller coasters – the bigger and scarier the better – his father… not so much. Whenever we have such a rapid rise in volatility in markets are main goal is not to “Do Something!” but rather to invest our intellectual capital into understanding what is going on … and then determine if we need to “Do Something!” What we have compiled is the following 1) This is an unprecedented situation (Lock down of the economy) so throw out your models based upon past recessions and timing or shape of recovery 2) We have seen unprecedented action by the Federal Reserve who is now vowing to play in every part of the Credit Markets making it only more difficult for investment managers to determine the “Proper Price” for assets they own or wish to own 3) It’s impossible to ascertain the psychological damage this health pandemic is having on the habits/mindset of consumer – just because we “Re-open the Economy” does not guarantee a resumption of consumption.
Let’s look at each of the three factors above one by one. The lockdown of the US and other economies around the world has effectively caused a “Demand Shock”. If you’re Amazon, it’s business as usual but for the majority of businesses their revenues are being slashed in some cases to zero (Hence 30 million Americans filing for unemployment claims in 5 weeks). There’s simply no precedence for this not even in times of war. In addition to the acute shock of shuttering businesses or having them run at minimal capacity at current what we still don’t know is will these current Social Distancing rules being put in place by govts. persist after the health crisis? If so, it completely changes the economics of so many businesses that the list is too long to highlight here. When speaking to one of the Top Commercial Real Estate Brokers here in San Diego recently, she said, “I’m not worried about the retail businesses that don’t reopen in a couple of months, I’m worried about the businesses that reopen and then 12 months from now realize the economics don’t work anymore”. I for one am not going to be dining out anytime soon if I need to wear a mask and surgical gloves… I’d rather stay home. Investors need to think very keenly about the businesses they are invested in moving forward as we believe society is going to experience a “New Normal” where certain business models simply will no longer work in that new environment while others will thrive.
When the Federal Reserve a few weeks ago announced that in addition to purchasing Treasury Bonds and Agency Backed Mortgage Bonds (Something they have been doing since the last financial crisis via their Quantitative Easing or “QE” Program) they were now going to be buying Corporate Bonds (Of all Credit Worthiness), CMBS, CLOs, etc. – I about fell out of my chair. Instead of letting capitalism work, the “Fed” has decided that the answer is to prop up the debt markets for responsible and irresponsible borrowers/investors alike. Their claim of wanting to add liquidity to markets so that they function properly is a nice thought, however the reality is what they are doing distorts markets and pricing. Bad actors need to fail, investors who made bad decisions need to lose money… it takes money away from the irresponsible or foolish and clears a path for new capital to come in from stronger/more astute hands. It’s this process of “Creative Destruction” that is at the very core of how and why capitalism has worked to drive the US Economy into the greatest economic engine that the world has ever seen. In an effort to “Help” – we believe the Fed is propping up companies that should go away and is delaying the process of getting those assets into stronger hands. Effectively we have the Govt. – Similar to 2008 – Privatizing the gains and Socializing the losses. The Federal Bankruptcy System was put into place by our founders for the express purpose of handling companies and their management teams that got it wrong. At Koa, we believe there shouldn’t be any participation trophies when investing – there are winners and losers… we just work to make sure our clients are winning!
Just because the Governors tell people the economy has reopened doesn’t mean people will get back to their old habits and modes of living. Not only are people still concerned about their health (Until we have a proven vaccine and therapeutics) but layer on the economic uncertainty that has hit the economy like a bolt of lightning. I mentioned earlier that there have been 30 million new claims for unemployment benefits in the last 5 weeks… what you’re not hearing about are the number of people that are still employed but have had to swallow 20-30% pay cuts by their employers. Even for those that have their jobs – the excess income they may have once enjoyed is no longer part of the equation. When people are worried about their economic reality, they don’t tend to spend – they tend to retrench. It’s for this reason that we are still waiting to see what the new baseline for consumption will be when the economy is allowed to re-open in the coming weeks/months.
Markets usually go through three stages when the economic cycle turns downward – Panic, Acceptance and Despair before they finally bottom out. We believe that the sell-off we experienced in equity and credit markets In March was your panic moment. There was uncertainty about what the Central Banks and Govts. would do from a monetary and fiscal standpoint – now we know… they are “All In”. However, both have limitations – the Fed can provide liquidity, but it can’t stop insolvency. The Govt. can put money into your hands, but it can’t make you spend it. The markets are still hopeful that we’ll have a V-Shaped recovery evidenced by this steep bounce we’ve had in our markets over the last 5 weeks. If any of you have been listening to quarterly earnings from the various companies, the majority of them are pulling their guidance for the rest of the year because they have no idea where demand for their services or products will bottom out yet. We believe that once that new lower baseline is set in the coming months, the market will need to accept that our very levered economy is going to suffer a number of bankruptcies on the business and personal level … something that always happens at the end of every business cycle but one that will be exacerbated by abnormally low interest rates and an expansion that ran the longest in our history (Since the previous recession). The Fed and the Govt. can try and play Atlas, but in the end, we think Economic Gravity will win out. Expect more pain on the economic front for the economy in the quarters ahead and understand that we won’t experience a bottoming out in the Equity and Credit Markets until we’ve run the course on acceptance and eventually despair.
Koa Wealth Management
11260 El Camino Real, Unit 220, San Diego, CA 92130
May 2020 MC PDF