Is the “Sky is Falling” Crowd Wrong?
I have been a card carrying member of the “sky is falling” crowd for years. And I have been wrong. Stock prices are at their all-time highs. Some stocks are selling at multiples of sales that historically have been applied to earnings. Why was I wrong and what are the investment implications for people like me who, being retired and septuagenarian, must gradually draw down savings, cannot replenish them through earnings, and don’t have enough time to recoup losses or wait years for high potential, but distant payoff investments to bear fruit?
There are two main explanations for the misjudgment of the bears. The first is that we did not understand the market power and unprecedented growth potential, unconstrained by the need for capital, of companies using digital platforms to create undreamt of value for customers and stupendous wealth for owners, regardless of how the economy is doing. Other investors were more insightful, and bid certain technology stocks up, so much so that a tiny number of companies – Apple, Amazon, Microsoft, Facebook, etc. – now account for a hugely disproportionate share of the market capitalization of the major stock indices. Furthermore, the stunning success of companies built around digital technology has set off a frenzied search for the next round of winners. Hence, we see seemingly irrational prices paid for companies that are still losing money.
There will be a few colossal winners as new technology, e.g., blockchain, is applied , but mostly losers. Differentiating them is impossible based on the usual tools of security analysis. Picking tomorrow’s winners will require an insight advantage that can be gained only by a deep understanding of the nature of the business. That will be available only to very few. If you don’t have a long time horizon and an ability to absorb a string of losses, you should stay away, regardless of how easy it looks at the moment to make big profits in newly public tech stocks.
The second reason I and my fellow Chicken Littles have been wrong is that we grossly “underestimated the speed and amount of money the Federal Reserve would make available to the financial markets. We also have been surprised by the level of investor insouciance as to the potential, long-term impact of the Fed’s actions on inflation, productivity, GDP growth, and earnings. We never thought we would see what happened in 2020. Federal Reserve bank credit rose over 78% and currency, measured by M-1, rose over 58%. As a consequence, prices have never been higher relative to various measures of underlying earning power, nor has total debt ever been higher relative to GDP. In the meantime, government-enforced lockdowns in response to the COVID-19 pandemic have destroyed hundreds of thousands of jobs, many permanently.
Investors seem to have become convinced that they live in a consequence-free world where no matter what happens stocks will not stay down long. Paying attention to the relation between what Jim Grant calls the “ancient beacons of price and value” is seen as a sure-fire way to miss out on the next move up.
The monetary and fiscal authorities act as if they believe that by turbocharging the production and distribution of the symbols of wealth, they will “kick start” the creation of real wealth, which comes only from the production of goods and services. There are, however, no examples from history where this process has worked long run.
I tend to be cynical about the behavior of our economic overlords. They are very, very highly educated, book-smart, mathematically gifted people. They have understood something that I did not, namely, virtually unlimited credit creation can exert a powerful short-term stimulus on financial markets for a very long time – long enough for them to be comfortably in retirement before the proverbial roof falls in. I find it hard to believe that such intelligent people can really think they know better than markets what interest rate structure is most conducive to a thriving economy long run.
Jim Grant, the estimable publisher of Grant’s Interest Rate Observer, has a pithy explanation of the Fed-driven dynamic that inflates the value of financial assets while simultaneously weakening the productive capacity of the economy:
“Ultralow interest rates are a financial psychotropic…. [They] turn savers into speculators and quarantined millennials into day traders. They facilitate overborrowing, suppress market signals, misdirect investment dollars, and promote the dubious business of turning well-financed public companies into heavily indebted private ones.” [insert link]
But, a critic might say to a Chicken Little, nothing bad has happened yet; and, if the monetary and fiscal authorities had not kept interest rates near or below zero and had not sent the public money created from nothing in response to the damage from the pandemic, there would have been a severe depression. This is almost certainly true. The economic powers-that-be, however, are silent about the second order effects. Keeping interest rates at 5000 year lows and sprinkling throughout the land currency created from nothing provide short term relief, but fix nothing. Even worse, government palliatives make the time longer and the depth of pain (unemployment, bankruptcies, loss of savings, etc.) far deeper than would have occurred had markets been allowed to adjust without government interference. How can more debt and more distortion of market signals (interest rates) make things better?
What eventually happens? Do markets eventually override government efforts to squash interest rates? In that case, financial markets collapse and investors should hold cash. Do governments inject so much “paper” currency (fiat money) into the economy that people eventually become fearful of a generalized loss of confidence in dollars and start rushing to exchange money for goods and services as quickly as they can, i.e., there is accelerating price inflation? If this happens, investors should own gold and commodities such as oil and gas. Do we get some strange combination of both?
While I am convinced bad outcomes for the economy as a whole are inevitable and become worse by the day, I have no idea what is going to happen, when, and in what sequence. So, I am taking a “chicken” approach:
- I have gold which should hold its purchasing power if the public loses confidence in government-issued “paper” money.
- I hold cash, which I will be glad to have if financial markets crash.
- I have equities in energy companies and Berkshire B which might enable me to participate somewhat if equity markets remain strong.
- I have no ability to gain insight as to which digital technology-based companies are good value relative to current price today. Even though I know some will do spectacularly well, I am going to avoid them, especially since euphoria seems rampant and despair nowhere in sight.
I am guaranteed to be partly wrong. Thanks to the Fed, there are no safe havens for people who want some return on their savings without fear of permanent capital loss.
What do you think and why will I continue to be wrong?