FWIW # 29 Patience and Confusion

Can you believe these markets? The volatility of interest rates and equity markets demonstrates two aspects of today’s markets. The first is the automation of buying and selling through the use of computer algorithms with no human involvement. Emotionless trading has eliminated human fear in many short-term trading scenarios, causing an increase in trading volume and volatility. In the future, more and more of these machine-led trading programs will exist. Market participants must incorporate fearless trading into their strategies. These automated trading strategies carry a higher level of risk. Two weeks ago, the markets had a second rally in this bear market, rising over 5% in just a few days. September was expected to be an up month until reality reared its ugly head last week. Inflation is not disappearing. Most of the month’s early gains were lost in a single day, with the rest at risk. However, computers are not solely to blame for the current situation.

Today, there are far fewer active investors that were investing during the inflationary 1970s. The overwhelming majority of speculators and investors today are optimistic that the Fed can flip a switch and stop inflation. Most of the gray-haired participants from the 1970s have extra large amounts of cash reserves since they know the truth. Even if a person missed the majority of the 1970s, when the stock market fell 40% in 1973 and 1974, rallying back from that decline until late 1977, when another selloff occurred, the 1970s taught us that, contrary to what some of our current monetary authorities claim, inflation could not be toggled on and off. Once inflation is embedded in an economy, maximum time and effort are needed to re-anchor consumer expectations and, more importantly, stop the spiral of inflation-driven costs and demands for inflation-adjusted incomes. The fearless algorithms and lack of first-hand experience have led many market participants to believe it’s different this time. Only youthful inexperience is different this time. Let’s look at the issues involved and see why patience and discipline are crucial for coming out of this financial confusion.

The first step is to understand that inflation is neither a supply chain crisis nor a demand crisis but rather a monetary crisis deliberately created by the monetary authorities for political purposes. Lyndon Johnson had the Fed finance the Vietnam War and his expensive social programs. That’s what caused the disastrous 1970s and led to Paul Volcker’s bitter monetary medicine in 1979–1981. The same two reasons have caused today’s inflation. The Afghanistan and Iraq wars and the expansion of social programs for twenty-two years, which were financed through borrowing, left the country on shaky financial ground.

Federal Reserve policies deliberately expanded monetary aggregates and lowered interest rates on government loans. The first sign of trouble was the 2008–2009 financial crisis. What did the Federal Reserve do? It produced even more money and increased demand for bonds at manipulated low-interest rates through quantitative easing and the purchase of bonds with digitally printed money. The Fed continued devaluing the US Dollar until 2020, keeping interest rates close to 0% and printing dollars as if a reckoning was not imminent. Then COVID-19 hit. Both the Republican and Democratic administrations used the Federal Reserve to “save” the country during the COVID-19 crisis. Money aggregates and bond purchases exploded to prevent a repeat of the Great Depression of the 1930s. Political manipulation of the Fed for the last 30 years has left the country unable to handle the crisis through deficit spending without igniting inflation. Currently, the monetary and political authorities intend to change the rules.

The Fed and all classically trained economists developed the theory that 2% inflation was good for the economy. Never mind the fact that 45% of the population not only had no way to benefit from 2% annual inflation but also lost 20% of their fixed income and savings every decade. Too low interest rates and excessive money creation were neither a mistake nor an accident. It was intentional for political purposes. Think I’m wrong? Just listen to the President when he misleads the people by speaking about monthly changes in the CPI rather than the trailing twelve months.

Stock market participants who believe inflation will disappear on its own are being too smart for their own good. So are those who believe the first signs of a recession will cause the Fed to stop raising interest rates and shrinking its balance sheet. Actions that will bring down inflation are: (1) a sharp deceleration in the growth of the money supply (underway now); (2) the shrinking of the Fed balance sheet through the sale of bonds and retirement of the money it receives (slowly being implemented); and (3) increasing interest rates to the point that the real rate is higher than the core inflation rate (much more to go). Think about it. The money supply and credit pool will shrink as the Fed sells or allows bonds on its balance sheet to mature. Borrowers will have to pay more with a smaller pool of available credit. All three of these actions will have an effect. The result, however, will not be a mild economic slowdown. The economic and market contraction will be challenging. Too many people and businesses that require loans to stay afloat will find that money is scarce. Their businesses will shrink or fail. Their employees will lose their jobs. The ripple effect will impact even successful businesses. It won’t be pretty. Earnings in the economy will decline, as will stock prices. Speculators will eventually develop a fear of disaster, even if the computers don’t. The stock market is based on guessing future earnings. Earnings will be under pressure. You should pick the stocks you want to own. Look at their stock price relative to their current operations and dividend yield. Consider the five-year average of operating earnings as a percentage of the current share price. Wait until the return on investment (ROI = operating earning/current stock price) is high enough. This ROI exercise will provide you with a target price and a dividend yield that exceeds the last five years. Don’t be misled by analysts and the media who emphasize how far the current price is below its previous high.

Will the Federal Reserve’s actions stop inflation? Eventually, but not in the short term. Last week, the railroads agreed to a new labor contract that provides union workers with a 24% pay increase between 2020 and 2024, with 14.1% coming immediately. In addition, they will get cash bonuses and increased benefits. There is a substantial movement to increase the federal minimum wage from $7.50 to $15. This is a 100% increase. The list of economic sectors facing higher wage costs is broad. In the 1970s, this was called “wage push inflation.” Employees deserve these increases since short-sighted management and politicians in the last forty years have used globalization and illegal immigration to stifle US workers’ pay, pushing workers to struggle to maintain their living standards while at the same time politicians were implementing inflationary policies.

Currently, economists, politicians, and large debtors who are politically connected argue that an inflation rate of 2% is unreasonable. According to them, inflation should be tolerated at 3% to 4% a year. In other words, instead of devaluing the dollar by 20% a decade, they want a devaluation of 30% to 40%. They fully understand the effects of this level of devaluation on the middle and lower classes. This is a serious red flag that this discussion is going on. You need to listen.

If the Fed does what it should do and adheres to the program until inflation is brought down to 2%, the stock market will likely face a liquidity issue. In such a scenario, a further 20% drop may occur. Why own stocks then? Because past inflation does not disappear. No one knows what path the Fed and Washington will take. If they falter, inflation will get even more severe. It is critical to ensure that no matter what happens, you will financially survive and prosper.

You need to have sufficient liquidity to take advantage of higher interest rates and buy more high-quality common stocks if and when the stock market experiences a major liquidity event and if interest rates reflect anticipated inflation (see the 19 Rules for Getting Rich and Staying That Way to learn how to build a flexible bond portfolio). Be patient.

Above all, the value of the US Dollar, and therefore your cost of living, is changing permanently. Even a severe recession will not be able to reverse the devaluation that has already occurred. You need assets such as real estate, stocks, and liquidity to make it through the confusion being fostered among the public.