FWIW # 19 Protection October 2021

FWIW #18 ended with a suggestion for the reader to protect themselves. Many of you wanted to know what I meant by that. The short answer is it depends on your personal situation. Here are some examples.

The Federal Reserve has suppressed interest rates for 13 years. Many speculators have taken advantage of this manipulation by borrowing more money to buy and hold assets, such as jewelry, art, real estate, and stocks. These individuals rightly feel they are financial geniuses because the value of their assets has appreciated. During most of these 13 years, the slack in the global and US economies prevented the excess monetary aggregates from causing inflation on goods and services. Inflation roared ahead in the assets markets, but most people don’t consider asset price inflation a bad thing. After all, speculators buy assets hoping they will go up in price.

Along came the Chinese-caused global pandemic. Asset prices dropped precipitously for a month. The Fed stepped up its creation of digital money to allow Congress to borrow and spend enormous sums. We entered the world of thinking in trillions of dollars, not billions. Very few people understand that a trillion is one thousand billions or one million millions. The mantra was and is “Do whatever is necessary to save the economy and the world.” Notice this is not just about saving the US. The global economy is now the focus of the Federal Reserve, contrary to its mandate. It will tell any critic that the global economy is important to the US. In some respects, that is questionable since the US runs a consistent trade deficit with the rest of the world. If every one of our exports stopped, and we stopped importing any goods or services, the US would have more wealth since we would not be buying more than we sell. Nevertheless, the average American does not understand that some of the emergency spending in Washington went to shore up foreign countries, including some “rich” foreign countries.

The virus and policy decisions made in Washington have caused significant dislocations in the global economic supply chain. Demand by individuals for goods and services has been increasing as the Fed-fueled gusher of money has rippled through the economy. The fiscal stimulus from the government just added more of a tidal wave of spendable money to people’s bank accounts. With demand for goods and services exploding, but their supply being constrained, inflation has taken hold in the economy. Now the Fed admits what they call transitory inflation has gone on longer and risen higher than they anticipated. They still continue to flood the economy with money, even as they talk about reducing the stimulus next year.

Here’s where you had better protect yourself if you are a borrower. The economic environment has changed. Every day that the Fed continues to create digital money and send it into the economy and Congress continues to create feel-good spending projects, the inevitability of higher and longer excessive inflation mounts. One of the key monitoring points for the Fed is a survey of consumer sentiment about inflation. It always points to the “well-anchored” consumer sentiment. The fallacy of that perspective is the rapidity of change that can take place in consumers’ minds. Some economists believe consumer sentiment has already broken away from the belief inflation is under control. The Fed will have opportunities to point to economic data indicating a slowing economy, but it will be grasping at straws as far as inflation is concerned.

We are coming up on the first Christmas since the country reopened after the Chinese virus dislocated the world. As has been demonstrated in the last few months by the surge in travel, the surge in purchases of goods and services, and the surge in football stadiums being filled to capacity, Americans are going to go all out this holiday season. When they do, and when they find out the prices of available goods and services are substantially higher, it will rip away any belief that inflation is not permanent.

There is a high probability that the Fed will lose control over interest rates in the next year. In the 1970s–1980s, the fixed income market was ruled by the “bond vigilantes,” fixed income speculators who knew the Fed was trying to manipulate the fixed income market to the government’s advantage. While no one fully understands the addiction the world economy has contracted to trillions of dollars, it is a good bet large investors who populate the fixed income markets are concerned about the change in systemic inflation. These investors are likely also concerned about the monetary authorities’ and politicians’ callous attitude toward the effects of their policies on wide segments of the US economy.

The probability of interest rates moving substantially higher has increased. The business media talks about the 10-year US treasury note “spiking” because it went from 1.28% to 1.55%, and then settled at 1.48%. Historically, from the early 1800s till now, the 10-year note stayed in the range of 3.75% to 8% approximately 80% of the time. It is not illogical to think the 10-year note could go to 3.75% if inflation stays above 4% for the next year. That would be devastating for borrowers who are accustomed to interest payments at current levels. In addition, bond mutual funds and ETFs would have serious price declines and losses. The longer the Fed persists in ignoring the start of inflation in the economy, the greater the disaster for long-dated bond investors. It’s amazing how blatantly the monetary authorities do the bidding of their political masters. Finally, if a person is going to owe money, the best way is a 30-year fixed-rate mortgage or loan. If that is not possible, building liquidity now to pay the likely interest rate increases later makes sense.

The stock market left the realm of common sense a long time ago. This market validates the old saying that a market can be irrational for longer than anyone can imagine. The traditionalists will tell the media and the world that a rise in interest rates of the magnitude discussed above will cause a stock market decline. In all likelihood, an interest rate increase will cause an economic recession, or, at the least, an economic slowdown. The stock selloff will come from multiple directions. Stock liquidation to generate cash for investing in the fixed-income markets and liquidation of margin debt by speculators will lead the way. Compounding this selling will be computer-generated selling. Speculators who subscribe to the “cockroach” principle (get out at the first sign of trouble) will be in the mix as well. How deep and for how long the decline will be is unknowable. When the psychology of this current stock market breaks, I’m confident there will be a quick and sharp selloff. In March 2020 it was close to a decline of 37% from its highs. That quick selloff was followed by an immediate rebound, allowing the stock market a positive return for the year. Why?

As Congress spent money it did not have, the Fed created the money. For more than 12 years, stock market participants have profited from buying any dips in stock prices. This strategy has become so profitable, even novices know about it and the easy profits it generates. Therein is the problem. Easy money in the stock market tends to evaporate sooner or later. Unfortunately, but understandably, most speculators who became addicted to the easy money stay around a few days too long and get caught in changing financial conditions. While I don’t know what will happen or when, I do believe the probability of a sharp and sudden decline has risen. Nevertheless, owning companies in all market and economic times is critical to building wealth. What to do? It’s important to know what you own and therefore feel comfortable that the companies will survive economically, no matter what volatility takes place in the stock market. When you own mutual funds and ETFs, you believe you know what is in them, but the manager can change the makeup at will.

If a shift in the popular attitude toward inflation keeps the Fed and the government from their easy and addictive opium of low interest rates, excess monetary aggregates, and fiscal stimulus, the economy and the stock market could slip into a stagflation scenario similar to what occurred in the 1970s. The stock market in particular, which has enjoyed some serious annual gains since the 2008 Great Recession crash, could decline and then spend a decade going sideways rather than down or up. With the emphasis in the stock market on capital appreciation, speculator frustration will build as the years progress. Speculators who have bought into the concept that capital gains are the primary objective of owning mutual funds and ETFs will become more frustrated. After the initial drop, traders will figure out a narrow-range pattern and return to their happy gambling. It will be critical, if this scenario materializes, for a portfolio to generate cash flow for reinvesting. Periods of stagnant stock prices are the time investors should and can establish a portfolio that performs beyond expectations in the next up market cycle while building additional investment income. Protect yourself by owning the companies you believe in. Build liquidity to use when the market responds negatively to outside influences.

Notice the commonality between the ways to protect yourself? Master-of-the-universe money managers profess that “cash is trash.” The monetary authorities reinforce this attitude by making sure most people will reject the miniscule returns on safe, short-term fixed-income assets, forcing the money into high-risk speculations. Now, I ask you, when is it best to seek out and own any asset? The answer is when no one else wants to own it. In this case, the monetary authorities are confiscating the rightful return on cash assets from holders. With the change in economic variables such as supply constraints in energy, logistical dislocations in supply chains, the psychological change in inflation expectations, and the pent-up demand from life changes due to the pandemic, the monetary authorities will not likely be able to respond to a sharp selloff in the stock market. Multiple opportunities will appear in all three markets: fixed-income securities, common stocks, and real estate. What will be the catalyst for constraining monetary and fiscal policy?

No one knows the future timing or cause of the authorities’ policy constraints. It’s my opinion that the catalyst will come from an unexpected direction and be an event that causes serious doubts about the future. The event will dramatically demonstrate the need for a political reordering in this country and expose the deliberate mismanagement by monetary authorities. When it happens, liquidity will be the number one asset of choice.

If I were an investigative journalist, I’d certainly examine the connection between the Biden administration and Russia. As discussed in FWIW#18, policy changes by the current administration have been a major factor in oil prices rising to $80 a barrel, and, even more importantly, in the price of natural gas doubling to a multi-year high price since January 2021. Two of the country’s top three adversaries, Russia and Iran, are primary beneficiaries of these policy changes, while US citizens are negatively impacted.

I’ve only seen one report of the Iranians trying to entice the Biden administration to release $10 billion in frozen Iranian funds. This is a concern because it may imply the Biden administration is considering the proposal. The Iranians say they may negotiate the nuclear treaty if the funds are released. Watch for reports of the money release or Iranian movement at the bargaining table. The Biden administration is following Obama’s tilt in policy toward helping the Iranians.

Study history. Never has there been a country with weak political leadership that didn’t end up in a major conflict because their enemies took advantage of the situation. Tragically, our senior military leadership is more concerned with building a “woke” military than with teaching soldiers how to defend this country from our enemies.

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