Less Complexity, More Intellectual Honesty
By Julien B. Booth
September 6, 2022
I hope this note finds you and your family healthy.
Life is such a wonderful collection of cumulative lessons in realizing how little we know. Each of us figures this out in our own time and fashion. The markets dispel lessons to me daily. Recognizing my ignorance and the collective nonsense from the 24/7 “experts” in every given field imaginable is now imperative for survival.
My intent below is to touch on several macro themes that now dominate financial markets and how they must be integrated into our new decision making models. On balance, I am becoming more positive now than at the height of the 2021 speculation. I have always found that uncovering true value is far more fruitful when the broad consensus is this negative.
Similar to local banking, the original intent of Wall Street/modern institutional banking was to provide access to capital for functioning businesses needing growth capital, refinancing needs, access to new plants and equipment etc. This system has generally worked well judging by the U.S. markets becoming the de facto standard for global companies wanting to list their bonds and stocks on U.S. exchanges. We are fortunate to live in the U.S. on many levels.
For the past several years the complexion of markets has in many ways departed from the underlying capital structure (debt, equity) needs of corporate clients. The combination of near 0% interest rate policy, $3TRILLION of direct stimulus, the “growth” of new capital products (Crypto Currency ecosystem) and other cultural changes fueled a Golden Age of Wall Street being able to “manufacture” products for investors to buy.
Wall Street never fails to satiate the desire of investors watching their friends get “rich” in the newest creation. The list of recent products is long, but the highlights include SPAC ($2 Trillion of special purpose acquisition companies), NFT (non fungible tokens built on Crypto backbones), and a myriad of companies (Robinhood/Coinbase etc.) and ETFs promising growth rates beyond the reason of a basic observer of history. Tom Brady and Matt Damon advertising crypto were a tell after all!
Additionally, many individual companies are now primarily just structures that derivatives, options, ETFs and other “products” can be created upon. The meme stock boom, something I still do not fully understand from a risk perspective, and the rampant bidding wars in real estate are further bellwethers of the amount of risk-taking behavior of the recent cycle.
The short story, when you give money directly to individuals, they are seldomly prepared to make prudent, long duration financial decisions. Wall Street was glad to assist in separating the two.
In many ways, corporate structures have become a skeleton where the finance industry can create products. The underlying stock option volume on the largest Nasdaq companies is measured in $Trillions and creates massive transaction volume (think commissions). Net, net, these derivative products materially change how securities behave. Boring securities (like bonds) are now attached to derivatives (options etc.) that introduce volatility. Thank goodness for financial innovation (note sarcasm).
Ultimately, every system of trade/cooperation is built upon the integrity of the underlying participants. I believe it is fair to say we are in the post boom period where rationalization of past behaviors is being realized. It is not pleasant to watch, but it is absolutely necessary for a healthy system. Capital often ends up where it is treated best.
It is important to recognize that Federal Reserve 0% policy has contributed to much of the historic speculation. We have written about QE and 0% rates for some years and I will not belabor this topic. The more the 400+ experts and economists at the Federal Reserve get involved (heavily influenced by political flavor) the less resilient our system seems to become. The moral hazard of constant bailouts has created a “Don’t Feed the Bears” type of conundrum for the entire financial system.
I have had to come to terms with accepting what “is” vs. what “should be”. Regardless if I am right or wrong about an underlying company’s specific performance – the way the security will trade in the near term – is heavily influenced by technical factors. The trading behavior has often rendered the value of a “boring and safe security” moot – therefore making its portfolio behavior less valid in a traditional context.
Holding periods for securities (now measured in weeks) provides further empirical context. Few people view debt and equity in the context of owning a claim on an actual business.
The equity positions we have accumulated act as a port in a storm. I was looking for 1) Lower beta names (volatility) with 2) high, long-term insider ownership and 3) the most stable shareholder base possible. Additionally, I wanted securities with anti-fragile underlying financials (bulletproof). It has worked with limited success. Utilities have been the standout from a capital preservation standpoint – driven by perception of safety vs. the underlying interest rate preference. Gold stocks have not worked to date.
The markets have two additional structural headwinds that also will be reconciled in the coming quarters: $Trillions in Quantitative Tightening (opposite of new money QE) and multiple quarters of Year over Year growth declines vs the stimulus fueled excesses. These factors conflict with the traditional way of viewing slowing growth and slowing inflation = interest rate declines.
Interest rates will decline, but only after the Federal Reserve puts the economy into recession – ostensibly to quell the inflation created by their predecessor policy. Ironically, even a casual observer of history knows that inflation is always a monetary phenomenon.
The highwater mark for risk assets was mid November 2021. This high watermark coincided with the step down in “asset purchases or QE” from $120 to $105 Billion per month. The Federal Reserve policy (along with $3 TRILLION of direct stimulus) had been juicing “everything”.
Risk behavior peaks can be seen in QE1 (March 2010), QE2 (June 2011), and QE3 (Mid 2016). There has only been one period of QT (late 2018) that was abruptly halted after a steep drop in risk assets. The Federal Reserve then “pivoted” under Presidential pressure by cutting rates in 2019. There is a pure circus mentality to this policy from a capital allocation standpoint. I so wish for some degree of intellectual honesty from leadership (at any level).
Net, net Federal Reserve policy is the largest factor in my present equation. The balance sheet of the Fed exceeds $8.2 Trillion. They are the elephant, the room, and the entire building. We must accept this reality.
The above comments are subject to change as we get inflation data, further growth slowdown indications, Fed policy changes, etc. I welcome a wide open dialogue. Anyone who claims to fully understand the world these days is delusional, a liar, or both.
Thank you for your interest.
Julien B. Booth
Chief Investment Officer – Fixed Income & Real Assets
BRC Wealth Management