FWIW # 34 Fear & Greed & CBDC

When the markets are fearful, you should be greedy. If you look on pages 46 and 113 in my book 19 Rules for Getting Rich and Staying That Way Despite Wall Street, you will see a drawing of what I call the FEAR & GREED Investment Pendulum. It’s very clear many markets are gripped by fear today. What is most interesting is how fear is evidencing itself as greed in the stock market. That unusual situation is typical of this Alice in Wonderland world (SEE FWIW #33).

Let’s take the markets one by one and see how fear or greed is influencing asset prices.

The US Treasury

Start with the US Treasury markets. The news media and some market participants say this highly liquid market has turned illiquid. If the speed and magnitude of price changes are any indication, the market is illiquid, since these securities normally trade at small price changes even in large amounts. One reason for the volatile situation may be that those who own treasuries don’t want to sell, while speculators gripped by fear want to buy, and short-sellers want to cover their short position at any price. Hedge funds, being the copy-cats they seem to be, were substantially leveraged as short-sellers. The SEC even went so far as to speak to British authorities about the market position of one major British hedge fund.

Short-term treasuries are the only truly safe investment anywhere. Yes, I know inflation is eating away at their maturity value, but if the current financial crisis continues, all other investments will decline in value more than the short-maturity treasuries, thus giving the holder liquidity when all other markets are under duress. Topping it off, the short maturities pay a decent amount along with their liquidity and value protection. Therefore, speculators’ fear of the unknown financial crisis gravity is driving the rally in treasury prices (decline in yield). There is a caution, however. After rushes to buy (driving down yields) when any bad news surfaces, yields move back up from the low point, indicating the economic outlook is (1) the Fed is still suppressing interest rates and still has an accommodative policy, even if in a different way, (2) inflation is not close to the 2% level and likely won’t be for several years, which will be disastrous for working and retired families and will require higher interest rates in the long run, and (3) a financial crisis that can’t be controlled by the Fed or political elites will eventually engulf our economy.

If the country is going to experience a Fed-controlled recession rather than an uncontrolled depression, it will be necessary for the Fed to switch from an interest-rate-focused policy to a controlled money supply policy that allows markets to set interest rates based on the supply and demand for money. Because of the disastrous Fed policies of the 1960s and 1970s, using an interest-rate-control policy like we have experienced for the last 30 years, Paul Volcker’s switching the Fed policy to controlling the money supply sent interest rates soaring and the economy into a sharp but short recession. The longer it takes the current Fed to change monetary policies, the higher inflation and interest rates will go and the deeper and longer the subsequent recession will be. If the Fed continues its current course of satisfying the political leadership in Washington, the country will eventually experience a 1930s-style depression that can’t be solved using the fiscal and monetary policies developed over the last 30 years.

The Stock Market

The stock market appears to be impervious to the goings-on in the economy and financial arena in general. It’s not. What appears to be greed is fear. Let me explain. Last year’s 19% decline in the S&P 500 was a recognition that Fed-created free money was over. Inflation was here and the Fed had to address it, so grossly overvalued asset prices adjusted downward. Speculator belief in the Fed’s unwillingness to continue eradicating inflation from the economy is evidenced by the volatility of the markets so far this year. With the unbelievable guarantee given to all depositors in both Silicon Valley and Signature Banks, the Fed and the political leadership in Washington signaled they are going to do whatever it takes to make certain the economy appears healthy until after the November 2024 election. It will be interesting to see if this magic can work. The point is this: not only will inflation not see a 2% annual level in the next few years but also if a recession pushes inflation down, it will likely spike back up, considering the political implications of the inept crisis response by Washington.

During 1982 to 1984, the leveraged buyout industry aggressively expanded. It did so because speculators had shunned common stocks in the 1970s, believing they were “intangible” assets rather than “tangible” assets that responded positively to inflation. But some on Wall Street realized two things: (1) common stocks represent ownership in operating companies that have revenue, which adjusts to inflation, owe debt, usually at interest rates lower than the inflation rate, and (2) they consist of tangible assets that are worth more than prices reflected on the balance sheet of the companies. In other words, a dollar of value could be bought for much less than a dollar. Wall Street speculators learned their lesson. The buoyancy of the stock market today reflects both greed—speculators understanding the effects of entrenched inflation and likely more inflation in the next several years—and fear of not having some form of protection from inflation other than stocks and real estate. Currently, speculators give no thought to potential leverage implosions that could spill over into the public stock markets. What to do?

I’ve said it before: the key to surviving and thriving in any economic or market situation is to recognize it is impossible to avoid being impacted by what is happening. If the stock market declines sharply, because of either a recession or a leverage implosion, stocks in the portfolio will decline; however, if the portfolio has a total return strategy, the decline will be cushioned and there will be funds available to add to the portfolio when prices for targeted stocks are lower. Your net worth long term requires buying good companies that pay a dividend when the market is under selling pressure.

During any inflationary period, the future value of any fixed-income securities (bonds and preferred stocks) will be eroded by the difference between the interest rate paid by the security and the inflation rate. For example, a bond with a 2% yield and an inflation rate of 6% will effectively lose 4% of its purchasing power (value). That doesn’t mean a portfolio should not have fixed-income securities. These investments are critical for their steady cash flow and their ability to be sold when either an emergency or an opportunity arises. The banking crisis today is what is called a duration problem. You can minimize any duration problem in your portfolio by following Rule #17 in the 19 Rules book.

There is a reason a portfolio should be allocated 70% to common stocks and 30% to fixed income. Common stocks respond positively over long periods to the growth in the US economy. The ones you should own share their profits with shareholders through dividends, may increase the dividends over time, and, since they are operating businesses, offer a certain amount of protection against inflation. Structuring the maturities of the 30% in fixed-income assets as discussed in the 19 Rules book will give you liquidity and flexibility.

The Fed

Watch the Fed. The longer it takes to change its monetary policy from controlling interest rates to controlling the money supply, the more embedded inflation will become in the economy and the more severe and long-lasting the eventual economic correction will be.

When listening to the “smart” people in the media, it becomes evident they have enjoyed the Fed created free money of the last 13 years. I heard one today say that 4% to 5% inflation was not bad and was more normal than the 2% Fed goal. I don’t know where he got his education, but I do know he skipped economic history classes. These speculators should take a moment and step back and survey the forest rather than looking at just their trees. This country is as divided as it has been since the Civil War in 1861. Over 45% of the population does not own any securities except bank savings or CDs. Working people’s economic viability was suppressed for over 20 years by the political and business elites. If their livelihood, purchasing power, and savings are eroded by 40% to 50% over a decade, the ensuing revolution will make the Civil War seem like a neighborhood squabble. The rich who are driving the illegal immigration debacle because the want cheap labor have ways to mitigate inflation. Working people and retirees don’t. The illogical basis of an inflation rate at 4% to 5% is seen by the fact that creditors, having been injured by the confiscatory monetary policies of the last 13 years, will not continue to accept a rate of return substantially below the inflation rate while debtors and the federal government continue to usurp creditors’ rightful returns.

The other component of the evolving economic manipulation seen since 1995 is the willingness of Fed officials and political leadership to protect the very people who are abusing the monetary policies for their own benefit. Since the mid-nineties, whenever there was an economic crisis, either large ones like 2000, 2008, and 2020 or small ones like the dips between the major ones, the Fed and political leadership have stepped in and protected the very people who caused the crisis. In a truly capitalist economy, like the one we once had in this country, those who were incompetent or careless and made bad judgments were crushed by the economic downturns. More competent and careful entrepreneurs picked up the pieces of the mistakes and made the companies into stronger and more profitable businesses. Does anyone think the depositors that recklessly stored too much of their assets and operating capital in SVB or Signature Bank would have gone out of business if their deposits were not insured? No, the good businesses would have been scooped up by smarter entrepreneurs, and the only ones suffering would have been the owners and managers who put their companies at risk. The short-sighted policies of the monetary and political leadership in protecting their friends and supporters during crises will be a major factor in creating the eventual crisis the authorities can’t fix. That’s when the careful and competent will be able to put the economy on a more solid footing.

I may sound like a broken record, but be patient, know what companies you want to own at lower prices, and build up liquidity.

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In February 2022, FWIW #23 was devoted to cryptocurrencies, including the potential for a central bank digital currency (CBDC). The information in that FWIW #23 is still valid. The information from the Federal Reserve, which was the basis of most of the essay, pointed to skepticism among the Fed and US Treasury about whether a CBDC could work in this country since a CBDC would effectively move deposits from banks and other non-bank depository institutions to the Federal Reserve, where there would be no risk associated with the CBDC. We have just seen the speed of money movement in the latest banking crisis. Who will be making loans if there is no mechanism for having and keeping deposits in the banking system. Will the monetary authorities be responsible for deposits and making loans?

There have been rumors and talk that the Fed’s implicit guarantee of all deposits, including uninsured deposits at SVB and Signature Bank, looks and feels like a CBDC. That opinion and thought does not reconcile with reality. There are key questions about a CBDC: How will the public accept a CBDC? How would it be implemented and adopted? How will a CBDC be used relative to other payment instruments? How will the current market structure and financial stability be impacted?¹

From my previous research and the current readings, it appears the introduction of a CBDC into the existing financial system is in the distant future. My sense is the Fed will continue to evolve its thinking and examine how a CBDC can be implemented, but it will not happen until the current financial and payment system breaks down to the point that a new financial structure is required, i.e., the unrepairable financial and economic crisis referred to above.

The distance between now and the implementation of a CBDC in this country and other countries with an open financial system is brought clearly into focus in some of the readings about CBDCs. Even on a global level, there is the risk that holders of a CBDC in one country may “shop” for a CBDC with a higher interest rate and move money to another country’s CBDC if the interest is higher. The potential chaos caused by instantaneous movement of large sums is real. Think about the impact of the $42 billion deposit run on SVB and the effects it had on the bank. It is more than likely that CBDCs in the global markets by countries with open financial systems would require a coordination of central banks, which may evolve into a one-world central bank with a one-world currency. Sound familiar?

Bitcoin has almost doubled in the last few weeks as speculators have looked to it as a refuge from the banking turmoil. That doesn’t make sense. Bitcoin and other cryptocurrencies are not assets that can be hidden from the authorities. More importantly, cryptocurrency holders are at the mercy of the honesty and competency of those who control the mechanism of cryptocurrencies, as has been proven by FTX and other crypto disasters. The illogical name of stablecoin is a good example. Speculators rush to change US dollars into stablecoins so they can buy Bitcoin and other speculative coins or to just avoid the monetary policy’s impact on the dollar itself. That doesn’t make sense, either. If the dollar is depreciated by the authorities and a stablecoin is pegged to the same depreciated dollar, then the stablecoin’s purchasing power is also depreciated. When money is no longer free, as it isn’t now, nongovernmental cryptocurrencies will eventually get too expensive or implode, as has happened in the recent past.

Until there is a global crisis the authorities can’t fix, the probably of a CBDC is very low in any country with a free and open, even if manipulated, monetary system. Your portfolio’s liquidity and equities is the key to surviving and thriving.

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¹ Ken Isaacson, Jesse Leigh Maniff, and Paul Wong. “An Examination of First-Mover Advantage for a CBDC.” FEDS Notes. Washington, DC: Board of Governors of the Federal Reserve System. Nov. 25, 2022. https://doi.org/10.17016/2380-7172.3230