The Freedom in Knowing the Market Doesn't Owe You a Thing
The Fed takes out its 'needle' next week... The central bank's next move... A rate cut won't protect you... The only thing that will... Why the market owes you nothing...
I (Dan Ferris) was excited to see investor and author Howard Marks' new memo in my inbox this morning...
Marks is the co-founder of Oaktree Capital Management, and his memos and books are essential reading for all investors. I've recommended one of his books, The Most Important Thing, dozens of times in my newsletters, podcasts and conference presentations.
Marks writes about the complexity of investing in stocks and bonds in a way that anybody can understand, and which every investor should find useful.
In today's memo, titled, "On the Other Hand," Marks ponders the complexities of Federal Reserve interest rate policies...
He recalled the deterioration of the mortgage-backed securities ("MBS") market in mid-2007, which led to the July 31, 2007 bankruptcy of two Bear Stearns-managed MBS funds... JPMorgan Chase (JPM) bought Bear less than a year later for $10 a share, more than 90% below its pre-crisis high of $133.20 a share.
The Fed cut interest rates by 50 basis points (0.5%) on September 18 of that year.
In a press release announcing the cut, the central bank said it moved "to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate [economic] growth over time," likely as an attempt to distract investors from the growing disruptions."
At the time, Marks remembers asking himself...
If you went to the doctor for an ailment and he pulled out a huge hypodermic needle, would you take that as good news or bad?
The market took it as good news in 2007, and the S&P 500 rallied 6% after the cut, topping out a month later.
Ten more cuts followed over the next 18 months... The S&P 500 bottomed out more than 50% below its September 18 level – the date of the first rate cut.
Fast forward to our current 'Fed situation'...
The S&P 500 is up almost 20% this year, amid popular expectation of a 25-basis-point (0.25 percentage points) rate cut at the Federal Open Market Committee meeting next week.
The patient, though feeling quite well these days, will get stuck with a large hypodermic needle next week.
The signal is mixed... "You're fine, but if I don't stick you with this giant needle right now, you're not gonna be fine for long."
A real medical patient would naturally wonder... "Gee, how often will I have to do this?"
But, if history is any guide, the financial patient won't wince when stuck. He'll be elated.
As Marks wrote this morning...
All else being equal, there's a direct connection between declining interest rates and rising asset prices.
This is "the dominant feature of the world of finance over the last 10 years," he said.
Marks also addresses the seamier side of rate cuts: by reducing the returns from fixed-income instruments like bonds, the Federal Reserve encourages greater risk-taking, by both businesses and investors.
When the Fed lowers rates, businesses pay less for capital, encouraging them to invest in projects that they might not take on otherwise.
Meanwhile, investors can't earn enough income on their capital, encouraging them to speculate in riskier stocks, bonds, and God knows what else.
Overall, I agree with Marks' picture of the Fed...
He characterizes the job the central bank does as difficult, and much more complicated than most folks think.
When I hear people talk about the possibility that the Fed will prevent a recession, I wonder whether it's even desirable for it to have that goal.
But I also believe Marks doesn't go far enough, and he's definitely more polite than me...
Fed economists believe they're engineers, finely tuning a complex machine...
But in truth, the Fed's 400 economists are less like engineers. They're more like Stanley Kubrick's band of apes in the classic film, 2001: A Space Odyssey.
They're jumping, hooting, and hollering, unable to fathom the mysterious impenetrable obelisk that is the U.S. economy and its financial markets.
The Fed isn't bad at its job. The job is simply not doable and the Fed refuses to admit it...
I know I pointed this out in Wednesday's Digest, but I hope you'll agree we can hardly repeat it enough: The Federal Reserve was formed to prevent financial crises, back when a crisis was a relatively minor event that put a couple dozen banks out of business.
Yet within two decades, Fed-fueled speculation in the stock market would lead directly to the worst economic calamity in our history, perhaps in all of history.
Far from causing anyone to question the Fed's existence, let alone its role in the disaster, economists like former Fed Chairman "Helicopter" Ben Bernanke, insist that, if only the Fed had intervened sooner and more deeply, the whole episode could have been avoided.
James Grant, editor of Grant's Interest Rate Observer, was once asked what he would do on his first day at work if he were appointed chairman of the Federal Reserve.
"Resign," he said. It's the only answer a decent, intelligent human being with a sense of history could ever give. Grant understands what I also believe...
The job of the Fed shouldn't exist in the first place...
On Monday, I said poor corporate behavior was oddly reinforced by inevitable restructurings after disastrous acquisitions. I blamed liquidity – the ability to sell those troubled assets quickly and move on to the next mistake. The corporations take symptoms of disease as signs of good health and proceed accordingly.
Bernanke's view constitutes a similar perversion. If the patient doesn't respond to mild electroshock therapy, put him in a bathtub full of water, plug in the toaster, and throw it in there!
Maybe I shouldn't be so critical of Bernanke. After all, it's only human nature, isn't it? We frequently do a lousy job of setting up incentives.
Think of it this way...
Which of the following two actions would reduce a greater number of automobile accidents and related fatalities and injuries?
More airbags, seat belts, and harnesses? Or the total elimination of all those safety features, plus the installation of a six-inch steel spike protruding from the center of every steering wheel?
I bet the spike would discourage reckless driving, speeding, falling asleep at the wheel, and other big mistakes better than what we currently do, which is to make it as safe as possible to ram your car into a tree.
Sure, I'm oversimplifying...
But the point is, do you incentivize better behavior by alleging to protect investors from themselves, while mostly not actually doing so?
Or does that tell them it's OK to take huge risks?
If there weren't a huge regulatory apparatus around Wall Street, would as many people have gotten burned by Bernie Madoff?
Or would our society be a lot more cautious about so-called "financial innovations," from mutual funds to leveraged-loan exchange-traded funds ("ETFs") and everything between?
When you save someone from himself, do you help him... or hobble him?
I'm fully aware that our brains are built to fabricate stories not just for other people, but for ourselves.
We're built to lie to ourselves when it's necessary. Research suggests self-deception can "boost power and influence," according to a 2012 article in the Wall Street Journal.
My point is that we need to reduce incentives to deceive ourselves about how much anyone can protect us from our own behavior, whether behind the wheel or in financial markets.
America was once the land of self-reliance. Now it's the land of crybabies...
I hear endless clamoring for more rules and regulations, whining for the government to do something. And there's no end of hyper-educated, amoral, power-seeking busybodies so enthralled with their SAT scores and Ivy League status. They're convinced that only they are smart and great enough to lead us, the poor benighted masses.
Environmentalist and anarchist Edward Abbey wrote, "Grown men do not need leaders."
Maybe not, but they seem to love them all the same. They're led by the nose here and there, not least to buy and sell at the apparent behest of Wall Street via the actions of its minions at the Federal Reserve.
Is it riskier to understand you're doing something dangerous, or to deceive yourself into believing the government has your back?
Remember that quote from Galbraith's book I showed you on Monday?
He said regulation won't protect you. Only understanding how insane markets really are will protect you.
This understanding will protect you from the insanity of buying stocks based on the belief that Fed rate cuts will protect you. "Not fighting the Fed" will only fatten you for the inevitable slaughter. (Remember the old adage: Bears make money, bulls make money, pigs get slaughtered.)
I'm sure many of you will find these suggestions a bit insane...
"Of course we need government to protect us," you might think. Or even worse, "That's all well and good for sophisticated folks like you and me, Dan, but what about all the little people? Who'll look out for them?"
The same people who always do: themselves or nobody.
It's crazy how we elect the alleged best and brightest and send them to Washington, D.C., and the best they can do is tell us we're incompetent to run our own lives and we need to be protected from everything by superior individuals...
I mean folks like Elizabeth Warren, who wants to protect borrowers from themselves by canceling their debts.
She is willing to incentivize the worst possible behavior by separating individuals from the consequences of their actions. If she doesn't understand, she's ignorant. If she does understand, she may be downright evil.
To be learning and growing, you must get feedback from the world, interpret it, and respond appropriately. That's life. Denying you that feedback is as wrong as denying you the rewards when you get it right...
I don't care about your politics. Left, right, center... none of it matters.
Warren is just a convenient example, but both sides are filled with terrible ideas. Our Republican president is begging for the Fed to cut rates, saving us all from over-allocating capital to assets on steroids. He's as wrong as she is.
How to navigate this mess is a tough call. The late, great investor and philosopher Harry Browne gave his daughter a single piece of advice, which can help you cut through all this busybody-inspired noise: Nobody owes you a thing.
How will you behave in the financial market when you believe nobody owes you a thing?
Will you be more or less likely to buy things you don't need with (borrowed) money you don't have? More or less likely to speculate on hot initial public offerings ("IPOs")?
More or less likely to own a pumped up a stock like Tesla (TSLA), which Empire Financial Research's Whitney Tilson rightly calls "the most dangerous stock in America."
Every now and then I hear something like, "It's a different world today... things have changed since... whenever. Only more government can protect us now."
That is demonstrably false. Human nature hasn't changed since our brains grew and our prehensile tails dropped off (and really, they're still there, just way smaller).
Our responses to incentives haven't changed.
We're the same group that lucked out and got bigger craniums than the other apes roughly 200,000 years ago. We're still using the same operating system designed to avoid getting eaten by tigers.
We're still primarily motivated by fear in many areas: fear of missing out, fear of not selling at bottoms, fear of not buying at tops... fear of not appearing as rich as the Joneses...
In financial matters, more government has led us to worse economic calamities, not milder ones.
That hypodermic needle I mentioned before isn't loaded with Vitamin B. It's filled with high-fructose corn syrup, and the FDA will not protect you (the corn lobby pays better than you do).
Where does this leave us if the Fed cuts rates, as expected?
I can't say where it leaves you, any more than I can digest your lunch or raise your kids for you.
You need to figure it out for yourself. By all means, marshal plenty of well-informed sources around you – yes, including all of us at Stansberry Research – to help you decide.
But the decision to take financial risk is yours. Don't let anyone try to take it or its consequences from you. You need them if you want to be fully alive.
As for what I think you should do, anybody reading my Digest contributions the last couple weeks probably already knows:
- Buy value when and where you find it, like we do in Extreme Value
- Don't overpay for any asset
- Buy some gold
- Hold plenty of cash
Overall, it's not as important to make changes to your portfolio as it is to – as Howard Marks puts it in The Most Important Thing – have a sense for where we stand, and a respect for the cyclical nature of all financial markets.
52-week highs (as of 7/25/19): Axis Capital (AXS), Blackstone (BX), New Oriental Education & Technology (EDU), Hershey (HSY), Masco (MAS), and W.R. Berkley (WRB).
A quiet mailbag today. Do you have a question, comment, or concern? Send your notes to feedback@stansberryresearch.com.
Good Investing,
Dan Ferris
Vancouver, Washington
July 26, 2019