FWIW # 42 - Comparisons and Knowledge

Posted by Eugene Kelly(E. Aly) on Apr 1st 2024

Isn’t this fun? The string of record highs in the major indices is enjoyable. Enjoyable not only because of the ballooning value of portfolios, but enjoyable listening to the various commentators trying to explain why the market is going up like a rocket. Everyone has their own pet theory. Mine is based upon history, even though the circumstances today are different.

Read any account of the hyperinflation in Germany and Austria in the 1920s and early 1930s, and you’ll see stories about having to take wheelbarrows full of cash to the store to buy a loaf of bread. Well, we don’t have hyperinflation, and a wheelbarrow full of currency is not necessary to go to the grocery store, although some people have the same sense of shock and amazement at grocery prices. The U.S. has experienced approximately 21% inflation since January 2021, when people were expecting 6% during that same period. Most commentators in the media are quick to point out that the rate of inflation has come down to the 3% range. Some world-renowned economists say that a 3% inflation growth is fine and not to worry about getting down to 2% inflation increases each year. When it comes to compounding the domestic depreciation of the dollar over ten years (another way of looking at the actual inflation), it does make a difference: at 2%, the cumulative loss of purchasing power from the beginning is 21.89%, while at 3% it is 34.39%. Since the country has experienced a 21% loss of purchasing power already this decade, it’s clear that the cumulative effect by the end of the decade will be bad at a 2% inflation rate and devastating at a 3%. Who knows whether inflation won’t go higher again? No one. What the investment markets (other than the still-Fed-manipulated bond markets) are sensing is the Fed has given up on their 2% inflation target.

Now let’s go back to Germany and Austria during their hyperinflationary period. Those citizens who owned common stocks saw those stocks increasing in value, which partially offset the inflation, and they survived the collapse of the currency. To a lesser degree, this is what is going on now in this country. If the Fed is going to allow 3%+ inflation to become embedded in the economy, speculators and investors will adjust the value of assets to reflect this higher domestic depreciation of the dollar. That’s acceptable if a citizen owns stocks and/or real estate (although real estate is usually accompanied by borrowing a portion of the cost, which still means a sensitivity to interest rates). There is, however, a cancer in the economy created by the Fed’s capitulation to borrowers and speculators.

A few weeks ago, there was a news report that over 58% of Americans either directly or indirectly owned common stocks. This news was heralded as good for the economy because more people feel wealthier as stocks go up in value, and the Fed’s job of managing the economy will be easier as the rising stock market entices people to feel wealthier and spend more. It’s another example of myopia: seeing only on what the observer wants to see. What about the other 42% of Americans: those who don’t own any stocks, either directly or indirectly? Everything they need to exist costs much more than it did three years ago, but their wages, only catching up with inflation during the period 2017–2020 after 40+ years of falling behind, are now being significantly outstripped by inflation. Think about what it would be like to be on an hourly wage, with a little bit of money in a savings account (with the rightful interest having been suppressed by the government for 13 years), having a mortgage, car payment, and medical bills, and going into the grocery store today. Think about what it would be like if an additional worry was illegal immigrants vying for your job and being willing to work for less (which is still far more than they could make in their native countries).

When this 42% segment of the population’s frustration and anger at being deliberately pushed down economically reaches an explosive point, who do you think they’ll listen to? Their fears about inflation, illegal immigration, crime, and being ignored by the government in favor of other parts of the world even though they have been playing by the rules will cause them to follow authoritarian “leaders,” who will promise to give them lives of dignity. If this situation doesn’t correct itself, the leader who emerges will make Donald Trump look like a left-wing choirboy. This is one of the longer-term issues that needs to be factored into an investment policy. In the short term, the primary risk to this happy stock-market situation is an illiquidity event that causes market participants to seek out the safety of liquid investments. Since these deleveraging events usually come from a place no one expects, there isn’t much that can be done to protect against them except to have sufficient liquidity in a portfolio to take advantage of opportunities that arise. How much liquidity? That depends on you and your portfolio composition. Having enough liquidity to invest in three companies that reach an attractive level in a market downturn is a good target.

There is another major market factor that is being exposed now. The myth that the Fed is independent has been completely disproven by their actions. We are seven months away from the U.S. presidential election, and the Fed has just announced that they are going to cut interest rates three times between now and the end of the year. Hello? Can anyone think that cutting interest rates three times shortly before a presidential election is so crucial that waiting for the first quarter of next year, after the election, would not have the same economic effect? Cutting interest rates before the election is a political move. Just talking about three rate cuts is boosting the current administration’s chances for reelection. The Fed is not independent and never has been. Investors need to understand this crucial fact since we have evolved into an era when the Fed’s actions are deliberate in manipulating not only the level of the bond market but also that of the stock market, including the market’s volatility.

Many observers look at the stock-market level based upon historical data using the last forty years as a benchmark. This may be a grievous error. Here’s why: in the first stage of an inflationary spiral, the costs increase faster for companies than their revenues do. Eventually, and that time period is dependent on external unknown factors for each company, revenues and profits begin to reflect inflation and increase. The elevated level of the stock market includes anticipates the adjustment of businesses to this accumulated inflation, as well as the myriad other reasons for speculators to be aggressive — anticipation of more inflation, fear of missing out, generative artificial intelligence, anticipation of the Fed lowering interest rates, and an unknown number of other reasons. The point is this: those waiting for a serious collapse of the stock market may be disappointed. It’s possible, and even probable, that stocks may just move sideways for years as inflation is incorporated into stock prices. The stock market’s downward volatility will return — it just won’t be as great as many expect. What would cause the volatility? At this point, two general factors could have a serious effect on the market’s level. First, and less likely, is a geopolitical event that shocks and worries the marketplace. The reason this type of event is less likely is the experience of central bankers around the world over the last twenty years using their digital printing presses to flood the world with fiat money whenever they feel they can get away with it. In America we call this the “Fed put.”

The second, and most probable, reason for a drop in the stock market is a liquidity event. By that I mean some event that sucks massive amounts of liquidity out of the global monetary system, causing individuals and institutions both public and private to find themselves needing to sell assets to meet their ongoing obligations. Given the huge amount of leverage by governments, institutions, and the public, a large liquidity event could prevent central banks from being the savior of debtors and speculators, at least in the short-to-intermediate term. As with any event of this nature, it’s impossible to foresee where it will come from, but after it happens, everyone wonders why they didn’t see it coming.

How do you prepare your portfolio for this potential challenge? Liquidity, liquidity, liquidity. It doesn’t require you to run and hide or sell your companies. Knowing a target price below the current levels where you believe a few companies are undervalued and having the money to buy them is the key to seriously improving your portfolio’s long-term return and income stream.

The day will come. Be prepared and patient.