The End of the World as We've Known It
Invert the last 20 years... A punch in the face... The coming shock... Will the Fed chicken out?... Jury-rigging the U.S. financial system... The 'helicopter parent' economy... After the end of the world... No historical precedent...
I (Dan Ferris) like information and insights that are too compelling to ignore...
I like the way they seize hold of my mind and seem to insist that I pay attention.
After years of training my mind to look for certain types of information, I trust it to let me know what's worth paying attention to and what isn't.
Today's Digest is a result of a handful of comments and insights I've heard from investors I've spoken with, listened to, and read over the past week that I simply can't ignore...
To be completely fair, I realize that their comments are stuck in my head and won't leave me alone because they support my own view. So, yes, this essay is a massive exercise in confirmation bias...
But it's also a compelling and downright fun smattering of ideas about the current state of markets from some of the greatest living investors.
Taken all together, the comments savaging my thoughts these days outline a message filled with both risks and opportunities – economically and financially speaking...
We'll start with a big idea...
We are witnessing the end of the world as we have known it for the last few decades...
The COVID-19 pandemic, economically destructive lockdowns, heavy Federal Reserve and U.S. government intervention to counteract those lockdowns, and the war in Ukraine have ended one era and started another.
For investors, the previous era was characterized by reliable returns in equities and bonds and easy financing for large purchases. Those days are gone...
As one of the commenters I'll quote has pointed out, we are living in economically unprecedented times, for which he has found no historical analog.
This might sound startling to you...
Practically, this also could make it difficult to follow the advice I like to share frequently... Prepare, don't predict. After all, how do you begin to prepare for something that has never happened before?
Well, let's look now at some of those irresistible comments and insights stuck in my mind, which all underscore that point... and perhaps provide some ideas on what investors ought to do.
The first compelling insight was spoken during the current episode of the Stansberry Investor Hour podcast... by my friend, investor, and author Vitaliy Katsenelson.
Vitaliy joined us to talk about investing and his new book, Soul in the Game (which I read before it was published and highly recommend). He summed up my overall feeling today well when he said...
'Whatever happened to you over the last 20 years, just invert it'...
Devotees of Warren Buffett and his wise, old partner Charlie Munger will recognize the advice to "invert, always invert," as it's often given by Munger as a way to gain valuable insight in many areas of life.
It goes like this: To understand any problem better, learn to flip it upside down. Often, that means starting at the end, then working your way backward to see how you got there... It's a simple, effective mental model for gaining a fresh perspective.
To put another spin on it, this exercise is also a convenient way to remind yourself that the near-term future rarely resembles the near-term past.
We can quibble about the definition of "near term," but over the last 20 years or more, interest rates were falling, housing prices were rising, stock market valuations were rising, and the economy was growing (perhaps faster than it deserved, as Vitaliy suggests).
That's all in the past...
Now, we're facing a new problem...
Interest rates are rising, the stock market's overall valuation has fallen (and yet is still very expensive by the most reliable metrics), and the economy is shrinking in inflation-adjusted terms.
It's easy to get stuck in the thought pattern or follow the assumption that it'll all revert to the way it was for two decades... but it's probably wrong to rely on that solution, too.
What we haven't yet seen "invert" is home prices... But if you've read my recent Digests, like last week's, you know I'm expecting that trend to begin any day now.
One clue that it's imminent – besides the fact that mortgage rates have doubled this year so far – is the sharp drop in homebuilding stocks.
These companies are making plenty of money, but as a group, homebuilders are down roughly 40% this year, as shown by the performance of the SPDR S&P Homebuilders Fund (XHB)...
If housing were a true inflation hedge, they'd be down a lot less, if not up.
Vitaliy also expects the "reverse wealth effect" that I've described in recent Digests.
Specifically, that means lots of consumer demand has come from consumers borrowing and spending because they felt wealthy as their homes and investment portfolios rose in value.
In today's environment, with stocks in a bear market, they must already be starting to feel less wealthy. Lower housing values will make them feel even poorer.
Another investor I listened to recently is Ray Dalio, the billionaire founder of Bridgewater Associates, the world's biggest hedge fund with roughly $154 billion under management.
Dalio recently appeared in a video interview alongside Jeremy Grantham, co-founder of asset manager GMO.
In the interview, Dalio put flesh on the bones of Vitaliy's comments. Dalio's speaking style tends to lean toward stream of consciousness, so I'll sum up the insight that caught my attention...
We've just lived through a period where financial assets became much more valuable relative to real assets, typified by the 40-year bond bull market and the more recent decade-plus equity bull market.
But now, Dalio said...
The stock and bond bull markets have been hit with an inflationary 'punch to the face'...
Dalio suggests, as I shared via Lou Barnes of Cherry Creek Mortgage in last week's Digest, that investors aren't prepared for the inflationary shock that has hit them.
Dalio has studied 500 years of the history of reserve currencies. He repeated his view that "cash is trash" (including bonds) and said financial assets generally would fall in value.
He mentioned commodities as a way to get out of financial assets and into real assets.
The inflationary "punch to the face" line stuck with me. It reinforced my view that 2022 has begun by ending the world as we knew it.
Dalio's image of a brutal, unexpected inflationary shock was echoed by Rick Rule, the former Sprott (SII) executive (and still its largest shareholder), in a recent interview in Zurich with Stansberry's own Daniela Cambone.
Rule pointed out that the Great Inflation of the 1970s began during the mid-1960s. But he said folks hadn't experienced inflation for 20 years. It took them five years just to start noticing that their living standards were falling and their money didn't have the same buying power it once did.
He said folks know today that Consumer Price Index ("CPI") inflation is high... but not enough people have experienced a dramatic enough reduction in their living standards as a result of inflation – yet.
Since the shock hasn't hit home yet, they haven't changed their behavior to adapt to the new environment.
When they do, it'll shock the economy, causing a decline. Rule believes when the inflation shock finally hits enough folks hard, it'll be severe enough to make the Federal Reserve reverse course on its current policy path... and lower interest rates rather than raising them.
Another investor who believes the Fed will stop raising rates due to a slowing economy is billionaire trader Stanley Druckenmiller. He said so in a recent interview during the Ira Sohn investment conference.
But the Druckenmiller comments that really stuck with me were about two historical statistics that are potentially worrying and point straight to an increased likelihood of a recession...
We mentioned one of them in the June 13 Digest. Druckenmiller said...
Once inflation gets above 5%, it's never come down unless fed funds have gotten above the CPI.
Inflation as of the most recent CPI report is 8.6%. The fed-funds target rate that Druckenmiller is referring to after the most recent Fed meeting is 1.5% to 1.75%.
So, if history repeats or even rhymes well enough, the fed-funds rate will have to rise to roughly five times its current level.
It's hard to imagine how the economy and markets would look if fed funds rose that much. But I bet it would be ugly. Housing would crash. We'd be in a major recession. Stock prices would be way lower. It's easy to see why some folks don't believe the Fed will go that far.
The second worrying stat that Druckenmiller threw out was this...
Once inflation is above 5%... it's never been tamed without a recession. So, if you're predicting a soft landing, you're going against decades of history.
In other words, history suggests that interest rates will go quite a bit higher and that a recession is the inevitable result.
But, importantly, Druckenmiller agrees with Rule and thinks history will not repeat this time, and that the Fed will balk from pushing its benchmark target rate above the CPI.
He believes, like Rule, that the economic and financial damage will grow intolerable and the Fed will chicken out.
It's hard to disagree with that point of view. In fact...
The Fed has 'chickened out' a lot over the years...
Here's the history of the fed-funds rate since 1982...
This chart shows a series of lower highs and lower lows...
In other words, the Fed frequently felt it had to lower interest rates, usually to try to prevent or tame a recession... and has never been able to return the benchmark rate to its previous high.
There was always a new crisis or simply no courage to push it higher and risk creating one.
It's a clear pattern of chickening out. We normally think of monetary policy as cyclical, alternating easing cycles with tightening.
That's true in the short term, but the chart shows 40 solid years of easier and easier monetary policy.
Maybe you don't think this is such a big mistake.
I suppose you could say, "Well, Dan, the Fed was simply adjusting to new market realities. And after all, the economy has continued to grow, even though growth has slowed during the period on your chart..."
To take that rosy argument further, you could say, "And overall, the Fed has done a fairly good job of fulfilling its twin mandates of price stability and low unemployment, COVID-19 and the occasional recession notwithstanding."
Sure. Everything is just fine. The Fed is a mostly benign presence.
Or maybe not.
Perhaps the above chart shows the ongoing attempt to jury-rig the U.S. economy...
Maybe Fed officials have a strong bias toward ever easier monetary policy because it has tended to support asset prices, which might just help them get lucrative banking and speaking careers when they move on from public service.
And maybe that's not good for the rest of us. The economy and financial system have grown more and more complex, and the Fed continues to use its extremely limited, primitively simple, top-down tool set to ostensibly (but not really, it must know) tweak a multitrillion-dollar economy that is the result of untold bottom-up interactions between hundreds of millions of people.
Whatever you may conclude, the chart of fed-funds target data shows that there is no such thing as "returning to normal," at least not in the last 40 years.
Given the sequence of lower highs in the fed-funds target rate, I wonder at what level of interest rates the Fed will chicken out. The last top was 2.5% in December 2018 – and it got a lot of the credit for an associated 20% decline in the benchmark S&P 500 Index.
The Fed chickened out then, too. Jerome Powell, who had taken over as Fed chair in February 2018, stopped raising rates in January 2019 and then began lowering them to near 1.5%... before the emergency cut to near zero in March 2020 in response to the COVID-19 crisis...
Now, the Fed has raised the upper limit of the fed-funds rate range to 1.75%, with the futures market predicting at least one more 75-basis-point (0.75%) hike next month, which would put rates back at 2.5%.
Me? You probably know how I feel...
I don't believe the Fed controls the market or the economy...
At least not as much as is generally assumed in the popular financial press.
It controls its own actions and nothing more. If it could control anything else, you'd think it would act to prevent crises instead of constantly overreacting and underreacting to them.
I don't think the Fed will reverse course... at least not in time to prevent a disastrous recession.
The Fed's constant lowering of the general level of interest rates is over... You should invert your experience of the last 40 years.
If you don't believe me, consider the fact that even one of the Fed's greatest beneficiaries – a megabank CEO whose fortunes are backstopped by the Fed – knows what's coming and has issued a loud, clear warning.
As Digest editor Corey McLaughlin reported on June 2, JPMorgan Chase (JPM) CEO Jamie Dimon, perhaps the most respected bank executive in the country, warned a roomful of analysts and investors earlier this month:
I said there's storm clouds but I'm going to change it... It's a hurricane...
You'd better brace yourself. JPMorgan is bracing ourselves and we're going to be very conservative with our balance sheet.
That's from the guy who criticized endless doomsaying in the aftermath of the financial crisis, saying too many people saw "a black swan behind every rock."
Dimon has no reason to do anything but parrot the status quo today, but he's afraid of Fed tightening and he's afraid that the war in Ukraine will have bigger, longer-lasting effects. He's not saying he thinks the Fed will chicken out. He's telling us to prepare for a hurricane.
And as the CEO of one of America's biggest banks, Dimon must also know that constantly propping up the banking system with lower rates as the Fed has done just makes it weaker and more fragile. There is no way he's unaware of the longer-term cycles and the recent history of Fed policy.
He must know that, to a great extent...
The U.S. banking system, and to an extent, the economy, is like the child of helicopter parents...
When this poor youngster must finally, inevitably deal with reality on his own, he'll be a basket case.
Endless propping up of anything can't go on forever, and the whole charade's time is up.
That's why Vitaliy's comment is spot on, and that's why I say we're seeing the end of the world as we have known it.
Now, what does that mean for investors?
Like Dalio has said and like I've said numerous times, you must be truly diversified. You must prepare your portfolio for a wider range of outcomes.
The advice to "Prepare, don't predict" works terrific for unprecedented times...
Cash is the ultimate diversifier for an equity portfolio. Yes, as Dalio has said, your cash's buying power will decrease as inflation wears on. You'll definitely feel it when you pay bills, put gas in your car, or buy groceries.
But there's more to it than that. The farther stock prices fall, the more valuable your cash is relative to your stocks, helping to reduce portfolio volatility.
More importantly, as stock prices fall, the option value of your cash grows. (Buffett has called this idea "optionality.")
Cash becomes like a call option that never expires on the extremely attractive future opportunities you'll be presented with as the bear market pushes equities into irresistible bargain territory.
I also continue to believe gold will shine because it is no one's liability and doesn't depend on the solvency of any counterparty or the smooth operation of a computer network.
I also will continue to recommend attractive high-quality equities to Extreme Value readers whenever I find them.
But let's not stop here...
If we're really going to prepare...
Let's think about what could be around the next corner... If this is the "End of the World as We've Known It," what will our new world look like?
To this point, I put Vitaliy's ideas – and the others I've discussed today – to work this week and made a list of the characteristics of the last 20 years.
Then I inverted them to paint a picture of the environment you might want to prepare for and assets to consider...
- Higher interest rates, not lower
- Lower equity valuations, not higher
- Positive stock/bond correlation, not negative
- Sell the Rally, not Buy the Dip
- Risk-off mentality, not risk-on
- Cash-generating real assets, not innovation without profits or revenues
- Commodities, not stocks
- Foreign stocks, not U.S. stocks
- Value stocks, not growth stocks
- Retail traders moving markets, not institutions
- Ideologically driven capital allocation/economic policy, not economically driven allocation/policy
I'm not saying all these trends will hold 100% of the time for the next several years. But I'm saying that Vitaliy is generally right...
These changes and probably many more like them will characterize the world as we will know it over the next several years.
For example, take No. 10...
I don't mean that institutional traders will lose all ability to move markets and that only retail traders will move markets. I'm just saying that the "meme stock" episode shows us that retail traders are back as a force to be reckoned with after a decadelong period in which institutional money flows dominated the market.
The latest example is cosmetics firm Revlon (REV), which has soared more than 400% after declaring bankruptcy last Thursday, largely due to retail traders buying. The same thing happened when car-rental company Hertz went bankrupt in May 2020 – then rose 825% to become the original meme stock.
No. 11 comes in part from Dalio's recent interview...
He gave the example of Elon Musk's offer to buy Twitter (TWTR). Dalio noted, as we did, that Musk said plainly that it's not about money and he doesn't care about the economics of the business model of the company.
Making a play to own Twitter was all about freedom of speech... ideologically driven, just like Dalio said.
I feel a little funny quoting Druckenmiller and Dalio...
They're so famous among investors and so often cited as authority figures that it makes me feel like some lazy finance writer without a viewpoint, instead of a risk-taking practitioner who publishes research for real, self-directed investors.
But I think it's ultimately a healthy sign. The fact that these famous voices keep echoing in my head acknowledges that this moment is an increasingly difficult one to navigate...
Druckenmiller noted more than once during his Ira Sohn interview that the current combination of inflation, low interest rates, and the expectation of an economic downturn is a scenario for which he has found no historical example.
Even when history is a good guide, the future is still unknowable.
When history provides no guide whatsoever, you'd better do as Dalio suggests and make sure your portfolio is adequately diversified.
And you'd better do as Dimon suggests and prepare for a hurricane. With any luck, you'll be ready for a superstorm and it'll wind up being a mild thunderstorm.
52-week highs (as of 6/23/22): None.
In today's mailbag, feedback on Matt McCall's Thursday Digest... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"Matt needs to temper his assessments of eVTOL [electric vertical takeoff and landing vehicles] sales by recognizing every one of these flying taxis need a pilot – now in short supply – and, compared to current air taxis using fossil fuel, every eVTOL is range limited (whose batteries are charged by generating facilities using predominantly fossil fuel)." – Paid-up subscriber Jim R.
Good investing,
Dan Ferris
Eagle Point, Oregon
June 24, 2022