FWIW # 20 Reality November 2021

The business media continues to attribute the record-setting stock market to the Federal Reserve pouring money into the economy. They are correct in that the Fed's actions are a direct cause of inflation. As stated in the last FWIW, asset inflation has been the Fed's goal and it has accomplished that goal. Since inflation is an imbalance in which demand for some service or product is greater than the supply of that service or product, the demand for financial assets dramatically changed all the way back in 2008, but even more in 2020, while the supply of publicly traded common stocks did not change much. Now inflation in the real economy is running much above the Fed’s target, but its leaders say not to worry. The monetary authorities think inflation will return to their 2% annual target. They also point to the years when inflation, by their measurement, was less than 2%, logically saying over time it will average out to their target. That logic is almost criminal. If in the future the measured inflation settles at a 2% annual rate, it will not change the fact that inflation was sustained at a 5%–6% level. These are price increases that will not reverse. They are now embedded in the economy. In and of themselves, they will cause more inflation. If there is only one 12-month period at 5%, over a decade, the value of money is cut by at least 23% (nine years at 2% and one year at 5%). This, by the way, is a simple arithmetic average. Real-world inflation compounds. For instance, take the decade of 2020 through 2029. If it is assumed the inflation index at the end of 2019 was 100, at the end of 2020 it would be 105. At the end of 2029, if the other nine years go back to 2%, the CPI would be 125, making the inflationary currency destruction 25%. The currency's value would drop by more than a quarter instead of by what is considered acceptable, which is 2%, giving a 21.89% decline in the value of the currency. Either way, it’s easy to understand why the stock market continues to soar to new records even as the country's problems appear to be compounding as well. Why? Because the stock market knows the inflation rate will usher in a different economy, not seen in forty years.

How the Fed’s currency value destruction ends will be interesting. The Fed has seriously impaired the 45% of the US population who are not rich enough or savvy enough to own stocks in any way. The return on savings, for the last 13 years, has been forcibly taken from savers and given to the speculator friends of the Fed. Now the Fed, through its continued actions and the irresponsible actions of its political masters in Washington, is ignoring the inflationary fires. Is there any wonder the socialists have risen in power in Washington? Any elitist ruling group will find themselves in trouble when they deliberately confiscate property (fair interest on savings) from a helpless group of citizens. And there is another group of citizens who will be hurt. A number of the people who have been enticed into the stock market with their savings in order to earn something rather than nothing may find themselves unprepared for the downside volatility inevitable in the stock market. With all the technological advancements and historical knowledge in this country and the world, it is amazing the powers in charge have committed the same mistakes made throughout history by the elite ruling class. It is truly an interesting time to be alive, but I guess every generation in the past has been able to say that.

Two trends in the financial markets are fascinating to watch. First is the search for the perfect place to put assets to protect them from market volatility. The idea is to have what is called “non-correlated” assets, which will either hold their value or go up in value when the stock market collapses. Some highly sophisticated money managers use derivatives to mathematically determine what instruments will give them stability in a market decline. In many cases, the instrument itself uses leverage. In other cases, the managers heap up the leverage. A few, but very few, will succeed in ensuring their portfolios resist the overall decline. The flaw in these strategies has to do with both leverage and the concept of non-correlation. Think of the investment markets as one huge market built on capital and borrowed money. Actually, that is what it is. When a financial crisis occurs, it is generally because (1) a situation occurs in which capital becomes scarce, (2) borrowing money becomes difficult, and/or (3) asset prices used to collateralize the borrowings fall to the point the lender is impaired. As the various markets cascade downward, both capital and leverage are destroyed and/or become scarce. What was thought of as assets non-correlated with the stock market becomes correlated because one of the chief maxims of speculators is sell what you can since you can’t sell what you should. Look back in history and see what happened to non-correlated assets. The fact is only one group of assets is truly non-correlated with the stock market in a financial crisis. That asset class is cash and cash equivalents, defined as either one year or less FDIC-insured CDs or one year or less US Treasury notes.

The best way to protect a portfolio is to own quality companies that have proven abilities to operate at all levels of economic activity, pay a regular dividend, and, at the same time, make sure there is a significant level of portfolio cash reserves. It’s interesting that Warren Buffett has always said he would never have less than $20 billion in cash reserves in Berkshire Hathaway (BRK). In his last quarterly report, I believe the cash reserves were closer to $150 billion. BRK has an impressive array of wholly owned businesses and a stock portfolio that is equally impressive. Besides Buffett, BRK has two world-class investment managers who buy stocks for the company. It’s worth thinking about why these three excellent investment professionals choose to keep $130 billion in extra cash reserves earning essentially nothing rather than invest these assets.

The second trend is toward private and untraded investments by large and sophisticated investment managers. This includes not only private equity firms and hedge funds but also large pension funds and endowments. The shift of assets to these opaque markets is a direct result of the Fed suppressing interest rates over the last 13 years. The allure of these markets is the potential higher returns. Understanding the higher returns equates to higher illiquidity and leverage risks used in these various private markets seems to be ignored. In many cases, the speculator (hard to call a pension fund a speculator, but that’s what these return-seeking professional managers are) has to sign documents committing to investment holding periods ranging from 7 to 20 years. There will come a time when some beneficiary or their attorney asks the managers, who have a fiduciary responsibility, why they agreed to the leverage and illiquidity.

Last month, the FWIW alerted readers to the request from Iran that the US show good faith in the nuclear talks by releasing $10 billion in frozen funds. Very little was said in either the conservative-leaning or liberal-leaning media about this request. At the time, the FWIW suggested being watchful to see what the Biden administration would do or if the Iranians would return to negotiations. Well, the Iranians announced at the end of October they would resume negotiations in November. Have any media outlets asked the Biden administration if it released the $10 billion? No. You can bet the administration has or will secretly do so in the near future. At the same time, the Biden administration has announced it will open a consulate in Jerusalem specifically to deal with the Palestinians. The city is the capital of Israel and therefore, according to international law, the US must ask Israel for permission to open the diplomatic operation. Israel has said no. Secretary of State Blinken has said the US does not care what Israel says and Israel will suffer the consequences if it tries to block the consulate. Is this real? The Secretary of State of the US flouting established international law? The US has already pulled substantial defensive missiles from all our Arab allies in the region, as well as from Israel. Are these the seemingly innocent steps taken by a country that lead to miscalculation by adversaries? Coming on the heels of the Afghanistan fiasco, does this further embolden others who suspect that now is the time to make aggressive moves against the interest of the US? The Obama, and now the Biden, administrations have tilted to Iran and Russia. Why? The answer to that question is always the same in politics at all levels: Follow the money.

A final thought all of us should spend time thinking about. One of the most vibrant cities in the US is Denver, Colorado. What if an adversary attacked this country and killed every single resident in Denver? Could we get our heads around it? It would be an act that demands retaliation from our government. Stop and realize that more Americans have died from the Covid-19 virus than live in Denver, Colorado. The Chinese Communist Party, i.e., the Chinese government, knows this virus was released from its military labs. They stymie any effort to determine if the release was accidental or deliberate. Think of the citizens who have been killed and ask yourself why the political and business establishments in this country continue to do business with this adversary. War is an evolutionary exercise. In the beginning it was sticks and stones, which gave way to guns, which gave way to missiles, planes, and other high-tech devices. Everyone has their eyes on nuclear weapons and ships, planes, and masses of soldiers. While they are distracted, a simple man-made virus in a single lab can be turned loose on the greatest country in the world and just about bring it to its knees. Our economy is recovering from this first test because the monetary and political authorities were willing to devalue the currency to prop up the country. Perhaps war has changed. Instead of laying waste geographically and killing millions, an adversary may understand they can severely restrict and hamper an opponent economically, thereby not facing retaliation until it is too late. The pandemic has shown without a doubt the vulnerable position the United States is in because of globalization. What will happen to our financial and economic stability when the next virus is unleashed?

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