Thursday, December 29, 2022

Of Eggs, Baskets And Apple Eggnog

 When it comes to investing there are two schools of thought:

  • Don't put all of your eggs in one basket
  • Put all your eggs in one basket and watch it very, very carefully
In decades past Warren Buffett, the world's most prominent investor, followed the first rule choosing to invest in a largish number of carefully selected smaller companies; many of them were not even listed on any exchange.  But as assets at Berkshire Hathaway expanded exponentially it became impossible to invest so much capital without taking large, strategic positions in huge listed companies.  In effect, Mr. Buffett now follows the second rule and does so in a very big way, indeed.

Another of Mr. Buffett's rules was that he never invested in anything that we could not understand or appreciate fully (his investment in See's candy is legend).  This rule has also now been tossed out.

To the point: Berkshire's largest position, at an astonishing 37% of its portfolio, is Apple. Another 11% is invested in Bank of America and 10% in Chevron.  At 58% it's one hell of a large basket.  Furthermore, if any one person claims to truly understand what goes on in Apple... or inside a huge commercial/investment bank... good luck to him/her (another 12% is invested in Coca Cola and Kraft Heinz combined - that's more along his old style).

So, to a very large extent Berkshire Hathaway, and by direct inference Mr. Buffet's future legacy, has now  become hostage to Apple.   It's the largest company in the world by market cap: $2 trillion.. and looking at its chart I get a very, very queasy feeling.  It feels as if Apple is the only thing keeping S&P 500 from crapping out (ok, Microsoft is helping, too).

I'm afraid Mr. Buffett is going to end up with lots of broken eggs... and lots of Apple-flavored eggnog for the New Year.  

Wednesday, December 28, 2022

Reality Is A B!+@#

 Hello All, hope Santa was kind and y'all found something better than a lump of coal in your Christmas stocking - markets sure didn't.

I'm bemused to read the usual end of the year articles on markets: "Annus Horribilis", "Good Riddance To '22", etc.  Was 2022 such a bad year? Yes, if you look at 12 months only it was.  Everything from stocks, bonds, cryptos, and even real estate in some areas, suffered negative returns when measured from top to bottom.  But I think this is misleading and a roundabout way of saying/hoping that 2023 will be much better. "Can't have two bad years in a row, can we?" is the inference. I disagree.

Why? Because 2022 came after a period of eye-popping rallies in everything, including ridiculous items like meme stocks, NFTs and SPACs, all soaring on the back of money creation on an unprecedented scale.  If we look at markets from a slightly longer perspective and use S&P 500 as a yardstick, we get the following:

Jan. 2019 - Jan. 2022 : +100% in a mere 3 years!!

Jan. 2019 - today: +56% in 4 years, still a very significant rise for such a short period. 

Keep in mind that the long term average annual performance is +9.5% and, more significantly nowadays, 6% when adjusted for inflation.  By these metrics, SP500 is still far away from the average.

In other words, all that happened in 2022 was that the ridiculous froth came off - and that's it.  By historical standards equity valuations are still high (see chart below) and in no way discount a possible recession or an extended period of near zero GDP growth going forward.

There is still so much money sloshing around in the system in the US, EU, Japan and even China, that consumer demand remains strong, keeping the economy afloat and prices elevated.  But central banks everywhere are removing liquidity, even if slowly right now.  The US is on a definite QT path, the EU is going to start very soon and Japan surprised everyone last week by raising JGB rates - this only leaves China, but as the yuan is not a global currency (yet) it does not impact global liquidity patterns. 

Meaning: I project that 2023 is not going to be kind to markets.  Probably not as bad as 2022, but not a good year, either.  

We may all have visions of sugarplums dance through our heads - but reality is almost always such a b!+@#...

PS In these days of Quant Everything it is pretty rare for classic chart/technical analysis to work so well.  To Mr. Musk's woe, it worked.. big time (top Head and Shoulders pattern). Told you so... :)

Wednesday, December 21, 2022

Home On The Range Is Now Out Of Range

 The foundation of the American Dream is buying a home of one's own, most commonly by putting 10-15% down and financing the rest with a 30-year fixed mortgage. This dream is now out of reach for most middle class Americans.

For one, prices have soared 50% in just 3 years (chart below). Incomes most certainly haven't.

Case Schiller National Home Price Index

Making things even worse, mortgage interest rates have also jumped. It now costs twice as much to make a typical mortgage payment than in 2020 (chart below).

This situation has put a dampener on new home sales;  new homes for sale are now at the highest level since the real estate bubble back in 2006 (which precipitated the Debt Crisis of 2008-10).

New One Family Homes For Sale

The median home price now stands at $455.000, massively up from $318.000 just three years ago.  Since shelter costs make up 32% of the Consumer Price Index basket, bringing down home prices is crucial in controlling inflation.  Give it another few months.. builders will eventually have to start selling inventory at lower prices.  High interest rates are making things difficult for them too - they can't carry their inventory easily any more.

Tuesday, December 20, 2022

Japan Rings The Bell

They say that they never ring a bell in markets (to signal a time to buy or sell), but I disagree. Markets and their participants always ring bells, it's just a matter of having your ears tuned to the right frequency.

Point in fact: The Bank of Japan just rang a very loud bell by allowing the 10-year bond yield to rise from 0.25% to 0.50% (see chert below). It marks the end of zero/negative interest rates for the world's third largest economy behind the US and China, so it's not to be ignored.  

Ten Year Japanese Government Bond Yield

Economists and analysts have been largely ignoring Japanese markets, since they were mired in a disinflationary cycle for decades. Thus, the sudden decision to raise market yields came as a shock.  Why did BOJ do this? IMHO because it sees inflation becoming a serious issue, even in Japan, and must now act proactively to contain it (see chart below).

Japan Inflation (Blue) and 10-Year Yield (Red)

Japan's debt/GDP ratio is easily the highest in the developed world, now topping 260% (see chart below). And even though most of it is domestically owned, such enormous debt poses a serious threat if inflation is allowed to rise unchecked and therefore drag interest rates upward.

Japan Government Debt/GDP Ratio

Bottom line: If even Japan is taking global inflation seriously, what about the rest of us? Should we pay attention to the bell, or are we going to ignore it hoping that inflation is just a temporary phenomenon?

Sunday, December 18, 2022

How To Kill Inflation For Real

One of these days the Fed will openly admit that high inflation was caused by the massive creation of money in 2020-21. It may then also admit that keeping all this extra cash sloshing around is keeping inflation high (duh).  

Here’s a chart of M3 as a percentage of GDP: lots more money chasing goods and services that are growing at a slower rate than money is going to result in …drumroll…. Lots of inflation. Pretty obvious, right?

M3 Money Supply - Percentage Of GDP

In dollar terms, during  2020-21 the Fed created a massive extra $7 trillion - and most of it is still on its own balance sheet, which expanded from $4 trillion to $9 trillion in the same time. Clearly, the Fed needs to get rid of all - or most - of this extra cash in order to tame inflation. It is currently engaging in quantitative tightening (QT) at a maximum of $95 billion per month, a pace that will take 50 months to shrink its balance sheet back to 2019 levels. Can and should it speed up the pace? Yes it can, and yes it should.

Wait a minute, you say. Won’t withdrawing all this extra liquidity damage the economy? No, it won’t because lots of this extra cash isn’t being put to productive use. Instead, it just sits as overnight reverse repo with the Fed (O/N RR), ie banks and money market funds are parking it. The amount of O/N RR is currently at $2.1 trillion (chart below), and the Fed pays 4.30% or $95 billion per year, to borrow this money back from those it issued it to.  Nuts.

Fed O/N Reverse Repo At $2.1 Trillion

So, what is the Fed waiting for? Why isn’t it draining this inflation-producing liquidity lake as fast as it can? What is it afraid of? I don’t have a definitive answer, but I think the Fed is concerned that it will cause a liquidity crunch and precipitate a stock market crash. 

Sure, that’s a possibility. But letting inflation continue largely unchecked will soon create a much more ominous problem: the distinct  possibility that bond interest rates will rise unchecked and result in a vicious cycle that ends in sovereign bankruptcy.

For now, the path is clear: drain away at least $2 trillion as soon as possible and stay the course on increasing interest rates. 

Where Are The Customers’ Yachts?

 Today’s post title comes from a classic book about Wall Street greed written in 1940 by Fred Schwed. The story goes that a broker was giving a client a tour of the NYC marina, pointing out all the yachts berthed there. “This is our CEO’s yacht, that’s our sales manager’s boat and that one over there belongs to the head of a competing firm”,  and so on and so forth.  Finally, the client turns around and asks “So, tell me, where are the customers’ yachts?”

I was reminded of this book by the photo below showing two yachts side by side. One is a 26m “run of the mill” motor yacht typically owned by the mere “rich” and the behemoth behind it is Solaris, a mega yacht owned by Roman Abramovich. For further perspective, the second photo shows Corsair II, a yacht built in 1892 for JP Morgan. Draw your own conclusions on socio-economics.

Rich vs. Ultra Rich Today

The Ultra Rich 130 Years Ago

For reference, Corsair II displaced around 800 tons, today’s typical 26 m yacht comes in at around 200 tons (it’s mostly light fiberglass), while Solaris tips the scales at 11.200 GRT. Yup, money can’t buy you happiness, but it sure helps!

And while on the subject of ships, here’s a chart of container shipping rates.  They have now completely retraced their crazy spike, yet another sign that the REAL global economy is cooling fast. I’m betting there are several shipowners out there who are starting to sweat.

Freightos Container Index

Thursday, December 15, 2022

The Fed Cannot Afford To Blink

The Fed cannot afford to blink in its fight against inflation, and the reason is oh so simple: the US government cannot afford to pay high interest rates for much longer.

Here are the oh so simple charts.

  • Federal debt is now at 120% of GDP, the highest since 1945 when WWII required massive debt funding.  No such reason today.

Federal debt to GDP

  • Inflation has caused interest rates to spike.  Real rates (inflation adjusted) are deeply negative, so investors will soon start turning up their noses to US bonds - unless inflation goes down fast OR interest rates go up very significantly.

Inflation (red) and 7-year Treasury yield (blue)
  • With debt so high, the US simply cannot afford higher interest rates, definitely nowhere near 7-8%.  It would, basically, cause the US to go bankrupt.
==> Therefore, the Fed MUST bring inflation down WHATEVER IT TAKES. 

If you think the Fed will blink... good luck!  Let me put it another way: a recession is one heck of a lot better than bankruptcy.

Wednesday, December 14, 2022

November Inflation

 Inflation for November was announced yesterday lower than "expected" causing an initial jump in markets, which was almost immediately scaled back. 

Headline CPI was up "only" 0.1% for the month, but... averages are nasty critters.  Here's what lies beneath (month over month figures):

Headline = +0.1%

Shelter (32% weight in the index) = +0.6% 

Food (14%) = +0.5%

Education (5%) = +1.0%

All of the above are zooming higher, much faster than anticipated. 

So, how did we end up with a mere +0.1%? Once again, energy (ie gas at the pump, mostly) came to the rescue with an oversize price drop.

Energy (8%) = -1.6%

For some reason unknown to me medical care prices downshifted as well

Medical Care (7% ) = -0.7%

Finally, commodities other than food and energy (21% weight) came in at -0.5% almost entirely because used cars dropped by -2.9%.

In sum, inflation is easing but certainly not across the board. When you scratch the surface inflation is very, very strong and worrisome.

Tuesday, December 6, 2022

The US As Japan

What will the future bring for the US economy? I'm talking long term here, not the next quarter.

Here's my model: Japan.  The chart below is Japanese GDP in current yen - the economy has been "stagnant" (I very much prefer "stable") for 25 years. And, honestly, I think that's the best case scenario because, unlike the US, Japan is a socially homogeneous society that very rarely exhibits the kind of fractious politics common in America - at least after the Meiji Restoration in 1868.

 Can the US survive a flat economy for decades? Yes, but only if its politicians and society realize that the alternative is much, much worse, and cool down their extremism on both sides.

There's another reason for the US to embrace a flat economy: Global Climate Change. Or, as I prefer to call it, Human Biosphere Annihilation. In short, if our species doesn't halt Permagrowth it is headed for extinction.  

Monday, December 5, 2022

Refi To The Rescue? Nope.

Note: Charts from Yardeni Research 

Unlike Europeans, most Americans own their homes.  They finance their purchases with fixed rate mortgages which they can refinance relatively easily if/when interest rates move significantly lower from where they originally borrowed the money.  Thus, refinancing can be a  pretty good source of additional spending money - when available. 

Since interest rates usually drop significantly during recessions, refinancing is a type of cushion which allows homeowners a bit of wiggle room to weather a down cycle.  But, I think not this time. You see, mortgage interest rates were at historical lows for at least a decade before they zoomed up. There just aren't as many borrowers today with higher interest costs as previously, even if rates go crashing back down in the near future.

Understandably, refinancing activity has collapsed down to near zero.

And even though homeowner equity is at record levels due to higher real estate prices, owners won't be able to tap into it to bolster their finances any time soon. At least, not at interest rates that will make the exercise financially sensible.

With unemployment still near record lows and with ongoing robust job openings Americans are still ok.  But if/when a recession hits and people start losing their jobs en masse (already happening in  high tech) the refi window will not come to the rescue.

Thursday, December 1, 2022

Soft (ish) Landing Interpreted

Chairman Powell yesterday confirmed the Fed will slow the pace of its interest rate hikes from 75 bp to 50 bp.  Though it was expected, his statement created a strong relief rally in all markets, which chose to focus on that part of his statement, instead of these:

  • The Fed will keep hiking to a level higher than previously targeted
  • Inflation is expected to remain high for longer, necessitating a restrictive policy well into 2023 or further.  His reasons include structural shifts, such a demographics and changed employment patterns post COVID.
  • He expects a soft(ish) landing for the economy, rather than a deeper recession.
How do we interpret his pronouncements? For me, it's this: inflation will last for years and won't revert to 2% soon, or ever, and the economy will be weak(ish) for the foreseeable future.  In my book, that's called stagflation, though not the same as in the turgid 1980s.  Putting it in numbers, I expect inflation around 5-6% and real GDP growth around 0-1%.  

What does this mean for markets, assuming Mr. Powell is correct? For one, the yield curve inversion will soon reverse course and become more normal/flat around 5%.  For another, a period of near zero economic growth will hit equity valuations by lowering P/Es going forward.

Looking at real GDP growth for the last 70 years (chart below) we can observe a change in the nature of US economic activity. During 1950-80 the economy was highly cyclical, with frequent recessions and booms. During 1980-2000 there were fewer boom-bust cycles and a more consistent, albeit lower, level of economic growth.  Finally, from 2000 onward the economy was much more consistent, except for the Great Debt Crisis, though average growth was even lower. In percentages, average growth has declined stepwise from approx. 5% to 4% and now around 2.5%.

If our future is even mildly stagflationary, where should equity P/Es be? For perspective, here is a chart going back to the 1980s when they averaged around 12X.  Versus today's 17x, a reversion to 12x implies a 30% correction ON AVERAGE.  Of course, markets overshoot, and during long, drawn out bear markets they can also become despondent, so I would not be surprised to see multiples as low as 7-8X.

Chart: Yardeni Research

High inflation, high(er) positive real interest rates and near zero growth are very strong headwinds for equities, particularly "growth" stocks that do not pay consistent dividends.