FWIW # 14 Questions March 2021

When we study the investment markets and read investing history, particularly about the investment manias, two facts become apparent: (1) market manias and crashes are natural and unpredictable as to when they occur and their duration, and (2) for an investment strategy to thrive over the long term, it’s critical to survive a crash when it happens, and to have enough liquidity to invest in quality companies at depressed prices.

What causes market volatility?

Stock market manias and crashes throughout history have usually resulted from retail speculators joining with professional speculators in believing the stock market is a get-rich-quick scheme. Believing leads to using borrowed money. Leverage is a major factor in a subsequent market collapse. The more leverage used in the investing process, the smaller the margin of safety for surviving pullbacks in the markets. These confidence convictions are visible in the stock market today.

How is today's mania different?

There are a couple of aspects that make the current mania different.

The young retail speculators are concentrating their leveraged bets in a small number of stocks.

The aura of invincibility around the Federal Reserve’s ability to prop up the markets has given professional speculators and mutual funds the confidence to throw caution to the wind.

An active monetary policy stance by most central banks using fiat money is a game-changer in thinking about the future of investment markets. Understand first that the U.S. dollar, even though it is fiat money, is considered the safest currency in the world. With important central banks positioning themselves relative to the U.S. Fed, every country can devalue its currency as long as the magnitude of devaluation is within a certain range relative to Fed action. In other words, there is no place safe from inflation other than assets such as stocks, real estate, and newly created pseudo-assets such as cryptocurrencies, NFT art, and other illogically devised stores of value like sneakers.

Stop and think of the laws of supply and demand. Currently the demand for assets is high for two clear reasons: (1) the Fed is printing historic amounts of money to fund the fiscal stimulus and its own monetary policy, and (2) contrary to what the Fed says, speculators, individuals, and professional money managers realize inflation is here in terms of asset values. Industrial costs and consumer day-to-day living expenses are rising much faster than the Fed is willing to admit. That brings us to the first question.

Question 1: When the Fed is finally forced to reduce its aggressive monetary policy, what will happen to an economy dependent on a level of asset value demand that is unsustainable?

One principle many speculators and investors appear to have forgotten is the volatility correlation between reward and risk. If a stock has the potential to double, triple, or more, it also has the potential to lose 90% of its value in a severe market correction. Haven’t recently heard that principle, have you? Go back to 1970s double crashes or the dotcom crash in 2000. The high valuation rationalization today is just as filled with hysteria as those past periods when the market leaders went down 90% to 100%. The concentration of market value is just as great now, if not more so. Further, the potential for a reversal of economic growth is even greater than in those periods since the Fed’s monetary policy of devaluing the currency is reaching the point of diminishing returns.

In defense of the current Fed, in the 1960s, the Fed was a willing accomplice to the Johnson administration’s “guns and butter” fiscal spending policies. Then, the dollar was still pegged internationally to gold. These unsustainable monetary and fiscal policies led to the 1970s economic disaster, forcing the U.S. to remove the dollar peg to gold. The current Fed must worry only about its currency devaluation policies being less than those of its counterparts in the other developed nations and reaching the point of igniting runaway inflation. That is not as hard as it may seem. This global approach to currency debasement focuses on owning assets, but that is changing with the emphasis on income inequality.

How the Fed regulates the economy

Before the 2008 financial crisis created the worst recession since the 1930s, the Fed used two primary tools to impact the economy: (1) growth in the money supply and (2) changes in short-term interest rates. With the 2008 deleveraging and collapse of all asset prices, particularly real estate, the Fed started using additional mechanisms to stabilize the economy, primarily what it called QE2: quantitative easing. This strategy is the Fed creating digital money and using it to buy bonds in the market. Remember the laws of supply and demand? By pushing a button and injecting vapor money to increase the demand for bonds while the supply of bonds stayed relatively stable, the Fed drove bond prices up and yields down, allowing borrowers to take advantage of the lower yields. Lower interest rates meant the aggressive speculators and businesses could survive and expand, thus pulling the country out of the recession. Fed control over short-term rates is absolute. With QE2, it asserted control over longer-term rates. It bought bonds with maturities as long as 30 years.

Now, the 10-year U.S. Treasury bond yield is rising, surprising everyone. Since the Fed can and does buy bonds at all maturity points, it must be “allowing” interest rates on the 10- to 30-year maturity spectrum to rise. Holding short-term rates steady and allowing long-term rates to rise slightly is beneficial to the regulated banking system. The question is how far they will let rates rise. Likely, this change in interest rates is the Fed taking two policy stances: (1) recognizing the coming inflation climb to 3% plus level, and (2) improving the regulated banks’ ability to earn more money.

Politicians being what they are, Congress has finally answered the Fed’s urging for more fiscal stimulus to go along with its monetary accommodation. The amount of social spending has been breathtaking, and it’s not over yet.

The Fed states there is no real inflation, and, if there were, it can control that. Forget the fact no government in history has been able to control embedded inflation once it starts. The only cure for systemic inflation is a major deleveraging of the economy, accompanied by a severe recession with massive bankruptcies. That brings us to the next question.

Question 2: With the Fed suppressing interest rates and funding massive deficit spending, how will the poor and middle class of all ages, particularly the elderly, survive without losing their ability to maintain their lifestyle?

Senators Elizabeth Warren and Bernie Sanders are proposing a wealth tax. Unfortunately, the two of them are not the only people doing so. They want everyone with a net worth of $50 million or more to pay annually between 1% and 3% of their net worth to the government, over and above any income tax paid. They claim billionaires should pay their fair share. The fairness of that tax is left for more articulate observers. What is important here is to attempt to understand the logic and consequences of their proposal. First, non-publicly traded asset prices are subject to a wide range of estimates. Is a house worth $10 million or $15 million? A case can be made for both prices. The same goes for a private business. Is the business worth six times net income or ten times? There aren’t enough government workers anywhere, much less IRS agents, to handle the nightmare of challenges to whatever valuation the government puts on private assets.

But that’s not what they are after. They look at Jeff Bezos, Tim Cook, Warren Buffet, Elon Musk, Bill Gates, Larry Ellison, and the host of other billionaires who founded or built publicly traded companies and see their visible net worth. Their jealousy toward those who have succeeded is surpassed only by their desire to drive a wedge between the majority and these people who have more because they were smart, lucky, hard working, or in the right family. Could there possibly be another reason for their crusade?

All of these billionaires actually own less than 40% of the companies they founded. In most cases, the number is under 20%. Who owns the rest? Speculators, mutual funds, ETFs, and institutional investors such as pension and retirement accounts. Who are the beneficial owners of many of these funds and institutional investors? The middle class of America. These shareholders get up in the morning and go to work to keep the economy thriving. These people believe in the American Dream. These families are saving for their children’s education, for buying a home, for retirement, for the inevitable bump in life’s road. These shareholders own the majority of the publicly traded companies.

Now, suppose the wealth tax is implemented and the inevitable happens: the values of these companies go down, not up. As an example, suppose AMZN goes from over $3,000 a share to just $1,000 a share. Jeff Bezos’s net worth might fall from $150 billion to $50 billion. Will his lifestyle change? Not a bit. What about the middle-class mutual fund holder of the various retirement and investment accounts? Their net worth will decline appreciably as the share price declines and the market’s viewpoint for future appreciation dims. What about the employees who will be laid off because the profit objective of the companies will adjust to maintaining business rather than growing business? Some will call this effect an unintended consequence. Is it really an unintended consequence, or a known but unspoken consequence? This raises a question.

Question 3: Are the socialist senators just ignoring the full effects of their policies out of jealousy, or do they deliberately choose to injure the middle class to advance the socialist agenda?

The true secret of building wealth is to utilize the power of compounding. Yet, Wall Street and the business media continue to feed the falsehood of trading, using leverage, and finding the next stock that will rise fast so it can be sold and another bought. This mantra has been repeated so often, there is a new generation that believes it. Even more than past generations, this newest crop of speculators will learn a painful lesson. Their anger will be fanned by the rising securities litigation segment of the bar association. The rallying cry of “You only live once” (YOLO) justifies the all-or-nothing trading they do. What Wall Street doesn’t tell them is the secret of compounding, so these budding financial wizards miss the simple method of getting rich staring them in the face. Start with the formula everyone has available to them for compounding the returns on an investment portfolio:

Portfolio value × percent additions × (dividends percent + portfolio appreciation percent)

= Compound return

Notice the “percent additions to portfolio” as part of the formula. In many families, these are the retirement account contributions. In others, it is an amount available from raises, bonuses, gifts, and regular paychecks. A person who understands the power of compounding finds a steady contribution amount to enhance the returns. Notice the separation of percent dividend from percent appreciation. Dividends received are real and available for investing, not potential pie-in-the-sky appreciation. Dividends and contributions ensure the portfolio will have liquidity to take advantage of unforeseen market declines. Now, let’s see the power and weakness of compounding. Here are the numbers: A portfolio of $25,000, with contributions each year of 4%, dividends of 3% and appreciation at the 5.25% level, which was the average stock market growth in the twentieth century. Now, the investor begins with this portfolio at age 25, age 40, or age 55. They start withdrawing the money at age 65. Here’s what the portfolios look like at age 65.

The 25-year-old: $ 2,543,278

The 40-year-old: $ 449,364

The 55-year-old: $ 79,396

That’s the power of compounding, and its weakness. Time is the key to successfully enhancing the compound effect. These speculators in their twenties are lured to the here-and-now by Wall Street’s marketing machine, completely overlooking the concrete method for having more than they ever thought possible. These are average numbers; think about the potential for above-average portfolio growth by having liquidity when the market crashes and using the liquidity to buy good companies at attractive dividend yields and prices. This example does not even factor in the potential dividend increases over time. This brings up the last question.

Question 4: Why don’t the regulators and Wall Street publicize the compounding effect as much as they do trading of stocks and derivatives?

There is a common thread running through all four of these questions. In every case, the potential damage wrought on the poor and middle class of this country is chilling. If the political establishment used the pandemic to severely devalue the currency and destroy jobs for the lower and middle class, what will they do when their policies cause irreparable destruction to the economy and lower and middle class?

We all probably know the answer to these questions, but just don’t want to think about or admit them. Our portfolios are performing well and the pandemic is receding. All is well, just as it was in 1928, 1998, 2006, and January 2020.

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