Author: Diandra Ramsammy

Chances are that you remember Aesop’s ancient fable about the Tortoise and the Hare. In case you need a reminder, in that tale the speedy Hare mocks the slow-moving Tortoise, who then challenges it to a race. The Hare sets a scorching pace and leaves the Tortoise far behind. Then, sure of its victory, it takes a nap, only to find out later that the Tortoise has slowly but steadily won the race! The investment terms “value” and “momentum” often remind me of the heroes of Aesop’s fable. Value investing is a steady tortoise, and momentum investing is a jumpy hare. Value investors buy cheap stocks, momentum investors buy stocks that have been going up.

As you may know, we consider ourselves contrarian value investors. We like to buy stocks when they are down, cheap, and out of favor. In the early years of my career though, I briefly shadowed a successful momentum growth investor. I witnessed how value and momentum fared during the run-up to the end of the last bull market in 2007, the tricky investment conditions in 2008-2009, and finally, the first stretch of an unconvincing bull market. It was not an easy time for either momentum or growth investing.

There is a huge timing difference between when value investors buy and when momentum investors buy. The former buy when the price is low, and the stock may be regarded with scorn. Momentum investors get interested much later in the business cycle, waiting to see signs of an established trend. Their ideal buying moment is when a stock’s price rises, all the metrics show growth and improvement, yet there’s room for momentum to endure. Everybody knows, owns, and loves the stocks that momentum buyers seek out. The usual trouble comes with short-lived trends that are challenging for momentum investors to identify and time. The very best days for these investors come in the late stages of a bull market, when trends are well-established. The experience of a momentum buyer could be compared to jumping onto a train that’s already in motion.

We at Sicart consider ourselves not only value buyers, but also growth holders. Each value stock goes through a fairly frequent and repeatable pattern. It usually starts off with a big sell-off, when the stock gets much cheaper. At that point many investors doubt it will ever recover. They may well be right, but if they are wrong, a disciplined value investor has a chance to buy a great business at a very attractive price. When this happens, it’s usually not because a value investor is much smarter or faster than anybody else, but because he or she is more patient. Eventually, the business improves, the stock starts to go up. It not only recovers, but it also starts a healthy steady ascent, which eventually attracts momentum investors. They join the party, bidding up the stock even higher. First the gap between value and price disappears, and the stock is no longer a bargain. Then the price starts to exceed the value of the business. Value investors start to get anxious, but momentum investors don’t worry as long as the price continues to rise.

When more impatient value investors start to sell, we at Sicart become growth holders. We believe we bought the stock at the right price, and now we let our winners run. That’s where I combine my value investing discipline with the lessons I learned shadowing a momentum growth investor. There is no rush to take the gains, because there is a lot more money on the table. It’s patience, again, that helps me as an investor.

There has been a lot of talk lately that value investing doesn’t work, and momentum is the way to go. This is the same song we hear every 5-10 years as bull markets mature. Buying more of the fastest-rising stocks has become the winning formula, and passively riding out the wave has performed the best.

But I believe that value investing always works. To me that means being able to compound wealth slowly and steadily over time, without exposing investors to a risk of losing it all. Of course, there are times when “value” as a style delivers lesser short-term returns than “momentum” investing or even the indices as a whole. That’s the case right now, but it shouldn’t worry us much. Remember that, as with the tortoise and the hare, the goal is to finish the race!

I also learned from my brief experience with momentum investing that it works the best, and attracts the most attention and money, when it’s about to lose its effectiveness as an investment strategy.  When momentum turns, it’s not a gradual shift, it’s a drop off the cliff. Individual stocks – or the entire market — can give up the entire gain of a few years, in a swift 50% drop. For a single stock, that could happen in a matter of days. Each time these cycles occur, the latecomers to the market party believe that they will ride it to the top, get out, and wait until the dust settles. Unfortunately, that’s rarely the case. I’d dare to argue that no strategy has lost more money for stock investors than chasing momentum in the last hours of a long and tired bull market.

However, when the drop happens, and momentum investing goes out of favor, it’s a good time to behave like an investment tortoise – slow and steady, stay on your path. Pick up more cheap stocks, let them recover, and watch them become momentum stocks all over again. Aesop told the story 2,500 years ago, La Fontaine retold it 300 years ago, and we witness it in every alternation between bull and bear markets.

I’m not saying value is better than momentum as a philosophy (though you know where I stand), but I do say that there is wisdom in both. Why not be a value buyer, and growth holder?  The most renowned investors of our times, Warren Buffett and Charlie Munger, are just that. They buy when the price is right, and hold stocks forever. Many of their value stocks have long since become momentum stocks. They know the temperament of the latter, hence their ample cash reserves, ready to be deployed when the momentum abruptly comes to a screeching halt, and buying opportunities arise.

As investors, we definitely feel like a trusty tortoise rather than a hasty hare these days. How do you feel? Like a tortoise or a hare?

Happy Investing!

Bogumil Baranowski

Published: 2/6/2020

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

 

In investing, as well as in life, it pays to avoid dark alleys. Common sense and experience teach us what those dark alleys might be in life: dangerous places where trouble lurks and help might come too late. In investing, dark alleys are investments that can get us in serious trouble, and the worst of them can lose money for bears and bulls alike.

In my recent dinner conversation with friends the topic of Tesla came up. Yes, that celebrated electric car manufacturer led by billionaire Elon Musk. To disciplined value investors, Tesla has for years been the symbol of an overvalued, overhyped stock. The price has whipsawed dramatically a few times over the years, hurting both impatient bulls, and more recently, daring bears trying to short the stock and benefit from the price drop. We at Sicart have not taken either side of the trade, nor we have any intention to do so anytime soon. Buying a stock gives us an unlimited upside while selling a stock short would give us an unlimited downside, and you know how we feel about losing money!

To us, Tesla has been the investing version of a dark alley.

When I started out in this field, I thought that to be a successful investor you had to know it all, and have an opinion about everything. I would read all the news every day, go to every single conference I could find, take every meeting possible — for the sake of becoming well-informed. The time I spent that way jump-started my career, largely because it helped me define and shape what Warren Buffett calls “the circle of competence.” That is to say, what I really know well, and where I can have a true edge.

Fifteen years later, I have never stopped learning. Recently I’ve been spending evenings reading the most recent annual reports of companies that we respect and we would like to own. I’m much pickier than I used to be, though, about how I use my time. I also have a much stricter “no” filter. If a stock shows any of the red flags we watch out for, I dismiss it immediately. This practice has been a huge time saver, and, looking back, also a major money saver.

So, what are the red flags, in our opinion? First, too much debt. Second, questionable management. And third, an industry in a secular decline. Tesla grew its debt load from half a billion to over $11 billion in order to fund its losses over the last 7 years alone (Source: Company Filings). Almost all of its debt matures in the next 5 years. Elon Musk’s business practices might have rubbed too many investors the wrong way too. Finally, global car sales have been dropping, and 2019 brought a bigger annual sales drop than 2008, which was battered by the financial crisis. As a matter of fact, last year the annual global drop in car sales exceeded the number of all the electric vehicles sold around the world. (Some consider electric vehicles to be a separate market, but even so, that’s a dramatic plunge.) It does pay to remember that the car industry is cyclical, often tracking the general economy. Not surprisingly, at low points in the economy, debt-laden manufacturers often go bankrupt, wiping out their equity holders.

Now let’s go back to Tesla and those dark alleys. I have nothing against Tesla cars. I appreciate the idea of an environment-friendly means of transportation. However, as a student of history, I know that electric cars first hit the roads back in the 19^th century. They were popular at first, and even held a vehicular land speed record for some time. But then roads improved in the early 20^th century and range started to matter. At the same time, oil discoveries made gasoline more readily available. Soon, gas-powered cars dominated the market.

Fifty-some years later, electric cars still represent less than 2% of the global car market. And though Tesla as a company also sells batteries, solar panels, solar roof tiles and other products, cars represent 92% of its sales. Tesla and Elon Musk were able to create a renewed excitement and enthusiasm around electric cars. Tesla was meant to be expensive, high-end, luxurious. As a consumer, if I were in the market for a car, I might see Tesla as an intriguing alternative to traditional brands.

That alone wouldn’t make me want to own the shares of the company, though.

At least two of those red flags I mentioned are flying high for Tesla – high debt, and questionable management. With a $100 billion market capitalization, and $20 billion in sales, Tesla has never made money. In contrast one of its large, old, well-established competitors, which has worldwide sales 7 times higher than Tesla, is valued at 1/3 of Tesla, while earning $5B in profit and paying a 6% dividend. I’m not urging you to rush out and buy shares in any legacy car manufacturers, I am pointing out that with Tesla you are paying a lot for the growth, and an elusive promise of earnings one day. From the valuation perspective, Tesla is unquestionably expensive.

If you were to take the other side of the argument, and sell Tesla short, hoping to benefit from a price drop, you have to argue against boundless enthusiasm that isn’t entirely rational. The stock just recovered from a $170 low, and flew up to over $600, with some claiming it could reach $6,000.

As a disciplined investor, I see no reason to buy Tesla on the chance it goes that high. Nor do I see a reason to stand in the way of a moving train and take a bearish stand.

We know that there are thousands of stocks out there, and we believe that patience will bring hundreds of opportunities to buy them. We may like the car and enjoy Elon Musk’s showmanship, but you won’t see us buying Tesla shares anytime soon. Why? Because we like to stay out of dark alleys, in investing as in life.

Happy Investing!

Bogumil Baranowski

Published: 1/29/2020

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

In a recent conversation, a prospective client asked me a timely question: “What if this stock market will go up forever?”  In our opinion, no words have created more investment opportunities on the one hand and investment trouble on the other than “never” and “forever.” Investing requires us to continuously make our best-educated guesses about the future. We believe that the stock market aggregates those guesses in the most efficient way, but it’s driven by fear and greed, and oscillates between those two absolutes of “never” and “forever.”  

Investors usually want to buy low and sell high, but we seem to do the exact opposite. We at Sicart Associates often say that we are contrarian investors. We joke that it’s not because we like to disagree with everybody else, it’s because everybody else seems to disagree with us. In truth, we pride ourselves in seeing opportunities where most other investors don’t.

“This business will never recover.”  There’s a statement we’ve heard too many times. The stock price drops 50%, and immediately many investors who have praised the business suddenly can’t stop finding new challenges and issues. It can be very easy to confuse short-lived, temporary trouble with long-term lasting damage to the business. One failed product launch that has no bearing on the brand perception may be forgotten in a matter of year or two. The trouble, in our experience, is that most investors can’t imagine a year or two in the future. The stock price may imply that this business will NEVER get better. But to contrarians, it’s that very belief that creates a buying opportunity. This opportunity is available to us not because we are smarter or faster, but because we are patient. We can wait, trusting that “never” is only few years away.

“This stock will go up forever.” That’s another belief that’s led too many investors into trouble. In the 1970s the “Nifty Fifty” stocks were once believed to be invincible. Among them were Kodak, Polaroid, and DEC, all defunct since. More recently, the dotcom-era stocks of the turn of the century and the FAANGs of today are the “forever” stocks. Not all “forever” stocks of any era vanish in a matter of a decade or two, but buying them at an all-time high may ultimately result in dismal returns. However, price drops and buying opportunities may occur if an investor can expand his or her investment horizon to several years instead of several months. The history shows that usually the longer it’s been since the last major price drop for any “forever “stock, the higher the odds are that one is on the way — and usually the bigger the drop can be!

It’s not just individual stocks, but also the entire market that operates in absolutes. In my adult life, I have witnessed two bottoms, one peak, and another peak in the making — the one we’re all watching now. The consensus opinion each time is the same:  at the low, many believe that the market will never recover, yet it does. At the top, people think it will never falter, yet it does. This time is no different.

In our experience, “never” and “forever” are terms used mostly by those whose patience is limited, and whose investment horizon is counted in months, or a year at most.  If we at Sicart were to employ those words, we would say, “We never want to lose money, and we intend to grow it forever.” Otherwise, we will patiently buy low when others see no hope, and vigilantly sell high when others see no danger.

As Benjamin Graham, the father of value investing, famously said: “Though business conditions may change, corporations and securities may change, and financial institutions and regulations may change, human nature remains the same. Thus the important and difficult part of sound investment, which hinges upon the investor’s own temperament and attitude, is not much affected by the passing years.” – from The Intelligent Investor.

If human nature never changes, we might forever be contrarian investors. What about you?

Happy Investing!

Bogumil Baranowski

Published: 1/16/2020

Disclosure:

The information provided in this article represents the opinions of Sicart Associates, LLC (“Sicart”) and is expressed as of the date hereof and is subject to change. Sicart assumes no obligation to update or otherwise revise our opinions or this article. The observations and views expressed herein may be changed by Sicart at any time without notice.

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

The worst investment advice I ever received was the recommendation to get out of stocks and buy U.S. Treasury bills at the bottom of the market.

It was a cold winter evening in March 2009, at the deepest point of the most recent financial crisis (though we couldn’t know that then). I was four years into my investment career in New York City. I was invited to an idea dinner at a very pleasant midtown restaurant. It was a group of top-notch investors around the table, most of them a few decades older than me, and the general feeling was that it was time to abandon stocks for T-bills. I heard what the other guests had to say, but that just didn’t sound right to me. Maybe Francois Sicart’s (my then-boss, now mentor and partner) contrarian streak was rubbing off on me already.

That dinner still makes me think of Warren Buffett’s memorable words: “Be fearful when others are greedy, and greedy when others are fearful.” I was about to discover that stocks were on sale at astoundingly low prices for the first time in my professional career. Many wonderful businesses that had seemed out of reach only months earlier would become incredibly affordable.

At about the same time, I attended a breakfast with the CFO of Tiffany’s, the legendary American luxury jewelry brand. We all fit around a tiny table at the top of Rockefeller Center.  Outside, the weather was dreadful; a sea of impenetrable clouds shrouded the matchless view in gloom that mirrored the spirits — as well as the business outlook — in the room.

It was a good time to borrow a page from legendary industrialist Floyd Odlum’s playbook. In 1933, amid America’s Great Depression after a 90% drop in the Dow Industrial Average, he said, “I believe there’s a better chance to make money now than ever before.” He’d had the foresight to sell ahead of the 1929 Crash, and then had the courage to turn his capital into a serious fortune later on. (His tale has been retold by James Grant, the editor of Grant’s Interest Rate Observer.)

Floyd Odlum wasn’t the only fortune maker in the 1930s. Back then, John Paul Getty, Joseph Kennedy, and Benjamin Graham, among others, planted the seeds for even bigger fortunes to be made in the following decades. In the bear market of the 1970s, Warren Buffett started to turn Berkshire Hathaway from a failing textile mill into a hugely successful holding company, compounding wealth over the next few decades. Other recession-founded companies include GE (during the panic of 1873), Disney (in the recession of 1923-24), HP (in the Great Depression), and Microsoft (the recession of 1975).

After that March evening, the stock market embarked on a 11-year-long rise.  Tiffany recovered, prospered, and is about to be acquired for a big multiple of its 2009 price. The months that followed offered once-in-a-decade buying opportunities for patient investors.

I like a quotation from Will Durant, a prominent American historian: “Most of us spend too much time on the last twenty-four hours and too little on the last six thousand years.” It’s been 10 years since the most recent financial crisis, when the stock market dropped over 55%. It’s been 20 years since the Internet Bubble burst, when the Nasdaq lost a whole 80%. It’s been 45 years since the 1973-74 market crash, and wealth consuming inflation.  90 years since the loss of 90% of the stock market’s value during the Depression.

Each time, many fortunes were lost and never recovered. Each time, the drop was sudden, but the end of it, and the full extent of the damage, often took a while to dissipate. It was dangerous to chase the market to the top, it wasn’t easy to step back in, and it could have been extremely damaging to miss the recovery if one panicked at the bottom.

There is a time to buy, and a time to sell. In the investment profession, we expend immense effort looking for new opportunities, new stocks to buy. We hardly ever give much thought to selling. New investing ideas cycle through to replace old ones, but what if it’s wiser sometimes to step aside altogether?

Until eighteen months ago, we were trimming some of the long-term performers in our portfolio. At the same time, we had trouble identifying appealing new buyable stocks, so we let the cash pile grow. We like to own businesses, but we prefer to buy them opportunistically, when other investors don’t recognize their merit. Then we hold them for the long run, until they are loved and praised again. As Benjamin Graham — who mastered his stock-picking skills in the midst of Great Depression — wrote: “The Intelligent Investor is a realist who sells to optimists and buys from pessimists.” That sums up our approach in bull markets and bear markets alike.

In late 2018, US stocks have experienced a dramatic sell-off, with the S&P 500 dropping 20% top to bottom and the Nasdaq 100 falling 25%. It was a brief correction, cut short by the Federal Reserve’s pep talk. Yet we at Sicart, sitting on ample cash reserves, were prepared to act. We put more money to work in a matter of days than we had in the previous two years. It was one of the smallest windows of opportunity we have ever seen, and we were in a position to exploit it. But we believe that was a taste of things to come.

Joseph Kennedy is said to have liquidated his investments when he started getting stock tips from shoe-shine boys in 1929. Bernard Baruch stepped back from the stock market at about the same time. Warren Buffett shut down his investment partnership and returned capital to investors in 1969, describing the market as a “seemingly barren investment world” where “opportunities for investment (…) virtually disappeared.”

Here’s the status for late 2019: It’s the 11^th year of the bull market. We’ve experienced three interest rate cuts, there’s massive quantitative easing underway on top of earlier tax cuts, as well as record deficit spending, all in the name of not letting the stock market do what it’s been trying to do for years now – correct.

In The Little Book of Behavioral Investing, James Montier writes, “The vast majority of professional investors simply don’t try to arbitrage against bubbles because of self-serving bias and myopia. They are benchmarked against an index and fear underperforming that index above all else (aka career risk); thus they don’t have the appetite to stand against bubbles.”

We at Sicart don’t mind standing apart from “the vast majority of professional investors.” We will be putting more money to work when the time is right, but we are more cautious than ever. We don’t know what the end of this fiscal and monetary experiment will look like, or how this long bull market ends, but we do know that we need to be, in Warren Buffet’s words, “fearful when others are greedy, and greedy when others are fearful.”

Happy Investing!

Bogumil Baranowski

Published: 1/1/2020

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

With the stock market at an all-time high, patient and disciplined investors have gone right out of fashion, but that’s how we at Sicart still proudly identify ourselves. We don’t just attempt to hold the best- quality businesses we can identify, which we seek to buy at the lowest possible prices. We also remain historically underinvested, holding substantial (and seemingly idle) cash.

In moments like this one (which I might experience many more times in my investing career), I’m reminded of the words of Jean-Marie Eveillard, the famous value investor and long-time manager of the First Eagle Fund: “I would rather lose half of my clients than half my clients’ money.” The majority of our own money is invested alongside that of our clients. It is our intention to keep all of our clients, add many more, and preserve and grow their capital along with ours.

The last eighteen months (with the exception of a recent Fed-funded mini-rally) has been a period of flat, sideways markets. However, it’s been an increasingly exciting time for us, stock pickers, who intend to build a portfolio for the next five, ten, possibly even fifteen years. The pick-up in volatility and the market’s mild corrections have been short-lived, though. In the last 12 months we have managed to buy more stocks, and invested a larger portion of the capital, than in the previous three years. Yet we still hold ample cash reserves. There would be no trouble with that choice if it didn’t create an obvious drag on short-term performance. On one hand, we add new positions that have yet to perform. On the other, the fact the we are underinvested gives a meaningful and growing headwind versus the market for the near term.

This creates an opportunity to raise the age-old question – why hold cash at all? Why not stay 100% invested through thick and thin? Of course, the ideal scenario would be to stay 100% invested all the way to the top, and 100% in cash all the way to the bottom of the market. The trouble is that no one has ever perfectly called the top and the bottom. If you look at the cases of investors who have supposedly performed this feat, you’ll find that in reality, what they did was to allow their cash balance to grow as the market rose beyond reason, and reinvest it all when the market dropped and investors panicked. The biggest concern with this approach is fear of missing the peak of an ever-rising market as we maintain our investment discipline. Regrettably, it’s a fear that has often cost investors more than they could afford to lose.

Since numbers don’t lie, let’s do a little experiment. Let’s assume that we have two portfolios, A and B. B is always 100% invested, but A chooses to go to 65% invested in the late years of a bull market. For simplicity’s sake, let’s assume that the managers’ picks for both portfolios are the same, equal to the overall market performance. (We give the managers no credit for stock-picking ability!) Let’s also assume that the manager of Portfolio A is exceptionally early with his decision to raise cash level, and it takes another whole five years from today for the market to correct and become more reasonably priced.

Finally, we’ll imagine that the stock holdings return 12% compound rate over those next five years – close to the (exceptionally high) last five-year return of the S&P 500 Index. Portfolio B (100% invested) will have grown each hypothetical $10,000 investment to about $17,600, while Portfolio A (steady 65% stock exposure) will have reached around $14,600, a whole $3,100 less.

Before you decide which strategy, you prefer, let’s entertain a scenario where stocks do drop by 50% after those five years. That’s in line with the historic market corrections. I might be a year shy of forty, but I have already seen two similar corrections in my adult life, and my senior partners have weathered half a dozen — if not more!

After that drop, our hypothetical Portfolio B is valued at around $8,800 and Portfolio A at around $9,800. That’s an immediate lead of $1,000 for the patient Portfolio A. But consider this: Portfolio A now holds over 50% in cash, ready to invest! In this scenario, if stocks were to compound again at a historically high 12%, it would take Portfolio B (100% invested) a whole six years to reclaim the previous peak value — or over a decade if the market returns 7% (close to the actual ten-year total annual return for the S&P 500). That’s assuming Portfolio B managers do the impossible — keep their cool, and stay fully invested all the way to the bottom and back up!

Portfolio A’s lead will grow from the market lows, and if you assume that Portfolio A’s stock picks do a little better on the way down, and a little better on the way up than the fully-invested Portfolio B, that $1,000 lead will grow even faster in the next 5-10 or 15 years.

It’s difficult to ignore that a mere 33% market correction would erase the entire hypothetical five-year lead of Portfolio B over A, and 33% doesn’t even get us to the pre-2016 Presidential election market levels. For example, a 65% drop in stock prices would have derailed Portfolio B for almost a decade, assuming historically high 12% S&P 500 returns. That lag would increase to over fifteen years given a 7% return, which is close to a ten-year actual annual return for the S&P 500. That’s how long it would take Portfolio B to reclaim its past highs. With a 33%, 50% or 65% drop, Portfolio B (100% invested) would lag Portfolio A (65% invested at the peak) by a growing margin for decades to come.

With those numbers in mind, next time we wonder if we are missing the boat, and possibly never catch up with the market, we remind ourselves how even a minor market correction would not only put us ahead of a 100% invested portfolio, but also set us on a very promising path of outperformance for decades to come. Most of all, it’s important to note that even if it takes five years, Portfolio A ends up on top.

The United States is in the eleventh year of the longest-lasting, most heavily-subsidized, politicized, propped up, helped, and cheered on bull market ever. We are eager to be 100% invested eventually, we don’t believe this is the time though. We at Sicart consciously choose to sacrifice some of the near-term upside in the name of protecting capital from the near-term risk, while staying well-positioned to capture an even bigger long-term upside. It might prove to be the hardest investment decision of our careers, but we remain convinced it’s the right one given what we know. The underinvested portfolio remains the wise choice, especially for anyone who intends to stick around in the investment world for many decades to come. We do! Do you?

And as a bonus, here you will find a short explanation why Warren Buffett and Charlie Munger hold “idle” cash: 2019 Berkshire Hathaway Meeting.

Happy Investing!

Bogumil Baranowski

Published: December 5^th, 2019

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

As readers of my articles, you probably know well that books are very important to me. This is an account of two that have been a great influence on me, in very different ways. I discovered both of them around 20 years ago. One has defined my career, and the other still defines stock markets and the economies around the world. The first one I bought, and cherish. The other one I browsed through carefully once, but never cared to own … was I wrong?

At the end of my new book – Money, Life, Family, I include a list of books that changed my life. If you have watched my TEDx talk, you’ll know that I was inspired to become an investor by Peter Lynch’s One Up on Wall Street. I picked up that book in a little English-language book store when I was a foreign exchange student in Brussels. As I shared in a Hikecast interview with Jake Taylor earlier this year, I chose between two books that day.

Peter Lynch’s book introduced me to the life-changing idea that stocks are small pieces of businesses. As obvious as that may seem, until that point, I had learned about ratios, alphas, betas, deltas, gammas — I even knew how to price derivatives (!), yet I didn’t see stocks as pieces of familiar businesses, whose products and services we may even use. My prior exposure to stock investing had been a paper “portfolio” that I kept as a 15-year old watching companies getting listed on the then-nascent Warsaw Stock Exchange (originally founded in 1817, closed in 1939, and reopened 52 years later). My paper portfolio was a list of exciting tickers with prices that moved up and down for reasons beyond my comprehension. It wasn’t until after reading Peter Lynch’s book that I bought an actual stock and… quickly lost a fair share of my real portfolio! That was my first experience owning a piece of a business – and as luck would have it, also my first permanent loss of capital. It was a great lesson in patience, too — the stock recovered, and rallied shortly after I sold it!

To this day, whenever I’m invited to speak about investing, I like to start by asking my audience two questions. First, have you ever made money owning a stock? Second, have you ever lost money owning a stock? Most investors have had both experiences, though hopefully more of the former, and less of the latter.

What was the other book that I held in my hands that day, but did not buy? It was ostensibly the tale of a wise man, capable of single-handedly conducting the biggest metaphorical orchestra (i.e. the U.S. economy) the world has ever known. Not only that, he even seemed able to predict the future. His special position gave him the power to make decisions affecting all of us by controlling the price of the money we use.

His story reminded me vividly of the central planners setting prices of everything from butter to tractors in Soviet-era communist Poland of my early childhood. They attempted to predict the demand for each item in the economy down to the smallest nail, in order to ensure that the supply would match it, at the right price. As history tells us, it was a policy that failed spectacularly. The resulting economy’s inefficiency was so extensive that consumers couldn’t even find nails in stores at times! When the Berlin Wall fell, the market was set free. Millions of consumers and businesses made free independent decisions, free market set the prices, shortages disappeared almost overnight.

Ten years after the fall of the Berlin Wall, there I was in Brussels, reading about this central monetary planner who set U.S. interest rates, i.e. the price of money.  Whether you are buying diapers for your baby with your credit card or financing the purchase of your house with a mortgage, even planning your retirement, the price of money affects you. The book in my hand was  Maestro: Greenspan’s Fed and the American Boom by American journalist Bob Woodward. Published 19 years ago, it was a New York Times best seller. In the book description you can read: “On eight Tuesdays each year, Federal Reserve chairman Alan Greenspan convenes a small committee to set the short-term interest rate that can move through the American and world economies like an electric jolt…”

The book also shares praises of the bull market of the day, today known as the dotcom bubble: “the American economy is pushed into a historic 10-year expansion while the world economy lurches from financial crisis to financial crisis.”

Nasdaq peaked at over 5,000 a few months before the publication of Woodward’s book, and bottomed at 1,114 three years later, a 78% drop, and a $5 trillion lost in the stock market downturn. It took 16 years, zero rate policy, quantitative easing, and an unprecedented monetary intervention to bring the Nasdaq back to 5,000 and beyond. Once again, we are celebrating a historic 10-year expansion and believing that we can achieve fairy-tale prosperity by simply printing money! The history does rhyme, doesn’t it?

Two books, two tales. One of these books inspired me to pick stocks and own real businesses: the other made me aware of powerful monetary policy that can send tidal waves through asset prices, stock prices included. As much as I believe it’s the stock picking that counts in the long run, I don’t think it’s wise to ignore the influence the price of money has on the stocks we buy or hold.

Here I am in New York City, 30 years after the Berlin Wall fell. I know that when the market is set free as it was in Poland in the early 1990s, price discovery works at its best. When the price of money is set free one day, I doubt it will be zero. I also know it will have a massive impact on stock prices. Fortunately, businesses will continue to provide goods and services that consumers want. As stock pickers, we at Sicart are always ready to invest. We don’t know where interest rates will go, or even if the Fed will be around in the future, but we do know what kind of businesses we like to own, and when the prices are right, we never hesitate to buy them.

Almost 20 years have passed since that memorable day in Brussels, and I still wholeheartedly believe I picked the right book to inspire me in my investing career.

Happy Investing!

Bogumil Baranowski | New York City

Published:  November 27th, 2019

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

With stocks at all-time highs, some tech IPOs falling short of expectations, and one huge IPO spectacularly imploding before take-off, some investors may be wondering if there is an art to cashing out. This may be a good time to look at two examples from twenty years ago, during the Internet Bubble.

Two decades ago, many companies went bust, but there were two with shockingly different stories. One had its founder sell all, hedge, and safely make it through the 80% Nasdaq drop. The other painfully watched his company’s stock price fall a whole 95%!

The first one was an Internet radio company, Broadcast.com, which was sold to Yahoo for $5.7 billion on (not a joke) April Fool’s Day 1999. It made Mark Cuban a billionaire. The catch was that Cuban was paid in shares of Yahoo. But at that point, rather than attempting to keep up with new market highs, he was growing increasingly cautious about the market. As he told Fast Company in 2002: “After we sold Broadcast.com, I hedged my stock with synthetic indexes, in case the market cratered in the six months before I could hedge my actual Yahoo shares.” The Internet bubble peaked in January 2000. Broadcast was discontinued by 2002. Cuban is still a billionaire.

The second company was an online book retailer, Amazon.com. Its founder Jeff Bezos wrote a shareholder letter after the bubble burst, and opened it with one word: “Ouch.” From the top to the bottom, the Amazon stock price fell $100 per share – from $106 to $6! 95% of shareholders’ wealth vanished. Amazon’s story could have ended right there, but the business was saved by a now-forgotten last-minute deal that raised enough cash one month prior to the crash to give Amazon a cushion to survive the following years. Shareholders, however, had to wait a whole decade to see Amazon’s price return to 1999 levels.

At Sicart, our investment approach is to buy good businesses at the right price, and hold them for the long run. We know that all stocks can become inflated beyond their real value, and that worthless businesses can attain exorbitant prices. Public markets succumb to unbelievable swings from fear to greed and back, but they also exhibit sobering judgment at times. WeWork’s recent failed IPO attempt is a prime example. A money-losing office-rental business disguised as a tech company was valued by some as high as $90 billion. In its last round of financing it reached a valuation of $47 billion — and is now hoping for a bailout at way below $10 billion. Some claim it’s worth nothing at all. Quite a fall, in a matter of weeks!

While we don’t believe that all companies are so drastically overvalued, we do think some will struggle to grow into their current valuations. Many employees, especially early employees of those companies, are sitting on substantial wealth created in an unusually short time. It is something worth celebrating, but it can also be a source of a serious worry.

With stocks at all-time high, we see a new peak in insider sales. Jeff Bezos made the biggest sales to date of his Amazon shares this summer. Bezos learned the hard way what a round trip from zero to a hundred and back feels like, and he clearly doesn’t want to go through that again. Facebook’s Mark Zuckerberg has cashed out billions in the last two years.  Uber founder Travis Kalanick sold a fifth of his stake days ago, as an investor lock-up expired last week. They are not the only ones cashing out; total insider sales are the highest since 2006, a year before the last bull market peaked.

The more insiders are selling, the more passive index funds are buying as the free float increases, and more shares become available to the public…wait! When insiders take money off the table, the public investors (through passive index funds) put more of their hard-earned savings on the line? That’s exactly right!

As investment advisors to families and entrepreneurs managing multi-generational wealth, we are frequently asked about the risks associated with having all of one’s wealth tied up in a single stock. Wealth creators enjoying life-changing fortunes start to plan ahead. They instinctively know what we have learned through our experience as investment advisors – making money and keeping it are not the same thing!

Our advice is always the same: we can’t call the top or the bottom of a single stock or of the market as a whole. However, our decades of experience help us discern to which end of the range we are closer. If your whole wealth is tied up in a single (possibly inflated) stock or an inflated stock market or sector, it could be wise to emulate Mark Cuban and other insiders and gradually take some money off the table.

We are all celebrating market highs, but we might be acting on them in different ways. Some investors are chasing new highs while others are stepping aside — so there is an art to cashing out after all!

Happy Investing!

Bogumil Baranowski | New York City

Published: November 21st, 2019

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

With interest rates dropping and yields disappearing while asset prices hover at all-time highs, we find ourselves in a highly unusual predicament. Over the last few years, in many conversations with clients, friends and fellow investors, I have come across a recurring phenomenon. On one hand, over the last ten years they have witnessed an unprecedented rise in the prices of their assets. However, they see that it takes a lot more capital to generate the level of income they’re accustomed to. In other words, they are asset rich, but income poor.

Tech billionaire moves back with his parents!

Sometimes as a mental exercise, I like to extrapolate ideas to their logical limits. Picture a young tech billionaire who takes a $1 annual salary (which is not that rare these days). Meanwhile his entire worldly possessions consist of a few t-shirts with the name of the college he dropped out of, and a billion dollars’ worth of highly-appreciated company stock. It’s obviously a very fast-growing company, but earns no profit yet. It issues no dividends, hence generates no income, making this tech billionaire the ultimate example of someone who is asset (super) rich, but income (super) poor! If we take this idea to its limits, he might actually need to move in with the parents to get by, unless he starts selling shares of his company. It’s an extreme situation, but today more and more of us find ourselves in somewhat analogous circumstances. Not that we all have a billion dollars, but if we hold valuable assets, we can be often described as asset rich, yet income poor.

We might be living in a multi-million-dollar home that has appreciated beyond our wildest predictions. Or perhaps we hold a portfolio of stocks whose value has increased in the last ten years higher than anyone could have foreseen. Many individuals have become asset rich in these ways. But at the same time, the income that such assets might generate has diminished to levels that are also unprecedented. Let me explain.

Asset prices go up

Most of us remember, with some retrospective pain, the S&P 500’s long brutal years of sideways markets marked by two major sell-offs between 2000 and 2013. Yet in the ten years since the darkest days of the Great Recession, stocks have been on the rise. The S&P 500 is up 320%.  Nasdaq is up 504%, and the Nasdaq 100 is up a round 600%! (Data through August 2019 is included here, Source: Bloomberg). It’s unlikely anyone was 100% invested in the Nasdaq 100 to sextuple their money, but surely but many investors multiplied their wealth over the last 10 years. Yes, this is an unprecedented gain. And yes, seeing a repetition over the next 10 years is highly improbable.

At the same time, home price indices in top cities around the globe have shown a mindboggling recovery from 2008 lows, in many cases flying past the 2007 highs. If you bought a house at the last peak or today’s peak, you may have little equity in the house, and you’d be more of a renter than an asset holder. But if you bought before the 2007 peak or during the post-Great Recession years, you might have built up a decent-size equity in your appreciated home.

 

S&P 500 (Performance since the Great Recession, Source: Bloomberg)

 

Home Price Index 20 Cities (Last 20 years, Source: S&P 500 Dow Jones Indices, and Fred)

Incomes fall

As the asset prices rose, the income from those assets was falling faster than ever, driven mostly by the infamous zero-rate interest policy.

The one-year US treasury rate stayed close to zero for 7 years (2009-2016). It recently peaked at 2.6%, and it’s headed downward again, which means that unless we are willing to commit our money for many years, we might not be paid anything for lending it to the government or leaving it with a bank.

Last year for the first time in 12 years, I opened a certificate of deposit with a bank, but the era of “whopping” 2%+ one-year CDs might be over soon. The chart below shows that the current 1-year treasury rate is 1.73% and dropping, but it’s important to remember that even a 5-year rate in real terms (i.e. taking into account reported inflation) is actually a mere 0.05%. In other words, the US government gets 5-year loans from bond holders by paying 0.05% annually (in real terms).

Having grown up in 1990s Poland soon after hyperinflation ended, I vividly remember my parents putting money into one-year CDs that paid double digit % interest. But in addition, given rapidly diminishing inflation, the real rate of return was also in double digits. Forget stocks, get one-year CDs and keep rolling them over — that was a solid money-making strategy for quite some time!

Today, it’s not just bond yields that are falling. At the same time, we have seen a decline in the dividend yield of the S&P 500 to under 2%, the second lowest level in its history (the nadir was the peak of the internet bubble). Any study of real estate cap rates (income yield) show a similar decline.

1 Year Treasury Rate (1990-today, Source: Robert Shiller)

S&P 500 Dividend Yield (1870-today, Source: Robert Shiller)

US dollar investors may complain about plummeting rates and yields, but outside of the dollar world, the developed countries of the eurozone or the yen are even worse off. They have seen a vastly-increased number of bonds with negative yields. Today about ¼ of the government bond market worldwide has a negative yield, and that share will likely only go up, given the current direction of monetary policies. In Europe, no major economy besides Italy has even a 30-year bond yield that exceeds 1%! Now, if we exclude the 40% of the government bond market worldwide that is the US treasuries, then over 40% of the non-US government bond is currently offering negative yields!

World Bond Markets (August 30^th, 2019)

Source: Bloomberg

A million is not what it used to be

Some time ago I was asked if a million dollars is still enough of a nest egg to retire on.  Apparently, there’s a belief that if you save a million dollars and put it in safe investments such as dividend-paying blue-chip stocks, certificates of deposit, treasuries, etc, you will be able to live off the income. Well, if that portfolio can generate a 5% income yield (not unheard-of historically), a million can generate $50,000 in annual income. That could be supplemented with some appreciation for a comfortable amount.

However today, with yields at historical lows or heading that way, a 2% to 2.5% yield is a more likely range for a portfolio of quality stocks and bonds. In that case, our income from each million dollar of assets just got cut in half to $25,000. Further, if for safety, we want to hold more in short-term US treasuries (which could soon pay as little as 0.15% if the rates head back to where they were only 3 years ago), then our imagined income might drop not to $25,000 from each million dollar’s worth of assets, but to as little as $1,500.

Low yields make it harder to retire early, so investors may need to stash away an even larger nest egg to contemplate living off income alone. Given the rising costs of housing, education and health care, not only is a million is not what it used to be – even the income it can throw off is diminished. This phenomenon can feel like a double whammy to many savers and investors.

Understanding the why

My parents like to remind me that ever since I began to talk, my favorite question was “Why?” So why do these conditions prevail now?

The answer is that asset prices are sky high; income generated by those assets shrank to the minimum and is now hitting uncharted negative rate territory. Maybe pumping over $20 trillion of new money into a $80 trillion world economy had something to do with it? That’s what central bankers decided to do in the name of helping economies recover from the Great Recession. We are trying to solve the debt crisis with MORE and CHEAPER debt…

When your hard-earned dollars, euro, yen etc. have to compete with freshly printed money, they don’t stand a chance. In my upcoming book (Money, Life, Family, My Handbook), I liken this scenario to taking a bath with a hippo; we all know who will end up outside of the tub, cold, wet, and naked—and it’s not the big guy with the gray hide.

Economic recovery or war on savers?

The Great Recession led to some unprecedented fiscal and monetary policies. Governments borrowed more, and central bankers lowered the cost of borrowing to zero. To help push that cost down, they sometimes used the central banks’ balance sheets to buy up assets –typically bonds — to depress the yields further by inflating their prices. The goal was to make people borrow and spend, in order to boost the economy as fast as possible. In fact, it was spending and borrowing that got us in trouble in the first place.

With zero rates the incentive to save is diminished, especially since bond yields are so low. We may also see low rates or negative yields (especially real rates, adjusted for inflation) as a wealth tax of sorts. A pay cut for the rich, you could say. Or just a pay cut for those that have anything saved up for rainy days, retirement or the future. Not only do we not get paid, but even a small inflation slowly erodes our wealth.

That’s a point that few years ago was brought up to then-Federal Reserve Chairman Ben Bernanke. He had a fittingly witty answer to it: “It’s ironic that the same people who criticize the Fed for helping the rich also criticize the Fed for hurting savers.” His answer sums up our predicament. With diminishing yields, investors felt forced to chase riskier assets and look for appreciation in lieu of the lost income. We got asset rich, BUT income poorer.

What to do then?

Ben Bernanke is gone from the Federal Reserve, as is Janet Yellen, and now Jerome Powell is getting ready to kick the proverbial can even further down the proverbial road. Those of us with long-term investment horizons have nowhere to go in the current economic and financial context.

What do we see? Higher risks, and need for more caution.

On one hand, asset prices are inflated, which poses a very serious risk to the investor’s principal. The higher the prices go, the bigger the drop we could expect. On the other hand, yields are low which may steer investors to less-than-sound assets such as the 100-year bond issued a few years by Argentina. Apparently, there were plenty of investors who had forgotten the long history of Argentine defaults, and today, that bond trades at 40 cents on the dollar (which is a 60% loss!)

Bonds carry another risk that is more pronounced the longer maturities are, and the more dramatic the interest moves become as we get closer to zero. For example, a 30-year bond that pays 2% will drop a whole 20% (its duration is about 21 years) if the rates go up by 1 percentage point. If we were to hold the bond until maturity (30 long years) we will receive the whole principal, but if we were to sell it after a rate increase like that, we’d be facing a roughly 20% loss. The lower the rates are, the further we reach out with bond maturities seeking some yield, the HIGHER the risk to principal we take on.

As we at Sicart call ourselves investors with an infinite horizon, we try to understand the risks before we reach for rewards. Our investment approach is not only to select what we would like to own, but also to identify what we choose never to own. We passed on the 100-year Argentine bonds and steer clear of most emerging-market bonds for that matter. We seek yield, but we remain disciplined and cautious. Dividends are a big consideration when we pick stocks for our clients’ portfolios because in sideways markets, dividends matter even more. Yet we never overlook the risk to the principal.

It’s not just stocks and bonds where trouble might be hiding; we also remind our clients that not all money market funds are all the same. For seven years, money market funds, checking accounts, and most savings accounts paid zero in US dollars. In the last three years, given briefly higher interest rates, we saw a 1-2% yield in money market funds. We actually took the time to learn why some market money funds pay a little more versus the others: it turns out the assets they hold are not the same, and don’t have the same risk profile. Money market funds broke the proverbial buck during the Great Recession: their value fell below par. Sometimes chasing the additional 5-10 basis point of yield isn’t worth the risk.

Or is it an opportunity in disguise…

It might be the worst of times for income seekers, but it might be the best of times for asset holders. This peculiar predicament gives us a great opportunity to move investments from high- risk, highly-inflated assets to those that are more attractively priced, and could offer a growing income over time. If you are a tech billionaire and want to move out of your parents’ basement, maybe this would be a good time to trade some of your shares for dividend-paying quality stocks available at good prices. If you are sitting on an appreciated portfolio of stocks, this might be the moment to consider whether they’re the best stocks to hold for the next 5-10 years.

Although the U.S. market is stuck range bound for 18 months now, this doesn’t tell you the whole story. After few market sell-offs in the last couple of years we see lots of stocks that are down 30-50% or more, some trading at 5- to 10- or even 20-year lows. Many of them, it’s true, for the right reasons; but others show plenty of potential to recover, grow, and even pay a decent dividend.

It might be the worst of times for passive investors and closet indexers, but it’s getting to be an increasingly exciting time for active managers and true stock pickers who take the time to see what they buy, and why!

Happy Investing!

Bogumil Baranowski | Published September 4^nd, 2019

Our readers may remember that I love water, and especially scuba diving. I recently had the pleasure of logging in a few dives in the South Pacific, an experience like none other. We were dropped off at the opening of an atoll (a ring-shaped coral reef), where the ocean regularly pumps water through a half-mile wide, 100-foot-deep canyon, only to claim it back later in the day. That peculiar phenomenon creates a treacherous current that makes divers feel helpless as pebbles in a mountain stream.

As I was caught by this monstrous current during my recent dive, visibility dropped to a few feet, leaving me clueless as to where the ocean was taking me. None of my extensive diving experience, the hundreds of dives I’d completed, certificates of all kinds, was any help at all. The dive guide’s briefing, ahead of time, had warned us of this in advance. Still, as the current grabbed me, I remembered Mark Twain’s famous words —“What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.” In that warm atoll, all my experience could have gotten me in trouble because I was in an environment with many completely new conditions. And that’s exactly how we at Sicart feel looking at the stock market environment today. In some respects, it looks familiar, yet it’s different enough from the past to get us into real trouble if we don’t pay attention.

We see at least five broadly held principles or tactics that have often worked well so far but could cause real trouble ahead: diversification, the “buy and hold” approach, passive investing, short-term thinking, and equating volatility with risk.

Diversification of investments is not enough; holding cash matters

Diversify, diversify, diversify – it’s a fundamental rule of investing. There’s a widely held belief that the more stocks, asset classes, sectors, and geographies are represented in a portfolio, the better. But in 2018 almost all asset classes produced negative returns for the year, something we haven’t seen in the history of finance. Maybe diversification is no longer the answer. In expectation of such a correlated sell-off of all assets, at Sicart we chose to do something controversial: we held more cash than usual. And while many asset prices lost value, cash did not, allowing us to put it to work while others panicked. We strongly believe that cash and cash equivalents, especially with today’s slightly higher interest rates, should be part of asset allocation, and should be seen as a truly uncorrelated asset that may come in handy over the next decade.

“Buy and hold” may not work, but stock-pickers will do well

As investors, we look for durable, increasing streams of cash flows generated by businesses that can grow and be profitable for as long as possible. The number of companies and industries that remain somewhat insulated from changes in technology and consumer preferences is diminishing, while the rest struggle to stay relevant amid “creative destruction.” This leads to an ever-shorter time span during which any major corporation can dominate the business world. Their tenure among the largest 500 companies has declined from 20 years (in the early 1990s) to under 10 years today. Buy and hold won’t work as well as it has. We see the next decade as an opportunity for true stock pickers who do their best to continuously stay ahead of the change, and who are more likely to capture the upside potential of newer, promising businesses.

Passive investing may fail as active managers could shine again

The last few decades have convinced us that being passive investors is the lowest cost, and the best choice to make. We have seen interest rates drop from 20% to almost 0%, half of the world rejoin the world economy after the Berlin Wall fell, and many more countries chose the path towards a free market economy, and a democracy.  Globalization took a major leap forward, lowering costs and opening new markets, with demographics helping boost the world economy as well.

But now, with interest rates trending up, the EU losing a major member, trade wars being fought, and demographics working against the market, many tailwinds will start to fade. For the next couple of decades, passively riding a wave of prosperity won’t be an option. US investors have been spoiled with a decade-long government-sponsored bull market fueled by ever-lower interest rates and ever-higher debt levels. If we look at European stocks or emerging markets, we’ll see that the US bull market was more of an exception than a rule and could easily be replaced by the sideways market trend of the rest of the world. In such a world, passive investors may be disappointed, while active managers will continuously look for and likely find new opportunities.

Short-term promises versus long-term success

The last ten years may have blurred the line between true investing (skill) and mere speculation (luck). With stocks rising higher and higher, and the investment horizon shrinking from years to months, many investment advisors and their clients might be in for a rude awakening.  In today’s market, it’s not possible to deliver the speedy gains some investors are used to. In addition, advisors may lose clients who haven’t adjusted their expectations to a more long-term focus. We see the next decade as promising for those who take a long-term view, recognizing investing as business ownership rather than trading paper for quick gains.

Volatility is not risk, it’s an opportunity in disguise

At some point the idea took hold that volatility — the movement up or down of a stock price –was an indicator of risk. In other words, if the stock price moved a lot, it was a risky investment. Many pricing models are built around this concept, facilitating billions if not trillions of short-term bets to be made on price movements.

In fact, a permanent loss of capital is the true risk — not volatility. If I buy shares in a company whose shares don’t move much, and the underlying business is eventually exposed as dead, fraudulent or bankrupt, my risk is the loss of my entire investment in that company. Its price movement until its ultimate demise has no bearing on the actual risk of loss I took on. Here’s another example: let’s say my stock moves up and down a lot, but I believe that it should be selling for 5 times the current price. If, in the worst case I sell it at cost or with a small loss, my risk is limited and small while the upside is very attractive. If anything, volatility creates opportunities for patient buyers to go shopping when others panic.

We believe that today’s lighting fast, tech-powered stock markets aren’t built to handle the growing political and economic instability, and if anything, they exacerbate the price movements in both directions. We see the next decade as offering an unprecedented pickup in volatility that will serve us well as we seek out more investment opportunities at great prices.

***

I made the best of out of my brief atoll scuba diving experience. Despite the bumpy start, the adventure ended happily, but only because we took the dive guide’s words to heart – “it’s nothing like any diving you have ever seen before.”

Looking at the stock market today, we say the same: what is ahead of us is nothing like we have ever seen before… let’s pay attention and act accordingly.

If you go diving in the South Pacific, pick the right guide, and if you are investing in stocks, pick the right advisor. Remember Mark Twain’s words because what we think we know for sure possibly ain’t so, and while there might be trouble ahead for many, we expect to find opportunities instead.

 

Happy Investing!

Bogumil Baranowski | French Polynesia

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

In the last couple of months, the unstoppable, must-own FAANG stocks are down 30% from their highs, and a total of over $1 trillion in market value vanished. What happened? Not long ago, Amazon, Apple and Alphabet (formerly known as Google) each flirted with or surpassed historic trillion-dollar market value thresholds. Where did all that money go?

A trillion made, a trillion lost

“Who here has lost money in a stock or an investment?” — That was my query this summer when I was invited to speak to group of curious minds at a major tech company in Silicon Valley. I often use that question to break the ice because I think it sets the stage for an honest conversation. I usually start by naming the first stock I bought, explaining why I liked it, how I lost money on it, and, most important, what I learned from it!

In the case of the FAANG stocks at all-time highs, we at Sicart saw a brewing storm and potential big losses for gullible buyers. They had heard about sky-high expectations, but didn’t realize they were already late for the party.

The first will be last

In many fields outside of finance, you can often rely on last year’s performance to predict next year’s winner. The best students in a class, for instance, often stay on top predictably. Investing flips that logic on its head, though, because investment success includes not just the grades (profits and growth), but also the other dimension — the price! Sometimes you can pay so much for the results that you won’t make money on your investment and you may actually lose. That’s why it’s crucial to know how much you are paying for profits, and how much extra you are paying for growth.

At times that the equation makes sense and you get an A student for the price of a C or D student. But sometimes A students are priced as if they were ALL bound to be Nobel Prize winners scoring in all categories all at once. That’s when the expectations priced into the stock are so outrageous that it’s only a matter of time until the market wises up, and corrects its mistake.

That’s exactly what started to happen in October among the market’s FAANG darlings.

The history rhymes

Sometimes the stock market resembles a TV channel with never-ending re-runs. The characters change, the setting varies, but if you look a little closer, the story is the same. Until October 2018, many experts tried to convince us all that the FAANG stocks had become one-decision stocks – you buy them and never sell. We were told that their growth would never slow down and their prices would only rise. Of course, there are many parallels to this situation in stock market history: The Internet Bubble of the 1990s, the Nifty Fifty stocks of the late 1960s and early 1970s, or the radio stocks of the late 1920s.

Is the continuity of thought toward higher prices broken?

In his memoir, famed stock investor Bernard Baruch (who not only escaped the 1929 market crash but even profited from it), reminisced about crowd madness at the start of the Depression. He noticed that something trivial or important can break what he referred to as the continuity of thought.

This last October something changed. With FAANG stocks down almost 30% from their highs, skepticism and caution reawakened. Growth is still there, but it’s slower and not as certain.

If you have followed our writings for the last few years, you might have noticed how we took an increasingly cautious stand as the market was hitting new highs. We continued to trim our holdings in stocks that we believed were highly overvalued. Until only recently, it’s been challenging to find good replacements.

How do you make money in stocks?

In investing, you make money not by chasing growth, but by buying businesses for much less than they are worth. They could be fast-growing ventures or more mature, dividend-paying companies. They could be small or large, US or foreign — as long as you are paying less than the business is worth, you are bound to make money in the long run.

To us, the notion of buying anything just because the price has been going up for a while doesn’t qualify as investing. The higher the price goes and the more it disconnects with the fundamentals, the greater the risk of losing money. Buying that stock looks more like a gamble. That’s the ultimate recipe for every bubble we have seen in human history, from tulip mania in the Dutch Republic in the 17^th century to the Bitcoin frenzy of late 2017.

If anyone thinks they are smart enough to time their ventures in such a market, we applaud you.  But we know we can’t. Even a man as brilliant as Sir Isaac Newton couldn’t. He found himself in the midst of a very alluring market bubble of his time (the South Sea Company). It ruined him financially, and he wrote later, “I can calculate the motion of heavenly bodies, but not the madness of people.”

FAANGs before they had “fangs”

A dear client once mentioned to us that he noticed how often we held similar stocks to his other portfolio held with a different manager. But he pointed out that we tended to buy them when they were cheap, while the other manager liked to pick them when they were expensive. The results of the two approaches couldn’t be more different, as you can imagine.

FAANGs offered some great opportunities long before they were FAANGs. There was a time when these stocks were treated with great caution and skepticism. For example, Amazon lost 30% of its value from late 2013 to mid-2014, and for the next 12 months not only had no “fangs” but was actually considered “dead money.” Its price didn’t move at all until 2015. Apple fell from $100 to $55 between 2012 and 2013, and similarly showed no “fangs” for a while. Finally, Google lost 30% in 2010, and traded sideways for almost 3 long years until early 2013. Every investor knows that 3 years is a long time for any idea to turn around and show signs of life.

Yet these were the times when one could argue that those businesses were worth much more than the market was offering for them, and that may be the case again at some point in the future. As investors we’ve been tracking them for years, in growth and in growing pains. We watched them recover and become fairly valued, and then continue to their “rock star” status. As investors, we enjoyed a large part of that ride up, but we have been cautiously moving to the sidelines for a while now.

In the case of today’s FAANGs (the same as all other investments) given our contrarian approach, we tend to be early to join the party (before others get over their skepticism in times of distress), but we also leave the party earlier than many (before the blind optimism, and euphoria start to dissipate).

Buy the dip?

Today’s 30% drops among FAANGs are different from those of the past. These companies are many times bigger and growth is bound to slow down. In many cases their valuations have gotten so unrealistic that a 30% drop merely leads to a correction from insanely to wildly overvalued. This is a far cry from being actually undervalued and attractive.

To use a sports metaphor, investing is not about discerning where the ball has been, but knowing where it’s headed. We have no doubt that most FAANGs are bound to grow and likely to dominate their respective industries for a while. However, we also believe that their growth rates will moderate, and their valuations (multiple of earnings) will increasingly reflect that.

The question we should be asking today is how much FAANGs should be worth if they were growing at 1-3x the rates of their older mega-cap peers, instead of 10x-20x? It was none other than Bill Gates who suggested that tech companies should be trade at lower multiples than companies in slow-changing industries, given the fast-paced innovation and uncertainty they face.

FAANGs might have been the most exciting stocks to read about in the last few years, but given that they disrupted many industries in what seemed like no time at all, they may be subject to equally dramatic disruptions sooner than one would hope.

Where to next?

We are long-term, patient, contrarian investors. We don’t mind whether we find promising opportunities among growth stocks or slow-growth dividend stocks at any given time. As long as we get a bargain, we are interested!

There was a time when the market had little appreciation for FAANGs while they still had a very long runway ahead. There could be a time when we revisit them again, but today, we lean towards stable, durable businesses that the recent spell of volatility punished harder than they deserve. We see many of them trading at 5-year lows, and cheaper than they’ve been in a decade. We notice that not only do they seem to fare better in the stormy markets, but they may have some underappreciated growth in them, too. They may not be glamorous, but for now they’re more appealing to us than those former market darlings.

Bogumil Baranowski

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

The speed, the distance, the time…

How long is a skydiver’s free fall? Do you ever wonder?

A free fall usually lasts under a minute, I’m told, even if you start at 15,000 feet (or 3,650 meters) of altitude.

Two great contemporary companies hit milestones recently. Apple reached an astronomical trillion-dollar market capitalization, which is as remarkable as US Steel’s first billion-dollar valuation a century ago. Meanwhile, Facebook lost 120 billion in a day (comparable to the annual gross domestic product of Warren Buffett’s home state of Nebraska). That must have felt like a skydiving free fall to shareholders. It brought back long-forgotten memories of $50B-$90B daily free falls for some tech stocks when the internet bubble burst almost 20 years ago.

As my physics professor used to teach us if we know the speed and the distance, we can figure out travel time. That made me realize that at Facebook’s record free-fall speed, Apple would need less than 10 days to get to zero… or even less time until a parachute would come in handy!

Zeros, zeros and more zeros

Numbers can behave strangely. What’s a million dollars? How much room would it take up in nice stacks of crisp one-dollar bills? And how about a million of those million-dollar stacks – in other words, a trillion dollars?

A “million” translates well across cultures. A million is always a one followed by six zeros, but a trillion is a different story. It’s an even more confusing number for those of us who learned elementary math outside the UK or the US, where a trillion is one million million million or one followed by 18 zeros (known as “long scale”) rather than 12 zeros (“short scale”) as it is for the British and the Americans.

When I was a kid taking English language classes, the measurements of miles, yards, feet, inches, pounds and ounces and the Fahrenheit temperature scale seemed harder than mastering vocabulary or grammar. I didn’t know yet that the Anglo version of trillions would add to my confusion!

But I had to grow comfortable with many zeros far sooner than many of my worldwide contemporaries. In the early 1990s, my parents began earning salaries in the tens of millions rather than the thousands. This wasn’t because we discovered oil in our backyard, but because of hyperinflation created in Poland by the transition from a centrally planned economy to a free market economy. Money lost value faster than we could spend it.

Zeros come and go, that’s what I learned as a teenager. We dropped 4 zeros from our banknotes, tied the currency to a hard currency, (the US dollar at the time) inflation slowly dissipated, and after a while people started to trust Polish money again. The entire episode might be just a footnote in the history books now, but it wrought widespread financial havoc and led to sudden wealth destruction on a huge scale. In those days the dollar was as revered as gold is today.

How about a quadrillion?

Speaking of historical milestones, big numbers, and inflation, a few years ago Japan’s government debt hit a quadrillion yen ($10 trillion USD). If you add 3 more zeros to a trillion, you’ll end up with a quadrillion (or 1 with 15 zeros – US scale/short scale). Japan is struggling with the opposite problem that Poland had in early 1990s: they seek to prevent prices from falling by printing and borrowing more currency.

How did they get to so many zeros and an exchange rate vs. the dollar of 1 to 100? Yes, you guessed – inflation! Japan experienced a spike in inflation in the 1970s, reaching 23% annually in 1974. Poland decided to drop 4 zeros from their banknotes, Japan kept theirs. Their central bankers are creative though, and that quadrillion-yen debt is disappearing. Japan is paying its own debt with more new money, effectively writing it off. Zeros come and go.

Making a trillion

My childhood experience taught me that the fastest way to mint new paper millionaires is hyperinflation. That’s also the fastest way to turn former millionaires into paupers. As a figure, a million might be a million everywhere, but clearly, its purchasing power can fluctuate.

Is Apple’s trillion-dollar market capitalization a product of printing presses running too hot? Perhaps. Zero-rate easy-money policies have certainly helped fuel asset price inflation, along with some of the excitement in the high-growth tech world in the last decade or so. Still, there is more to the story.

Apple successfully raised itself from the ashes in the last 20 years and then conquered the world, selling almost $250 billion worth of iPhones, iPads and Macs every year. Its annual sales trail only Walmart, Exxon, and Berkshire Hathaway, but it is the profits that make all the difference. Apple generates over $50 billion in profits every year, which is 4 times as much as Walmart and twice as much as Microsoft or Google. In other words, if you combined the profits of Walmart, Microsoft and Google, the total would come close to matching Apple’s.

In the long run, any company should become more valuable as its earnings potential grows. Apple’s earnings grew steadily over the last 20 years, and are up about 25% in the last 2 years. Yet the stock price didn’t go up just 25% since 2016 – it doubled. Big share purchases shrank the share count by 10%+ in that period, but that still doesn’t justify a share price hovering around $200.

The secret is in the valuation. The multiple of earnings expanded from a little over 10x to closer to 20x. That metric is a function of many factors, but usually the faster the earnings grow, and the more stable they are, the higher the multiple can be. Again, the future is the only thing that matters in investing.

Apple might deserve to be a trillion-dollar company today, but its future is a different question. The only way to make money on its stock henceforth is if it continues to grow, and if the market assigns it even higher earnings multiple.

Infinite investment horizon

As investors we need to answer one big question: what is our investment horizon? We have to answer it honestly, without considering outside opinions or trying to make ourselves popular. The horizon is an essential element in every investment decision.

In our practice of investing fortunes for families and entrepreneurs, we believe that their investment horizon is infinite because the fortunes span generations. Our goal is to weigh the risks and rewards of each investment, and compound wealth over many decades. We believe that our exceptionally long-term investment horizon is our biggest advantage. We doubt we can build better financial models or read annual reports faster or better than the next guy. What we can do is exercise patience in buying, holding and selling assets. In our field we’re not sprinters; we’re marathoners, ultramarathoners to be precise with 100 mile or a 100-year mark in mind.

Finite Assets

The current challenge we see is the short and shrinking shelf-life of assets. The largest companies stay at the top of the market for shorter and shorter spans, especially compared with the middle of the last century. Only ten percent of Fortune 500 companies have been on that list since its inception in 1955. What this tells us is that buying and holding stock in the most successful contemporary company may not prove to be the surest way to preserve capital.

Why not? As investors, we buy earnings of companies or cash flows. We pay a multiple of earnings, 10x, 20x, or 30x, and we hope to receive the current amount or higher from the moment of purchase until the theoretical end of time. We discount all future cash flows of the company to today, and there we go, we have its value. Although the past record of any company is informative, its future record is where the value hides.

If the life of a company is not infinite like our investment horizon, we need to exercise extra caution. I’ll say it again: we value longevity more than speed getting to the top of the rankings.

Apple is unquestionably a huge success today. Yet as a disruptor in the phone and computing world, it may be disrupted itself, especially if we extend the study period (and investment horizon) from the next 4 quarters to the next 4 generations or 100 years.

Making it, and keeping it

A trillion dollars is a huge sum and $120 billion is a massive one-day stumble. It’s also a wakeup call to remind us how quickly paper wealth can disappear when the market changes its mind.

Apple, Facebook, and others are just a sign of the times. We all get excited about their novelty and their amazing performance in the market. However, we must remember that the same forces that created fortunes can destroy them just as fast. Ideally, we’d all like to capture the wealth creation on the upswing then transfer our gains to assets where change happens at a glacial pace. That’s the ultimate dream of any long-term investor.

The biggest winners of the internet bubble days weren’t those who turned nothing into billions overnight — but those who kept what they earned. We are in the business of wealth preservation, and as much as we celebrate new highs for the tech darlings, we don’t want to forget that making money and keeping it is not the same.

The difference has never been more striking than it is today.

Happy investing! We will see you at the 100-mile mark!

Bogumil Baranowski | Cozumel, Mexico

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

I recently had the pleasure of delivering a TEDx Talk to a wonderful audience of bright young minds in California. My subject was “The Great Investor in You.” During the following book signing many attendees approached me with various thoughtful questions and comments, but one really stuck with me: “How do you invest,” a student asked, “when nothing works?” It’s such a good question that it deserves a longer answer than I could give that student on that day.

See what works, and what doesn’t

This query reminded me of a story I came across years ago. A widow was put in charge of a family business operation after her husband’s unexpected death. The employees, concerned about the firm’s future, were looking for direction. Despite the widow’s previously limited interest in the company, she came up with a good first step by asking everyone to list which of their business practices worked, and which didn’t. After that, her instructions were simple: do more of what works and less of what doesn’t.

(If only decision-making was that easy in investing, we’d all be swimming in riches!)

What doesn’t work, then?

Until the beginning of 2018, investors could have believed that everything (or anything!) in our field worked, especially if your definition of “working” is that whatever security you buy, it goes up. We at Sicart watched the market with great curiosity and growing caution. Almost anything we bought (or even looked at) increased in price. Even some truly unexciting corporate bonds were showing appreciation that nicely supplemented their meager yields. Volatility disappeared and every market seemed to be on autopilot, heading skyward.

Since the early days of February, though, we have experienced some truly volatile periods. Even now the charts of major indices look “broken” as someone described it recently. They definitely don’t point straight to the sky anymore. Maybe just buying almost anything and hanging onto it for a few months is no longer a valid strategy.

Momentum & growth

There are many wonderful tools these days that allow us to look back and see which factors (growth, valuation, profitability etc.) were operative in periods ranging from the prior month to the prior year. We have noticed how anything to do with growth and momentum in price or sales has dominated the top of rankings. The easiest way to outperform the broader market was to buy the strongest performers by those standards.

But that clear-cut approach may not have been as successful in the choppy market of the last few months. Fewer companies show unbreakable momentum, and the winners of the last few years seemed to have flat-lined for now.

Value

The term “value investing” means different things to different people. Some believe it’s buying stocks at a low multiple. Others, using a broader definition, think it means buying stocks for less than they are worth. The value investing crowd has been under a lot of pressure in this ever-rising market. How does a bargain shopper succeed in a market where expensive stocks only get pricier?

The peculiarity of the year-to-date market volatility and weaker performance didn’t leave “value stocks” unharmed. Interestingly enough, many low multiple/high dividend stocks have struggled more than the market darlings. Many investors hoped to see growth stocks give up their gains quicker than the traditional value stocks, which haven’t even kept up with the rally of the last few years.

Active investing

If momentum is not an obvious choice of strategy, and traditional value hasn’t proved its merit in this market, the whole idea of active investing is being questioned more than ever. We have seen many prominent hedge fund managers throw in the towel in the last few years, and passive index investing has never been more popular.

As investment advisors, we are concerned that passive investing works beautifully in fool-proof markets where prices consistently rise. However, it disappoints dramatically when things turn, and the choices made by active investors start to matter. What choices do we have, though?

Back to basics

We have the privilege of working with entrepreneurs and multi-generational families. Their fortunes have an unusually long investment horizon. In fact, as a friend reminded me recently, the investment horizon of a family fortune is infinite.

This brings us back to the wise widow leading her family businesses with an investigation of what works and what doesn’t and doing only what works.

This strategy works in investing, but only if we know what time horizon we have in mind. Since nothing seems to work in the current sideways market, we suggest extending the investment horizon to 5-10 years or more.

Over our years in business, we have learned that over the true long run, it’s not the hottest stock- of-the-month approach that works best, but rather old-fashioned, disciplined, patient bargain- shopping for quality businesses. If we can consistently pay much less than we get in value and we hold our investments for a long-time, possibly forever, we just can’t go wrong — though we will not win every beauty contest on the way.

The earlier mentioned factor rankings, but with an extended investment horizon to 7-15 years rank the trusted value investors yardstick: price-to-earning as the best predictor of a stock’s outperformance over the long run. Although few of today’s investors care to look beyond a month or two, we are happy to be among those who do. A long-term horizon takes the pressure off investors to figure out “what works” in shorter periods of time and focus on what works in the long run.

And what really works, time after time, is buying securities for less than they are worth. The bigger the gap between the price and value, the better!

 

Happy investing!

Bogumil Baranowski

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Are catch-phrases, always right?  

The investment profession is full of terse advice like “Buy low, sell high,” “Sell in May and go away,” and – especially relevant now, “Buy the dip.” Here at Sicart we appreciate the wisdom in the first adage. We can see how the second one makes sense, especially if you have big summer vacation plans. However, with the last one, we have a bit of problem.

A bell, a dog, and a Russian scientist

The Pavlovian response, also known as classical conditioning, refers to a training procedure originally devised by the Russian physiologist Ivan Pavlov. Working with dogs, he paired a biologically potent stimulus (food) with a neutral stimulus (a bell or a ticking metronome to be exact). The dogs quickly learned to associate food with the sound, and began to salivate whether or not they were fed.

“Buy the dip” — it’s time to buy, another rally is coming – that’s been our conditioned response for decades now.

However, scientists following up on Pavlov’s work have found that a conditioned response is relatively impermanent. Should ours be as well?

Time to unlearn?

Each time the market has dropped in the last 40 years, it rebounded quickly, no matter what had brought it down. This pattern helped strengthen the argument in favor of indiscriminate passive investing and led some to discredit active investing.

Why was that the case? Over the years, significant market corrections were diligently followed by lower interest rates and more accommodating policies intended to prop up the economy. The smaller corrections were seen as brief pauses, with renewed optimism fueling the next leg of a bull market.

The bell rings… and it’s time buy more again! Or is it?

Fundamentals don’t matter, do they?

We consider ourselves contrarian long-term investors. We constantly seek out bargains, and we don’t mind waiting few years to get the return we want. This is the kind of prudent behavior known to shoppers world-wide; we just do it in the stock market.

The fundamentals drive our process because over time, stocks trade in line with the earnings. As a company’s earnings go up, its stock price increases. Everything else is perception, sometimes making what should be cheap stocks expensive. In an ideal scenario, we like to see a cheap stock with improving fundamentals and recovering valuations. Then we get paid both for the earnings, and the multiple expansion.

But sometimes an individual stock price or the overall market decouples from the trends of fundamentals. Then it’s anyone’s guess where it will head to next. Lately the trend has been upward, and usually that lasts much longer than reason would suggest.

We’ve left the fundamentals behind

The Shiller PE (cyclically adjusted 10-year price-to-earnings) ratio for the S&P 500 recently reached 31.5x. Its 120-year range is 5-45x, with 15-25x being the most common level in that period.

Between 1980 and 2000 this metric increased from 5x to almost 45x:  interesting to me because that period coincided with my growth from a toddler to my current height of over six feet! (Almost a perfect correlation, as I’m sure quant-oriented investors would notice.)

I stopped growing, and Shiller’s PE fell from 45x to 15x over the next 8 years. The following decade didn’t bring a new Great Depression with the PE’s drop to 5x as some feared, but quite the opposite, a miraculous rise from 15x to 30x+. (No correlation here with my weight or height.)

If there was a correlation between valuations and anything else, it was the interest rates. The 10-year treasury rate fell from 15% to 2%, only to start rising more recently. That’s an unprecedented tailwind for all asset prices.

When the rates dropped to the ground, and the PE seesawed from 15x to 30x, the market somehow lost touch with the fundamentals. We do know that rates can be forced all the way to zero, and investors can be scared into assets with negative yields (some eurozone markets are a vivid contemporary example). Still, the PE will only climb until the gravitational pull brings it back to where it historically belongs.

Up and down we go

After a post-election rally and diminished volatility last year, we are up against something “new and fresh.” However, I was recently told that there are only 7 plots in all forms of tales, legends, books and movies over the last few thousand years human history; they just repeat again and again.

True also for the financial markets, only there is really just one story. Cheap markets become expensive only to become cheap again. The characters change but the plot is the same.

After a January rally with record in-flows of new money to equities, February brought a sharp turn. The last two months gave us many days with 3%-4% market swings as well as big intraday swings. We are quickly getting used to them. However, the down days outnumber the up days. As a result, the US equity market and most major international indices are down about 10% from recent highs.

Usually under these conditions the majority would scream, “Buy!” — but it is a fading scream today.

Peculiar rally, even stranger sell-off?

The rally lasting from the 2016 elections through January was driven by renewed optimism about economic growth, lower taxes, and a more favorable business environment.

What we notice is that the fundamentals didn’t drive the market up, and it’s not the fundamentals that are bringing it down (just yet).

If you have read our earlier posts, you’ll know that we’ve been waiting for a meaningful correction for a while. We believe that the disconnect between price and value always eventually ends because fundamentals drive the markets in the long run.

History shows, though, that it’s not the fundamentals that fuel the last leg of a bull market or end it. Bernard Baruch, a legendary investor who lived through the Roaring 1920s and profited from the 1929 market crash by going against the crowd, called this phenomenon “the end of the continuity of thought.”

Change of heart

After witnessing celebrations of the post-election rally, we are now seeing a growing list of worries: inflation fears, trade war concerns, Amazon’s battle of tweets, and Facebook’s debacle. None of these are fundamental in nature. They might affect the fundamentals in the long run, but for now they mostly harm market sentiment.

Amazon’s and Facebook’s stories embody most of the themes that paved the way for this bull market’s grand finale and its abrupt end: US presidential elections, FAANG rally, and an insatiable appetite for growth.

Look out, it might rain!

When bad weather is forecast, everyone grabs an umbrella. When we see that the market is out of sync with the fundamentals, and that optimism might be turning to healthy skepticism, the reaction is not so simple. Here are few decisions we’ve made:

1) we are holding more cash than usual, keeping it available to use when things get interesting;

2) we regularly review our holdings and cut those whose prices we believe to be the most out of touch with reality;

3) we add to the highest conviction stocks that have started to appear in some pockets of opportunity;

4) we select some market protection, namely precious metals (gold specifically) and some inverse ETFs that go up when certain asset classes go down.

THE BELL RANG!

May is around the corner. Maybe it is a good time to “sell and go away” as in the adage we began with. Nevertheless, we caution against “buying the dip.” Being unusually picky may keep investors out of trouble until the markets eventually catch up with the fundamentals – as they always do, in the end.

Happy investing!

Bogumil Baranowski

 

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

What happened?

Over the last few days, we have seen about a 10% correction in major equity indices around the world. It definitely got everyone’s attention. Globally, estimated $5 trillion of paper wealth vanished in a matter of days. What happened though? No war, no impeachment, no lasting U.S. government shutdown either.

An upbeat job report allegedly sparked fears of inflation, and quicker interest rate hikes. Why would that matter though? After a decade long recovery, supposedly booming economy, record low unemployment, record long accommodative monetary policy finally wages tick up. Why panic? Is it even a lasting spike in wages, or maybe oil price swings and natural disaster recovery activity have something to do with it, and if so it will be a short-lived spike anyway.

Staying disciplined

Our goal is never to beat the market or any specific index in any period of time, our goal is to preserve and grow wealth over the long-term. As much as we always enjoy the treasure hunt for new bargains, we hate taking big losses.

For a while now, we’ve been watching the markets carefully and with a healthy dose of caution and skepticism (We Take A Careful Look At Our Cautious, Contrarian Stand – August 1^st, 2017).

Given our disciplined contrarian investment approach, we’ve been seeing more reasons to trim our increasingly overvalued positions than to add new ones. If the market doesn’t offer any truly compelling investment opportunities, we choose not to alter our discipline and shop for lesser opportunities just because they happen to be less overvalued than the market as a whole.

As a consequence, our investment strategy led to record high cash levels in our portfolios. Those, on the other hand, triggered some really good questions. “As a stock picker shouldn’t you be finding opportunities in all the markets?” – was one of many that came up.

Holding cash is an investment decision

Our advice remained unchanged  (The Most Unusual Bull Market – September 26, 2017) – it’s an overvalued, overhyped, overinflated market with underwhelming fundamentals, and record leverage only possible thanks to record low-interest rates. If we can’t find what we like, we are happy to sit it out, and patiently hold on to high cash reserves. We think and invest in terms of decades not few month windows.

Fiscal and monetary debacle

The Fed has been raising rates gradually, and supposedly remains committed to continue on that path. It’s also shrinking its balance sheet, which could create an interesting dynamic when faced with an insatiable appetite for more government spending, thus more new borrowing. Who will buy Treasuries if the Fed is selling? And why the record spending if the economy is in the 9^th or 10^th year of expansion? Will the Fed stay committed to its prior direction given the new Fed chairman?

Unfortunately, still, the near-term market performance remains in the hands of monetary policy rather than the fundamentals. It’s a very difficult balancing act for the new Fed chairman. (More on the subject in my earlier article: The Emperor’s New Clothes – Understanding Today’s Financial World – June 23^rd, 2017)

Simple but not easy

Setting the market free to establish the cost of borrowing would diminish the role of the Fed and all central banks. This would trigger a possible storm in the financial markets, but likely set a stage for a healthier financial world in the future with less distorted capital allocation.

Maybe it’s a revolutionary idea today, but so was the end of the centrally planned economies in the Soviet-controlled Europe until 1990, and that worked out very well lifting many from poverty, realizing full potential of those nations, and building vibrant economies. Yours truly had the pleasure of witnessing the process in person. The transition wasn’t pretty, and the term of shock therapy was coined.

I am hopeful that the right time for the end of the centrally planned monetary policy will come in my lifetimes as well, but that could be a long-time away or not? In the meantime,… 

Is there a safe place to hide?

If anything, the last week’s crash (correction, blip, hiccup – you pick the label you like) proved to be a peculiar sell-off, where not the high-flying tech stocks led the market lower but the Dow Industrial Average, and overall “value” stocks, and dividend stocks fell more than the growth darlings of the last few years. Investors are still holding onto their hot winners hoping that they remain immune in this sell-off. That may change quickly, when the market realizes how much growth has already been priced into those stocks.

What’s ahead?

We see many completely contradictory narratives attempting to make sense out of the dramatic sell-offs and the pick-up in volatility. We worry less about volatility today and in general. Volatility is the necessary ingredient of the price discovery process, and that’s what this market is trying to do. What worries us more is the extent of price and value disconnect that remains in the current equity and bond markets (both still close to all-time highs), and the unprecedented mispricing of risk.

Those that pay attention could see that it took few days for the high yield bond index to give back all the post-election gains, and it would take another 25-30% decline in the major equity indices just to get back to the election night.

What to do?

We don’t subscribe to the school of thought that you have to be 100% invested at all times not to miss out on the last melt-up of a tired aging bull market. When the market valuation is at an extreme high or low, 0% invested or 100% respectively might be a theoretically ideal place, but it’s a wide range, and everyone needs to find their own comfort zone.

We don’t claim to know exactly when the bottom or top of the market or any security price is. What has worked for us is the gradual approach. Slowly building, and slowly cutting exposure and positions.

We’d rather be imperfectly right than perfectly wrong.

Bogumil Baranowski

 

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

In our search for new ideas, we often come across companies we would never invest in. Steinhoff International is one of them. It’s a company we’ve encountered on a few occasions over the last year or two, and in each case, it triggered an immediate negative assessment. Nevertheless, there’s a story worth sharing here.

Steinhoff demonstrates some of today’s peculiar business practices that lead to huge wealth creation followed by even quicker wealth destruction. It’s also a textbook example of what an important role monetary policy has played helping such phenomena to continue.

You may have never heard of Steinhoff International – a retailer that took 50 years to build but only 2 days to collapse, wiping out $10 billion of market value in 48 hours. It’s a South African retail holding company dual-listed in Germany. It has about 6,500 retail outlets in 30 countries covering the globe from Africa, Europe, the United States to Australia and New Zealand. It handles 40 different brands, has 90,000 employees, and brings – or brought — in revenue of almost 20 billion euro.

Bruno Steinhoff started the company in Germany in 1964. It initially sourced furniture from communist Europe to sell in Western Europe. In the late 1990s, the company acquired and then merged with South African retailer Gomma Gomma. It continued acquisitions in Europe – UK’s Homestyle Group, and Conforma – Europe’s second largest retailer of home furnishings.

2 years ago, the company moved its primary listing to the Frankfurt Stock Exchange. It became a German-listed Dutch holding company with management in South Africa.

It kept up its M&A spree and acquired more retailers: Pepkor in South Africa and Poundland in the UK. The deals became bigger and more ambitious. Steinhoff’s acquisition of US-based Mattress Firm for $3.8 billion got our attention. Mattress Firm was an unimpressive roll-up of US mattress retailers. Steinhoff decided to pay a whopping 115% premium to acquire it!

Steinhoff’s market capitalization went from 2.7 billion euro to 22 billion euro in the last 7 years with revenue climbing from 4 billion euro to almost 20 billion. The debt increased from under 2 billion euro to 10 billion euro with major payments due in the next few years. As of March 2017, the total exposure to lenders and creditors was estimated at $21 billion (18 billion euro).

When Steinhoff did its US acquisition, we assumed it was betting big with someone else’s money. We had doubts about the strategy which featured the irresponsible use of leverage enabling with very aggressive acquisitions.

On top of obvious questionable managerial decisions, it’s impossible to ignore the role of the ECB’s (European Central Bank) monetary policy in enabling this buying spree.

In the last 2 years, the ECB’s balance sheet grew from 20% of Europe’s GDP to 40%.  Part of the program has been buying investment grade corporate bonds since mid-2016. By becoming a 15%+ holder of the investment grade market, the ECB not only dramatically depressed yields and compressed spreads — making borrowing even cheaper — but also became a not-so-proud holder of Steinhoff’s bonds.

In early December, the CEO left after an accounting scandal brought the company down. The chief auditor chose not to sign off on the financials, and the company has apparently limited visibility as to profits and cash flows. And now, the Steinhoff debacle is being called the biggest corporate scandal in South African history.

The stock dropped from 6.00 euro to 0.30 euro, bonds are down 50%, credit lines are being cut off, and the ECB has a major dilemma. Should it 1) dump the bonds and speed up the company’s demise, 2) hold on to them, or 3) possibly buy more?

Is the ECB about to bring back to life the Ancient Roman tradition of pollice verso – a thumbs up/thumbs down signal used to pass judgment on a defeated gladiator?

As much as Steinhoff’s accounting may raise questions, what should be said about the ECB’s accounting? How does a central bank account for a drastic loss on an asset acquired with freshly printed money that wasn’t there to begin with? Who will bear the loss? Or maybe if ECB bought worthless assets with imaginary money, nothing really happened after all?

The bonds the ECB holds used to be investment grade, and are about to be downgraded to junk. ECB bond buying policy only covers buying. There is no selling policy in place, least of all for holdings that get downgraded to junk as they hold them.

We can only wonder how many more stories like this have happened because of easy money policies. Steinhoff might just be a sign of the times, and a great lesson for investors: if something looks too good to be true and the story just doesn’t add up — it’s better to pass.

Maybe there is a lesson for policymakers, too. Excessively cheap, easy-money policies that were supposed to stimulate growth and employment can have alarming unforeseen consequences.

Bogumil Baranowski

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Our current, highly durable bull market is characterized by three qualities: it might be the least exciting bull market in history, it’s been possibly one of the hardest to beat, and when it ends, the resultant crash will have been anticipated for months if not years.

We used to have fun

To look at a comparable example it’s not necessary to go back to the days of Tulip Mania in the 17^th century. Investment bubbles are always driven by excitement and novelty. The vibrant stories of the roaring 1920s are still very much alive: we can almost hear the jazz, see the dancing, admire the big, powerful cars. It was an era of sudden success that inspired such notable books as The Great Gatsby.

Some thirty years later, we had the Nifty Fifty, when the most popular large-cap stocks on the New York Stock Exchange captured people’s imaginations. Among them were Eastman Kodak, Polaroid, Xerox, and Sears. For a while, you couldn’t go wrong buying those companies: they offered never-ending growth perspectives provided by exciting technological and consumer trends.

More of us remember the internet bubble of the late 1990s.  Companies with no revenue, no profit, no real business plan, consisting of little more than an exciting web domain, were reaching billion-dollar valuations. These were the fastest, the most successful IPOs. A short-lived phenomenon, that bubble nevertheless sparked investors’ imaginations. New waves of entrepreneurs got rich overnight, and online trading spread that wealth among day traders who swapped the security of salaries to turn their hard-earned savings into fortunes. A nationwide, even worldwide frenzy took over.

Even more recently came the 2000s housing bubble. You could make an instant fortune flipping homes, condos that could be bought with no money down and no discernible credit. Once again, people quit their jobs to pursue the latest strategy to get rich quick.

What all of those exciting bubbles had in common is the jealous neighbor mentality. It really doesn’t matter what the stocks or homes sell for until your neighbor starts bragging about making a fortune overnight while you are still punching the clock and counting your change carefully at the supermarket.

It’s different this time

But this bubble is not like the previous ones. First of all, the current equity, bond, and real estate bull market — in the US as well as globally — has lasted a good deal longer than most. What’s more, while Europe suffered from the debt crisis spreading across Southern Europe, and emerging markets have been buffeted by weak prices in the commodity markets, the US market has had a relatively smooth ride to ever higher highs.

Second of all, because it’s been slow in making, this bull market didn’t create overnight fortunes for many investors, as previous bubbles did. While we’ve experienced one of the biggest dollar and percentage increase in our nation’s net worth, it has gone mostly to those who were already “sitting” on assets: their homes, stocks, retirement accounts, bond portfolios. Obviously, there were those who took advantage of cheap credit and boosted their returns over the last decade, but most of the spoils went to truly passive investors.

Here at Sicart we can’t say we haven’t enjoyed the ride. Many investments that we expected to double in 5 years tripled in 3 instead. We won’t complain – but we can’t take full credit either. The bottom line is that those who held assets and did nothing benefited the most. There was no need to day trade or flip homes. What’s more the process took almost a decade, so the excitement of overnight fortunes never occurred.

Let’s keep the training wheels on

Most of us know how to ride a bicycle, and we learned using “training wheels.” I remember the day and the moment when mine came off. They helped you balance until you knew what you are doing, and soon  you were shouting, “Dad, Dad, look! No hands!”

The American and global economy experienced one of the most dramatic recessions in history less than ten years ago. There’s been much discussion about the causes and possible prevention of future events. Our take is simple: if money gets too cheap because of generous monetary policy, and if lending standards are relaxed for political reasons, there is trouble ahead.

To avoid a 1930s-style Great Depression, and taking advantage of all monetary and fiscal might that paper money, central banking, and fractional reserve banking allows for, this country avoided the worst damage by making money even cheaper, and relaxing lending standards even further. Ben Bernanke played the father-figure role: stern but finally relenting. He wasn’t the only one. The federal government played a major role, and so did central banks and governments around the world.

We can look at our economy as that kid learning to ride a bike. But, if I can extend the metaphor, our training wheels are still in place. Mr. Bernanke, as Dad, never got to see the economy free-wheeling on its own. Unfortunately, neither has Janet Yellen, who succeeded Mr. Bernanke. The same experience was shared by almost all key central bankers of the world. Neil Irwin named them appropriately in the title of his book: The Alchemists: Three Central Bankers and a World on Fire. One of the three, Mervyn King took this designation to heart, and called his own book The End of Alchemy: Money, Banking, and the Future of the Global Economy. It is a little bit disturbing to some of us to hear banking compared to magic.

As I wrote this article on September 20^th, everyone was holding their breath before Ms.Yellen’s press conference. We all want to know if the training wheels will stay on! A few days later, I think we are still confused about the next steps, and their consequences.

We might be grateful to our wizards for avoiding the next Great Depression, but it is that very assistance that has produced the least exciting bull market on record. And while their policies which might have fixed one problem they have clearly created another.

When is it going to burst?

It’s not only been the most boring bull market, but also the most questioned. As early as mid-April of 2009, the US equity market hit bottom, and hope was seeping back while the huge monetary and fiscal stimulus was underway. At that moment, famous market guru Jim Rogers told Barron’s that he didn’t believe in a U.S. stock recovery.

Shortly afterward, when the European debt crisis sent shock waves across all markets in 2011, a new wave of skeptics surfaced. John Mauldin published Endgame: The End of the Debt Super Cycle and How It Changes Everything. As the title implies, more debt is not a solution, and may cause a massive crisis in the near future.

In 2013, John Mauldin followed up with another great book: Code Red: How to Protect Your Savings From the Coming Crisis. I greatly enjoyed both books and many others published around the time, in part since I share Mauldin’s views. More and cheaper debt will not solve the economy’s problems. Instead it will eventually catch up with us in some ugly way.

Mauldin is far from the only author to take this position. In 2010, A. Gary Shilling authored The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation. In 2012, Richard Duncan wrote The New Depression: The Breakdown of the Paper Money Economy. In 2013, James Turk & John Rubino published The Money Bubble. In 2014, Willem Middelkoop released The Big Reset – War on Gold and the Financial Endgame.

Are we there yet?

The last six months have produced an even wider range of skeptics. Now even the major banks like Goldman Sachs, JP Morgan, Deutsche Bank, and major investors like Howard Marks, Paul Singer, George Soros, Jeffrey Gundlach, Carl Icahn, David Tepper among others, have shared their concerns with the public. Even the legendary Julian Robertson had to join the choir.

What I find most convincing about their opinions is that they are based on their worries about their own fortunes. Thanks to their success, they themselves have become the biggest clients of their own firms.

Actions speak louder than words, and Warren Buffett – who has been cautious about identifying a market  “bubble” in recent interviews – has begun accumulating a significant position of uninvested cash. If we’re not in a bubble, why the caution?

Being right and making money

All of the doomsday scenarios, from 2009 until the most recent, are correct. In a world where 2+2=4, we should already have a had a major market crash, and probably a major global recession. The economy would have cleansed itself from excess debt, and we would have started fresh in a more sustainable economic position. It would have been a painful experience to all, no doubt about it. But if the world must choose between less pain earlier or more pain later, there can be no doubt which is the better option. The one unavailable option is total escape.

Nevertheless, for the last decade the logic and common sense that normally undergird the market have been suspended. Monetary policy and fiscal stimulus (which have become intertwined in the last decade) are re-writing the rules and shaping a brave new world —

• without risks
• without economic, market, business, or credit cycles
• where capital can be created by printing presses
• where central banks become huge unfair competitors to private capital, distorting the natural pricing mechanism

 

Active investors can fall into a trap in a market like this. Benjamin Graham, the father of value investing, famously said, “In the long run the stock market is a weighing machine. In the short run, it is a voting machine.” Active investors (and we count ourselves among them) assume that the market can be irrational at times, but rational in the long run. What if the questionable rationality lasts a decade?

When the math doesn’t work

This least exciting bull market might be also the hardest to beat. Active investors are being outperformed and even the smart, well-funded hedge fund world has struggled in the last few years.

Some reports claim that hedge funds haven’t generated alpha since 2011: a date that coincides with the wave of doomsday-scenario books cited above. In 2016, hedge fund managers as a group earned the least since 2005, which is remarkable in a bull market.

Many big hedge fund managers are shutting down their funds, shrinking their operations or stepping down. Among those falling from hedge fund stardom is John Paulson who brilliantly predicted and benefited from the housing bubble crash. The world’s largest hedge fund, Bridgewater, seems to be also out of sync with the current market.

Sicart won’t try to time this market

We are more of a tortoise than a hare in our investing approach. We build and trim our positions slowly, and take the same approach when it comes to portfolio construction.

Accordingly, at least three steps are necessary in this climate:

First, an honest, diligent, and thorough review of all holdings, followed by the sale of the overleveraged, weakest, or riskiest securities.

Second, a higher-than-usual cash ( or equivalent) position – the US dollar may not be a great store of value over the next hundred years but in the near term, $100 is likely to remain $100.

Third, look into diversifying away from overpriced, overvalued assets through both inverse ETFs (which go up when the specific asset class goes down), and/or precious metal exposure. Gold has been considered a store of value for 5,000 years.

We’d rather err on the side of caution. As Meb Faber in Global Asset Allocation reminds us, most individuals do not have a sufficiently long time to recover from large drawdowns from any one risky asset class. What if they are ALL at all-time highs?

We have focused too much on the last 40 years as a model of what the markets can deliver in the long run. Yet if we expand the study to the last 200 years, passive investing has a very mixed record.

Our leaders want to convince us that they have the power to defy business cycles, outlaw recessions, and wipe out risk premiums. They’d like us to believe we live now in a risk-free, recession-free, ever-growing financial world. We have our doubts.

At Sicart we have a different mandate than risk-seeking, alpha-generating hedge fund investors. They try to maximize returns in the shortest of times, we want to minimize losses in the longest of times. We take care of family fortunes.

Hedge funds open and close, lose all the money, find new clients and start over. In contrast, we are in the business of nurturing family fortunes over generations. We must remain vigilant, disciplined, and conservative.

We are not in the business of making fortunes overnight. Instead, we are in the business of preserving them for as long as possible.

Bogumil Baranowski, September 22nd, 2017

Posted on Seeking Alpha.

Available as a video podcast or audio podcast (iTunes and Podbean).

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

We have forgotten what it’s like to experience a shrinking economy. The economic tailwinds we’ve enjoyed for decades, however, are beginning to turn into headwinds: demographics, consumer behavior and most of all — the debt mega-cycle. What has worked so well in the investment world for the last few decades may not only work poorly in the future, but also could get many investors into real trouble. Making and keeping money may become a lot more difficult than what we’ve gotten used to.

Thinking long-term

We at Sicart Associates don’t claim to have discovered a formula to predict the market’s direction for any particular span of time. Moreover, if we did have one, it would not be that helpful to our strategy and goals – wealth preservation over many generations. We believe that our job is to worry so that our clients have less to worry about. We think in terms of decades. So, this is a moment when we are looking backward at the last half century to assess where we might be headed to next. Fundamentally, we couldn’t be bigger optimists… but do we have some concerns about the near-term future.

The best 40 years behind us

The developed world has seen smooth financial sailing for dozens of years now, so long that many of us in the industry have known nothing else. So, let’s look at the special circumstances that brought about this halcyon period:

–we’ve had healthy population growth

–baby boomers have spent big, compensating for their parents’ post-Depression thrift

–productivity increased as technology not only became more prevalent but also lowered costs

–as a result, consumption increased, boosting GDP growth

In addition, fiscal policy has cooperated. We’ve ridden the biggest wave of constantly growing debt ever recorded. When we ran out of capital to lend, we’ve just printed fresh money to extend the “prosperity.” Last, but not least, so much private, corporate, and public debt would not have been possible without an accommodating monetary policy which in my lifetime has cut interest rates from 20% to zero.

Could anyone have asked for easier times? What amazes us is how long they have lasted.

Now, however, we see these trends as increasingly unsustainable. We expect rates to normalize. We expect deleveraging to take its toll, consumption shrinking, population growth slowing, and productivity flat-lining.

Double the debt, cut the rates, double the debt, cut the rates…

There have been economic hiccups in this prosperous period, of course: 1987, 2000, 2008, and smaller bumps in the road. Each time we could count on the government’s generous helping hand – they religiously doubled down on the debt, and cut rates in half to keep the party going. Dr. Greenspan put his gold standard beliefs aside for the time of his tenure as the Fed chairman, then a student of the Great Depression Dr. Bernanke picked up where his predecessor left off. Dr. Yellen not only promised us no crisis in our lifetime, but followed in the footsteps of Dr. Bernanke, keeping the rates very low, and only raising them (slightly). We understand – it’s almost impossible to disrupt institutional inertia. Or, for that matter, to propose alternatives to received wisdom that everyone accepts.

Why look back and learn something?

Nevertheless, if history teaches us anything, it is that every period of growth, expansion, and eventual credit bubble is followed by a major contraction. We saw it in the US between 1929 and 1932 when the economy shrank by 1/3, the stock market collapsed by 90%, and deflation cut prices by 18% (through 1936).  It took the Dow a quarter of a century to recover – a whole new generation was born, raised, and educated, before the market reached its previous high.

So, we wonder: How would have today’s passive investors fared in a turbulent period like that?

Maybe we can’t agree on the remedy, but we can agree on the cause.

No one doubts that there’s a great deal to learn from the Great Depression, but there’s some politically-generated confusion about just what those lessons are. Some claim the government did too much, some say too little. Some believe the wrong policies were put in place while others think the market would have self-corrected in time. Perhaps the more the government tries to “help,” the bigger the problems down the road. The one clear lesson from the past seems to be what conditions usually lead to an economic crisis:

– cheap and easy credit. It seems to have been a no-fail formula over decades, and centuries if not millennia. Looking for examples? How about:

–the Greek Debt Crisis

–Japan’s 1980s Bubble

–the Weimar Republic (Germany, 1920s)

–the South Sea Bubble (England, 1720s)

–the Mississippi Company Bubble (France, 1720s)

–late Roman Empire.

By debasing our currency and racking up a lot of debt in the last 40 years we haven’t invented anything new, but we did it take it to the next level.

Today

Businesses are doing great

During 40 years of tailwinds that are both unprecedented and perhaps unrepeatable, business has prospered greatly. High spending and consumption boosted revenues to ever higher levels, productivity and globalization lowered costs, which led to record profitability. The drop in the cost of debt, dramatic increase in leverage, and stock repurchases funded a one-time boost for earnings and stock prices in the last decade. General exhilaration helped expand valuations to record levels. In equities, these valuations are expressed as record high earnings multiples while for real estate and fixed income they’re record low yields. Many private equity deals and real estate projects have been made possible by sustained economic growth, higher prices and ever cheaper credit. At the same time, never-ending rounds of drastically low-cost debt financing have kept alive many otherwise bankrupt companies (zombies).

Consumers would rather go big than go home

Consumers enjoyed the ride as much as business people. The cost to borrow fell and we have been encouraged to borrow more to buy anything and everything. We’ve also been discouraged from saving. Now, we’ve not only recovered from the last correction in 2008, we hold more credit card, student, car, and mortgage debt than ever. Our investments and retirement accounts have been boosted by easy monetary policy, bidding up asset prices all around. We are richer than ever, and we’ve been able to buy more with less money down, and lower payments than ever. Just one outstanding example:

–record car sales (recently finally correcting)

-with record average car prices,

-record percentage of financed cars

-record percentage of leased cars thanks to customers who want to buy big but can’t handle the monthly payments.

The US government has never been richer

The US government at every level, right down to localities, has also benefited from the last 40 years. Not only did it get easier and cheaper to borrow your way to “prosperity;” but also with all the economic growth, and asset inflation these governmental bodies have enjoyed record tax revenues. Extrapolating all those rosy assumptions into the future makes all promised obligations and benefits seem almost reasonable. We are currently hearing once again about the nervous dance around the federal debt ceiling, and attempts to raise it one more time. The concept of “fiscal discipline” seems to have disappeared from political and economic dictionaries for good.

The trends are shifting though

More with less

More cars, more homes, more things — the mantra of the last few decades — resonates less with the younger generation. They are not big buyers, and spenders. Millennials prefer transportation-sharing apps to possessing cars. Access matters more to them than ownership. They’d rather use vacation home-sharing apps rather than owning a second home or staying in hotels. Younger generation has also less disposable income due to both the student debt burden and the limited availability of well-paid jobs which would allow for mortgage, car, or second home payments. Since there are at least as many Millennials as Baby Boomers, they may eventually step up to the plate, and mature into consumers, but still probably not to the same extent as their parents.

Demographics tell the truth

The biggest consumer generation in history is retiring now. They are still in debt, they don’t have enough saved for retirement. Many will have to rethink spending habits and start tapping into savings as income starts to shrink. Overall US population growth is the slowest it’s been since 1937. The current childbearing generation tends to have fewer kids, and to have them later in life. Immigration won’t help our economy as  much as it did in the past, either: on one hand, fewer people are coming and on the other, the current administration is less immigration-friendly than previous ones, ignoring the demographic realities.

End of easy, cheap credit

Credit plays a crucial role in the economy. Short-term credit helps companies manage their working capital and helps households get through brief monthly cash flow shortfalls. Long-term credit enables big investments in new productive assets, offices, warehouses, and homes. The economy can grow faster than population and productivity growth would normally permit – but only if we can continue to expand the overall leverage in the system. We are basically spending future savings (in other words, we will have to save in the future to pay off what we borrowed today), unless the central bank buys government debt, mortgage-backed secured and other debt obligations, then we are spending money that does not actually exist. The consequences of such an experiment are unknown, but unlikely to be positive.

Either way, we at Sicart Associates argue that there is a limit to how much debt any economy can maintain. If a free market in interest rates existed, current excessive public debt would have already pushed the cost of money higher. Thus, the general cost of debt would have risen and quickly put an end to the credit expansion. As Richard Ebeling, in his refreshing book Monetary Central Planning and the State, reminds us: “Monetary central planning is one of the last vestiges of generally accepted out-and-out socialist central planning in the world.” He adds “Government can no more correctly plan for the ‘optimal’ quantity of money or the properly ‘stabilized’ general scale of prices than it can properly plan for the optimal supply and pricing of shoes, cigars, soap or scissors.”

Eventually though, the total outstanding debt will not only stop growing; it will start shrinking (paid off, defaulted or not-rolled over), and rising rates will accelerate the process. Our consumption, spending, and financial engineering will correct themselves automatically.

When trends collide

What happens when decelerating population growth and productivity improvement run up against shrinking and more expensive debt and lower spending?

Asset bubbles burst

With consumers spending less and the cost of debt rising, revenues, margins, and cash flow will all come under pressure. Many assets will become less attractive, many businesses unprofitable, and perhaps even unsustainable. Valuation will compress, leading to meaningful correction in prevailing prices. We might see lower profits, lower prices, and higher cost of debt.

It’s a triple whammy for businesses and investors.

Government with emptier pockets and growing obligations

If tax revenue shrinks due to falling profits and incomes, deficits will expand unless the government cuts spending. That would require cutting welfare programs, pension fund benefits, etc. which maintain the livelihoods of an ever-growing senior citizen population. All the long-term assumptions of all pension funds at all levels would need to be rethought, and the gap between what they need and what they can actually earn will widen. Cuts, which may turn out to be unavoidable and necessary, would further undermine consumption, which spills over to businesses. They would suffer from even deeper profit cuts, and resort to even bigger employee layoffs. The result?  More pressure on tax revenue on one side, and greater need for unemployment benefits on the other. We might see higher spending needs, lower tax collection, and higher cost of debt.

It’s a triple whammy for the government policies.

Living standards adjustment

The macro correction could lead to higher unemployment, lower income, lower ability of the government to help, failing pension funds and asset price declines – homes, stocks, bonds all re-establishing values at substantially lower levels. We would both feel poorer, and have less disposable income that could be taxed at higher rates to offset a tax revenue drop. The Great Depression was an era of the biggest tax hikes in the U.S. history, with margin rate going from 25% to 94% by 1945. As demand weakened, prices would have to fall, creating a softer landing for those with sustainable income. Lower incomes, lost investments, higher cost of debt.

It’s a triple whammy for individuals.

Seeing and acting on it

It’s not hard to imagine how the last 40 years’ upward spiral driven by debt, demographics and productivity could easily become a death spiral. We at Sicart Associates are not the only ones who perceive the problem, but we are among the few who act on it. We see complacency and paralysis – cash levels among investors are at record low, short positions as well, and passive investing has never been more popular. Even investment professionals choose to either ignore the danger or take a “cautiously cautious” stand.

Buy and hold approach

We are big proponents of a “buy and hold” strategy: one-decision stocks. We buy them right, and hopefully don’t ever have to sell them. We see how that approach has done a magnificent job for us and many long-term investors, Warren Buffett among them. We do believe that times have changed. It’s not only dangerous to remain fully invested, and especially to be a passive investor; it’s also dangerous to stay blindly committed to the “buy and hold” approach. We are under the impression that we’re reaching the end of a huge cycle with peak levels of public, consumer, and corporate debt, ultra-low interest rates prolonging the cycle, and ultra-high asset prices and valuation temporarily masking the problem.

Today, successful investing is less about chasing the tail of a tired bull market, and more about preserving the capital.

Our clients are families, and our job is to take good care of their fortunes for generations to come. Today, our best course is to:

Hold only “highest conviction” stocks

Maintain excess cash positions

Keep fixed-income durations short given interest rate uncertainty

Consider some small gold exposure.

(We are more concerned about deflation hitting us first before inflation catches us by surprise later; thus, the possible role for gold.) Finally, to benefit from a potential market drop, we’d consider a very gradual use of an inverse ETF tracking a broad market index, and preferably one that is not leveraged. Additional leverage can give us a boost if we are absolutely right about the timing of the sell-off, but that’s hard to guarantee.

Abundance of investment ideas ahead, the US remains the favorite market

We expect to see some remarkable opportunities ahead, possibly even a true revival of Benjamin Graham- style fundamental equity research. In that situation, we’d probably have more ideas than money — our favorite time for stock picking.

We make it a practice to look anywhere and everywhere for ideas: among small and big companies, domestic, and foreign. We are exceptionally excited about the US market, though, given its size, diversity, and depth, backed by the 300M+ American population full of hard-working, smart, creative people and a vast, rich economy. It’s been a true talent magnet for a few centuries. We’ve been through ups and downs before. The point is to acknowledge that they happen, and to be prepared.

 

Bogumil Baranowski August 21^st, 2017

Posted on Seeking Alpha.

Available as a video podcast or audio podcast (iTunes and Podbean).

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

When we analyze an individual stock or the market as whole, we wonder how our conclusions can be wrong. Lately, we think the current market offers extremely low reward at an extremely high risk. How can it keep going up forever? Only if it finds buyers.

Since the last financial crisis, debt-funded corporate share repurchases have amounted to almost 20% of market capitalization, and they offset net selling across most other investor types. The best example of current times is Restoration Hardware which recently executed a huge and speedy buyback, loading up with debt and propelling its stock 170%+ creating a major short squeeze — while its peers remained flat, and its business fundamentals have been underwhelming.

Will anyone replace those buyers? And do they have the capital to do so?

Source: Thomson Reuters, Credit Suisse.

Wealth preservation vs. chasing the next hot thing

Many financial advisors will tell you that they are in the business of making money for you. Our practice, on the other hand, calls for preserving and growing family fortunes over generations. The two mindsets couldn’t be more different. We remain loyal to the same clients for many decades, and we care for their financial well-being the same way we do for our own. More conventional money-management firms, if they fail to deliver on their promises, can find new clients and new success with a novel investment idea.

We, however, understand that a disciplined, calm, deliberate contrarian approach serves us best in our endeavor. We may not always beat all asset classes or all indexes, but our top priority is preserving capital, and that we do very well. We are not complacent, however: we always question received wisdom, including our own.

Red flags all around

For a while now, we’ve been pointing out red flags in the investment world:

–record public, private, and corporate debt

–record valuations

–slowing economic growth

–staggering central bank-funded asset inflation

–record-low volatility

–record-high passive investing.

These disturbing phenomena are generally viewed with indifference in the world of finance, but we suspect they foreshadow the end of an unprecedented bubble. In other words, we are operating in an increasingly risky investment environment that offers decreasingly attractive rewards.

The most prosperous decade

On paper, the last 8 years have been a period of the biggest wealth creation in history. In the US alone, total net worth peaked at $68 trillion in late 2007, then dropped to $55 trillion in 2009. From there it soared to reach almost $95 trillion most recently. In a similar scenario, US homeowner equity got cut in half in 2009/10. Since then, in an unprecedented $7 trillion swing, it has doubled. Those are remarkable growth curves considering current weaknesses in economic recovery and productivity improvement, along with the slowest population growth in decades.

Our fear is that the most recent boom could be followed by a corresponding destruction of wealth, with potentially disastrous effects on the record number of individuals who will soon reach retirement age. Would their life savings survive a market bust?

Pain now, pain later, or the illusion of no pain at all

The world’s governments and central banks are currently faced with three corrective options. They may take actions that produce pain now or later, or actions to prolong the illusion that pain can be infinitely deferred. (Another term for this might be “kicking the can down the road.”) If you were sitting in the dentist’s chair you’d probably choose the last strategy. That’s human nature. But as professionals, we at Sicart are wary of illusion. If our leaders truly normalize fiscal and monetary policy, we’ll see major deflation and explosion of the asset price bubble, followed by a severe depression and massive unemployment. Unfortunately, all that pain might be required to shape a sounder economy for generations to come.

The big illusion persists

If our leaders choose to continue postponing financial pain, we’ll see more weak growth and more market distortions in asset prices, feeding further illusion.

Central banks will further expand their mandate beyond inflation and employment targets, and officially start to do all that is in their power to never allow any asset price to fall. This will only take the current absurdity to a whole new level.

Unfortunately, a great deal can go wrong with that attempt to defy market and economic cycles by riding the wave of ever cheaper credit and ever more debt. We may think we have escaped the pain of a serious market correction, but it will catch up with us eventually.

The Federal Reserve is already a big holder of mortgage-backed securities, propping up assets ranging from our home prices to government bonds. The European Central Bank (ECB) is equally active in government bonds, and has been a big buyer of corporate bonds. In addition the Swiss National Bank (SNB) has been shopping globally, snapping up mega caps in the US (Apple, Microsoft, Amazon, Facebook, and Alphabet, for instance). Meanwhile the Bank of Japan (BOJ) has become the biggest holder of local ETFs (71% of the nation’s ETF market as of July 2017).

Unlimited buying power and no accountability

Propping up the market is nothing new. Conceptually that’s what banker John Pierpont Morgan did in 1907, that’s what was attempted in 1929. However, Morgan’s capital was limited and private.

In 2017, we have central banks with unlimited buying power and unlimited options. The ECB took 12 months to even disclose what they’ve been buying in the corporate bond market, and did so only under pressure.

If we count the assets of the 10 largest central banks, Bloomberg reports, the total amounts to $21 trillion in central bank assets or 30% of the world economy; or 1/3 of the world market capitalization; or 1/3 of official world public debt, or the total value of the US stock market. How much is too much?

Source: Bloomberg

The other difference between the present and the era of J.P. Morgan’s intervention in the market is the duration. In 1907, it was brief. Today, however, the central banks’ involvement in markets can prop up prices for almost a decade, and there is still no end to it. Needless to say, such a long period of market distortion only creates an ever-bigger gap between the reality of market forces and the illusion created by monetary and fiscal wizardry.

The biggest leveraged buyout (LBO) in history? Biggest market rally ahead?

Could central banks buy another $50 or $100 trillion of anything they want at whatever price they want? Of course, they could. If they did, asset prices could continue to climb. Could the central bankers take all public markets in all securities private? Interest rates are set at zero, credit is free, risk premium is a forgotten concept, printing presses are allowed to run full speed. What’s more, central banks can buy and hold almost everything: government bonds, mortgage-backed securities, corporate bonds and equities, on top of what John Maynard Keynes referred to as – “barbarous relic” – gold.

Thought experiment

If you extrapolate this market intervention to the limits of imagination, central banks could eventually own all corporate and public debt, all banks, all formerly publicly traded equities, and all real estate: any asset with a price tag. When you go through that thought experiment, we end up in some really silly world…

Blast from the past

In fact, we are transported to the last days of the failing centrally-planned economies of Central and Eastern Europe. Back in the late 1980s local currency had no credibility as a store of value so people’s savings were in US dollars (referred to as “hard currency” and treated with the utmost respect). There were no public equities, no bond market, and real estate was most often leased rather than owned. Is that where we are headed? What will be our hard currency this time?

Haven’t we learned anything?

If central banks eventually own all assets, any former asset-holder will be sitting on a lot of newly printed cash with nothing to spend it on. What do you call a time when too much paper money is chasing too few goods? Hyper-inflation.

The IMF, studying the early-1990s policies in Central Europe concluded that “cheap credit, fiscal deficits financed by central banks had led to near hyper-inflation.”  Having witnessed that economic experiment at first hand, I sincerely hope we are not headed that way.

To undo the damage of the centrally planned economy in Central Europe almost 30 years ago, the IMF set a fundamental rule for the governments – it forbade the national central banks to finance government budget deficits and forbade the issue of new currency. Isn’t this the very rule that all major “free market” countries violate so openly these days? Is it time to reinstate that old rule?

No normalization in sight

Year-to-date, despite the supposedly improving economy and inflation picking up, central banks bought $1.5 trillion in assets with BOJ and ECB leading the race. If they keep up the same pace throughout the rest of the year, this will be the biggest buying spree in a decade. Something tells us that new highs for the stock market may have something to do with it.

Lately, the Fed has alarmed some observers with talk of tightening and balance-sheet shrinking, but we wouldn’t bet on policies normalizing anytime soon. In our definition, that means the Fed going back to its original role – lender of last resort, allowing the market to freely set interest rates reflecting true investment risks across the full spectrum of assets.

Revolutionary idea? Hardly. The same way the market sets prices of thousands if not millions of goods and services every day without the help of a dozen wizards secretly contemplating the next price change and communicating in codes causing the markets to whipsaw as central bankers “recalibrate the message” each time.

Reading the tea leaves

Recently the famous motivational speaker Tony Robbins asked Former Fed Chairman Alan Greenspan: “So, in this world of intense volatility and insane central banking policies around the globe, what is the one thing you would do if you were still the Fed chairman today?” Greenspan paused for a while. Finally, he leaned forward and said: “Resign!”

It was probably the clearest, and shortest answer anyone has ever gotten from Dr. Greenspan, who once famously said: “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant”. We know what he meant this time. It’s never been more difficult to be a central banker – never the stakes have been higher, never the dilemmas bigger.

We’ll take Dr. Greenspan’s frank response over recent Dr. Yellen’s comforting assurance of no financial crisis in our lifetimes. Those kinds of declarations seem to be usually very poorly timed, like Dr. Bernanke’s 2007 calming commentary or the words of the legend himself – John Maynard Keynes who told us in 1927: “We will not have any more crashes in our time”.

The bottom line: yes, central banks can become buyers of last resort, but in the long run, you can’t borrow or print your way to prosperity

The current misguided monetary and fiscal policy can last for a long-time, and central bank can establish themselves as buyers of last resort vs. lenders of last resort which was the intended role at their inception. This economic experiment will eventually have to end though.

The lesson here is not that capitalism or the free market economy has failed us.  it’s that statism, government interventionism, and central bank manipulation always eventually fail as they have done too many times before. The free market and capitalism haven’t had a chance to breathe in a while.

No one can tell just when the stock market will peak, but this is not a good time for complacency, passivity or paralysis. We wish smart decisions, good luck, and patience to everyone with a small or large fortune at stake. The next 40 years will be very different than the last 40, and likely the next 5 won’t be like the last 5.

We recommend acting accordingly.

Bogumil Baranowski – July 31st, 2017

The article was also published on Seeking Alpha.

Available as a video podcast or audio podcast (iTunes and Podbean).

 

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

A lesson from Hans Christian Andersen

Sometimes I think that we learn all we need to know in life as children, and then somehow forget it all as adults. On my frequent walks through Central Park, I pass the statue of the famous Danish writer Hans Christian Andersen, famous for his fairy tales. One of his stories has made a lasting impression on me. It’s the tale of two enterprising weavers who promise a vain emperor new clothes which will be invisible to those who are unfit for their positions at court. As you may remember, when the emperor chooses to parade his new attire, only a child in the crowd dares to say he is not wearing anything at all. Let us, for a moment, look at the financial world through the eyes of that child. (1)

New market highs in the land of make-believe

Around the globe equity, bond, and real estate markets hover at all-time highs. Valuations are extended to the limits, growth languishes, and we are beginning to question the quality of the weavers’ work — no matter how embellished their fairy tale has become. The weavers’ fabric turns out to be the ballooning debts, the threads are zero interest rates, and it’s all beautifully colored with relentless money printing.

Free market and its invisible hand vs. state interventionism and its firm visible grip

We recognize the free market’s ability to establish prices for goods, services and assets, through the natural forces of supply and demand. However, we also acknowledge the power and the extent of market manipulation through massive state interventionism, which passes today as “counter-cyclical pro-growth policies. “(2) Increasingly, we worry that this may be a failing strategy inspired by John Maynard Keynes’ faith that the state apparatus, and its ruling elite, will always save the day. (3)

Laws of economics: a quick refresher

Most of us got our grounding in economics some time after we heard fairy tales like “The Emperor’s New Clothes.” No matter when you took Economics 101, the three basic precepts are the same:

1) in order to invest or consume we are always spending our or other people’s savings, and we must repay those funds. Thus, there is a limit to what we can afford.

2) when countries have a trade imbalance, the country with a surplus accumulates the currency, and the country with a deficit eventually runs out of money. Then the exchange rate gets adjusted, and the trade is rebalanced – eventually you can’t buy what you can’t afford, can you?

3) if a government wants to borrow more money, the formula is simple: the more it borrows, the higher the rate it has to pay. Eventually it has to stop borrowing because it can’t afford to keep up payments.

You can see how there is a series of natural checks in this system. (4)

Where are the limits in our brave new world?

Over the years, these fundamental laws have been suspended. The situation resembles that of a builder constructing an ever-higher dam with ever-weaker material. “Look, I stopped the river for good!” he declares. We are smarter than that – aren’t we?

One factor that contributes to our illusions is the effect of fractional reserve banking, which permits creating more credit out of the same amount of deposits. It helps us enjoy economic booms, but also brings us regular busts, when the credit shrinks. As much as we appreciate the benefits of fractional reserve banking in good times, we need to remember the risks it carries, when the tide turns. Contrary to a growing popular belief, more and more credit is not the remedy for each and every downturn.

Secondly, trade imbalances can be maintained and extended – but not indefinitely. The printing presses of our trade partners’ central banks play a key role. Their newly printed money buys our currency, which they use to buy our public debt, which we provide with on-going, never-ending budget deficits. Again, the limit to what we can “afford” gets extended, maybe even becomes unlimited – at least for the time being. Eventually, we would need to adjust our consumption.

Thirdly, what happens when the government wants to borrow more and more? Anyone who has studied economics might have heard of the crowding-out effect. When government spending drives down private spending, and the government absorbs all the available lending capacity in the economy, the interest rates (the cost to borrow) go UP. These are simple laws of supply and demand. Free market interest rates go up, when the demand for capital goes up. This is the normal cause and effect.

But what happens if the government doesn’t need to rely on savings or the limited lending capacity of the economy? What if the central bank buys government debt with newly created money? Interest rates will likely stay unchanged or even fall, especially if they are controlled by an all-powerful central bank. That’s something we’ve experienced around the world over the last ten years. There is no limit on what the government can afford to borrow, and the prevailing belief is that more debt is a cure for any temporary weakness in the economy.

Back to the basics: capital

The foundation of a free market capitalistic economy is capital, i.e., the accumulated savings of all market participants. Capital is needed to finance our investments and our consumption. There should be a free market for that capital for those who have it (supply) as well as for those who want it to invest or spend (demand) – price discovery at its best!

Who is wearing invisible clothes now?

In our real-life parable, the savers are the last ones wearing real clothes, and instead of being praised for it, they are despised. Invisible clothes are proudly worn by everyone else. Governments spend money they don’t have and make promises they can’t possibly keep. Corporations borrow to buy businesses, pay dividends, and repurchase shares, which they can’t really afford. Consumer drive cars, wear suits and live in homes, none of which are really theirs.

War on savers won at last?

The outcome of recent trends and the evolution of contemporary economics put us in a peculiar position where the very foundation of the system –  savers and investors — is under attack. The artificial zero rate environment established by central banks pumping an unprecedented supply of money into the system has made savers’ and investors’ capital almost irrelevant. Legitimately-earned ready-to-invest capital is commingled with legally-counterfeited freshly-printed money. Thus, the praise of spending beyond one’s means and seeing credit as an ultimate remedy puts rational, responsible savers in an unfavorable position. Finally, we see emerging support for eliminating cash (5) to improve the effectiveness of a monetary policy. That’s the same policy which has brought us both real and increasingly often nominal negative interest rates, which is yet another assault on savers. As a result, savers are enticed to spend, and borrow rather than invest.

This recent phenomenon brings not so fond memories of some questionable ideas of the past. Karl Marx shared his disapproval of savers calling them “hoarders”, and John Maynard Keynes argued for “euthanasia of a rentier” expressing his dislike for thrift, and farsightedness. Lastly, Ben Bernanke not long ago blamed alleged “savings glut” for economic trouble, and challenges facing monetary policy.

New peaks of experimental economics

As a civilization with at least 5,000 years of experience with money, finance, and credit (6), we have never before reached the current levels of financial fantasy that bring us back to the vision of an unclothed emperor parading before his subjects who support his illusion so as not to be considered “hopelessly stupid.”

The correct incentives that lead to prosperity are temporarily out of favor. If history offers any guidance, the natural laws of economics can be suspended only for so long. We have to admit that sometimes we feel like characters in Samuel Beckett’s famous tragicomedy – “Waiting for Godot”. We’ll wait.

Having the courage of a child in the crowd

As contrarian investors, we often risk being considered “hopelessly stupid.” Yet we have no choice – we must find the courage of that little child in the crowd who speaks his mind.

In our role as investment managers taking good care of family fortunes over generations, we have to take steps to position our clients’ portfolios in these perilous times, where shortsightedness, complacency and passivity can prove exceptionally dangerous to wealth preservation. Blind faith and trust in the weavers’ words may get us in trouble.

The procession must go on!

This is how Hans Christian Andersen ends the tale:

“’But he doesn’t have anything on!’ said a small child.

‘Good Lord, let us hear the voice of an innocent child!’ said the father, and whispered to another what the child had said. ‘A small child said that he doesn’t have anything on!’

Finally, everyone was saying, ‘He doesn’t have anything on!’

The emperor shuddered, for he knew that they were right, but he thought, ‘The procession must go on!’ He carried himself even more proudly, and the chamberlains walked along behind carrying the train that wasn’t there.”

Maybe the procession must go on, but we choose not to follow an emperor wearing nothing.

Bogumil Baranowski – June 23rd, 2017

The article was also published by Seeking Alpha.

References:

1. “The Emperor’s New Clothes” – Hans Christian Andersen, 1837
2. The Great Deformation: The Corruption of Capitalism in America – David Stockman, 2014
3. The General Theory of Employment, Interest and Money – John Maynard Keynes, 1936
4. The New Depression: The Breakdown of the Paper Money Economy – Richard Duncan, 2012
5. The Curse of Cash – Kenneth S. Rogoff, 2016
6. Money Changes Everything: How Finance Made Civilization Possible — William N. Goetzmann, 2016

Disclosure: This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

It’s obvious to us that the US equity market is overheated, and that we are due for what may prove to be one of the biggest corrections ever recorded. We don’t claim to know when exactly it will happen, how much stocks will decline, and for how long. We are no prognosticators, we are just trying to make an intelligent interpretation of the familiar facts.

We consider ourselves value contrarian long-term focused investors. We like to buy good companies when they are down, cheap or out of favor. Even today’s market’s tech darlings had their long spells in the doghouse not that long ago.

We don’t usually bother to make market forecasts. We enjoy learning about businesses, distinguishing good ones from bad ones, and maintaining discipline in buying them. For us at Sicart this is more satisfying than analysis of the big-picture macro backdrop. Normally we find that to be a futile endeavor. Nevertheless, from time to time it’s the big picture that matters more than stock picking. This is one of those times.

What do we see?

— markets hovering at all-time highs

— valuations at record levels

— fiscal and monetary stimuli unleashed to the limits of imagination

— more of the same being offered as a recipe for lackluster growth

Yet there is a dwindling conviction that even with these measures, growth could be swift and orderly.

Thus, we choose capital preservation over near term growth at a record high risk.

As we are reminded by the past and by observations credited to such financial masterminds as Baron Rothschild, J.P. Morgan, and Bernard Baruch, fortunes are made by selling too early. Seeing a problem is one thing; acknowledging and speaking up about it is another. Acting on that conclusion is a whole different thing.

From the big picture, top-down point of view, we see a lot of red flags; from the bottom-up point of view, we see little (if anything) that we really like.

If you just look at the price chart of any major US or global index or for that matter, you’ll see an all-time high. Momentum investors might get excited about it, though they get easily bruised in this flattening market. We, on the other hand, are curious as to how much further can this go on, and what will follow.

No matter which metric you like to use — trailing 12-month price-to-earning, cyclically adjusted price-to-earnings, PEG ratio to account for meager growth — the conclusion is self-evident; the market is very expensive. According to many metrics, it’s the most expensive it has ever been, going back to the foundation of modern stock markets.

We would have no issue with a chart climbing to the sky, and valuations on a similar trajectory, if we held only stocks characterized by accelerating growth and improving margins. However, that does not reflect the broader market. GDP growth and underlying earnings growth have been decelerating.

S&P 500 companies are enjoying peak margins mostly because of the artificially low cost of borrowing, which is responsible for the majority of margin improvement since the 2009 market low. If that wasn’t enough, S&P 500 companies (excluding financials) almost doubled their leverage (debt-to-EBITDA), which helped grow earnings per share through record high buy-backs, and top-line through acquisitions. That one-time tactic has its limits.

Some pundits argue that during the internet bubble some valuation metrics were even higher. This, they claim, creates more headroom. They forget to mention that the last 5 years do not compare at all to the late 1990s. Back then the GDP was growing at twice the current rate while productivity grew at three times the current rate. What’s more, 5- and 10-year average EPS growth was in high single-digit percentage vs. less than 1% for the same periods today.

Let’s prime the pump!

With fragile growth, one might hope for more counter-cyclical monetary and fiscal stimulus from Washington. How much dry powder is left, though? Interest rates are close to zero. The Fed’s balance sheet hasn’t been this big since the Great Depression. US government debt hasn’t been this high since funding the world’s biggest war (WW2). Meanwhile total US debt –including corporate and consumer –has also peaked. These conditions would usually prompt easy money policies and more fiscal stimulus to “prime the pump” when the growth stalls. However, those tools have already been used extensively. What’s more, they have their limits. The record shows they haven’t been very effective. If anything, they’ve helped inflate asse pricess even beyond the peaks the market reached prior to the Great Recession.

The broad economic picture is only one side of the current situation. Looking at it another way, very few individual stocks meet our strict contrarian criteria. Yet a high concentration of all stocks hovers close to 52-week or even multi-year highs. That reminds us of a store where everything is priced the same, regardless of quality.

At the same time, very few stocks trade at comparably low prices: 52-week or multi-year lows, our usual hunting ground. The majority of companies that happen to be down have been tarnished by fraud, litigation, or questionable business practices.

Given the macro and micro backdrops, you’d think this supposedly efficient market would price the risks and rewards properly.

Unfortunately, the market sometimes operates like someone who boldly runs out of the house with no umbrella because it’s not raining — only to get drenched 5 minutes later. So, who is making calls in this so-called efficient market? With an unprecedented expansion of passive index investing, there’s less independent thinking and more blind following. This is a worrisome development.

More and more debt is not a sustainable solution.

Human civilization offers over 5,000 years of recorded history of debt. Bubbles go back as far as the Babylonians, Ancient Greeks and Romans over-expanded with the help of easy credit and debased currency. These cycles have been repeated throughout history. We have nothing against the use of credit but there is such a thing as excess leverage, as mankind has learned and forgotten over and over again.

Deleveraging is usually disruptive to the economy, society, markets, asset prices, and asset allocation.

There are at least four possible scenarios: 1) initial deflation followed by an over-large stimulus, leading to hyperinflation (example: the Weimar Republic in the 1920s) 2) just enough stimulus to keep the economy alive while escaping deflation for decades (example: contemporary Japan) 3) we miraculously grow our way out of trouble (historical example: none) 4) governments and central banks step aside, and let the free market correct itself, resulting in deflation, temporary recession, subsequent honest debt repayment through higher taxes, followed by interest rate normalization.

In more detail:

• A likely scenario would lead to stalled growth, increased unemployment, and deflationary pressures – massively unpopular results. The Fed and the government would follow their Pavlovian response and cut the rates to zero. Unleashed asset buying would swell the Fed’s balance sheet with more air. Meanwhile the government would augment the stimulus with higher spending and lower taxes. Debt levels would balloon further. Eventually creditors would have doubts about the government’s, consumers’, and corporations’ ability to pay their debts.  As faith in the currency wavers, inflation would finally kick in.
• Or: just enough fiscal and monetary stimuli would keep growth above zero, teetering between deflation and hyperinflation. (Imagine a tightrope walker on a windy day with a bit of rain and hail.) Government could keep this up for as long as possible, as Japan did for almost 30 years while a dramatic asset deflation eroded wealth (stocks and real estate lost 80%+ of their value over time). It’s a path of slow, almost invisible nationalization, where private market participants are gradually replaced by the government.
• We would like to be wrong about the near-term challenges. We would love to see growth accelerate at unprecedented levels so we can grow our way out of public, consumer, and corporate debt while the level of interest rates normalizes. However, history offers no examples of this.
• The most rational scenario is like an unpleasant dose of medicine, i.e. allowing free market forces to take over after decades of counter-cyclical fiscal and monetary interventionism. Deflation would take its toll across services, goods, and assets, while we deleverage the economy. Taxes would rise to pay off the excess debt we’ve accumulated over many decades. (Not only unpleasant, but difficult to execute politically.) Once this is accomplished we can grow from a new, healthier base. This process was carried out in the US in early 1920s and again after WW2, when fiscal discipline and responsible monetary policy were still virtues. This path could be self-imposed or enforced by creditors.

Clearly, the only two options are tightening and deleveraging now, or deleveraging later. The order of steps the economy follows will determine which assets will prove safe havens, and which ones eventually offer satisfactory returns.

The global GDP grows in two ways – population growth and productivity growth.  Every other kind of growth is borrowed (or stolen) from the future, through the use of debt. Given current demographics and the immigration stance of today’s administration, population growth cannot provide a sufficient boost for the US economy. Meanwhile productivity plateaued a while ago. Apparently sharing selfies, lining up to buy electric sportscars, and binge-watching streamed TV shows have not been incremental enough to our economic output – hence our obvious doubts about the rosy scenario.

Neither excessive public debt or attempts to turn them into success stories are a 21-st century invention. In the early 18^th century, Mississippi Company was a vehicle set up to help consolidate and reduce the cost of a massive national debt in France, and South Sea Company was a similar attempt in the UK, we all know that both led to infamous bubbles that fooled such brilliant minds as Sir Isaac Newton himself.

Today, successful investing is less about chasing the tail of a tired bull market, and more about preserving the capital.

Our clients are families, and our job is to take good care of their fortunes for generations to come. Today, our best course is

–to hold only “highest conviction” stocks

–maintain excess cash positions

–keep fixed-income durations short given interest rate uncertainty

–consider some small gold exposure.

(We are more concerned about deflation hitting us first before inflation catches us by surprise later; thus, the possible role for gold.) Finally, to benefit from a potential market drop, we’d consider a very gradual use of an inverse ETF tracking a broad market index, and preferably one that is not leveraged. Additional leverage can give us a boost if we are absolutely right about the timing of the sell-off, but that’s hard to guarantee.

Why are we optimistic despite such a gloomy backdrop?

We are big believers in the strength and resilience of a free market capitalist economy with its natural business cycles. We are highly skeptical of the efficiency and lasting success of counter-cyclical fiscal and monetary state interventionism. What gets us excited is the prospect of bargains across all asset classes that will follow the current effort to overrule inevitable forces of the free market.

We are playing the very long term game. We can wait. Today investing may feel like shopping in a crowded department store at the peak of pre-holiday frenzy, but we all know what happens after New Year’s Day — fewer shoppers, better selection, better prices. It only takes some patience.

Bogumil Baranowski, Sicart Associates, LLC – 5/19/2017

The article was also published by Seeking Alpha

Disclosure: This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Asset prices at record highs, and bound to decline

As much we avoid forecasting the market’s direction, we have reasons to believe the US stock market is too high. It’s not a question of “if” but “when,” “how much,” and “for how long” stock prices will drop. We believe that most asset prices could be subject to some of the biggest declines we have seen in decades, if not a century.

There are two possible paths from current highs. Both have been tried before, are well documented and well examined, and both lead downward. At Sicart Associates capital preservation is our foremost objective, so we need to pay close attention to this moment. While we are cautious near-term, and hold higher than usual cash levels, we are excited about the future buying opportunities that meaningful corrections always bring.

Stability begets instability

Twenty-five years ago, Professor Hyman Minsky (1919-1996) argued against the prevailing view that that economic crises were triggered by external stimuli such as oil crises, wars or technological revolutions. Minsky suggested that the internal dynamics of the system itself could generate shocks. (“The Financial Instability Hypothesis” – Levy Economics Institute of Bard College – May 1992)

In fact, Minsky believed that during periods of economic equilibrium, banks, investment firms and other economic agents become complacent. It is assumed that the good times will continue, so ever-greater risks are taken in pursuit of profit. In other words, the seeds of the next crisis are sown during the good times, in the form of increased financial leverage. Alas, Minsky’s theories were largely ignored outside of a small circle of like-minded experts until the 2007-2009 sub-prime mortgage crisis propelled him to near-rock-star status in the financial media.

Yet just weeks ago, on March 21^st, 2017, one of history’s longest periods of low stock market volatility ended with the first daily 1% drop across all indices. This span of apparent stability, topping one of the longest bull markets in history, reminds us of famous economist Irving Fisher’s observation on the eve of the 1929 stock market Crash and Great Depression that “stock prices have reached what looks like a permanently high plateau.”

And, of course, it also points us to Hyman Minsky’s warning that “stability begets instability … the more stable things appear, the more dangerous the ultimate outcome will be, because people start to assume everything will be all right and end up doing stupid things.”

Planting seeds of instability, and shocks

We at Sicart believe that wealth preservation and growth for family fortunes holding a variety of assets is especially threatened by not only natural business cycles, but also by the excesses of irresponsible government policies around the world attempting to defy deflation.

As a country, the US finds itself at a point of record-high debt, excessively easy money policies, and inflated asset prices. We see only two paths from here, and neither offers great investment opportunities in the short term. One path opts for tightening fiscal and monetary policies sooner, and the other for doing so later (if at all). Eventually, both trajectories lead to major drops in asset prices.

Fortunes are saved at market peaks, and created at market lows

We are strong optimists about the future of the US and its economy, but we choose not to ignore major stock market swings that can hurt our clients.

Famous financiers Bernard Baruch and Baron Rothschild are credited with saying that the secret to their successes was selling too early. The biggest fortunes have been saved by stepping out of the markets in the midst of a bubble – not after it burst. We take note, and today hold historically high cash balances while we wait for the biggest buying opportunities ahead.

History also teaches us that the biggest fortunes were built not by picking the top of bull markets, but by being ready at the bottom of bear markets. That’s the period when we’ll be able to add the most value after saving our clients from the disappointments of a bursting bubble.

The three big questions

We’d like to propose answers to three key questions that are on our minds, and on the minds of those holding a variety of assets today.

1. Why do we believe that prices are exceptionally high? How did we get here?
2. Why do we believe they need to come down? What are the two possible paths for them to do so?
3. How can we position ourselves now to take advantage of opportunities later on?

1. Why do we believe that prices are exceptionally high? How did we get here?

Today we are witnessing record stock prices, record valuations, record margins for companies, and slowing earnings growth — which without record-high stock repurchase programs funded with record-cheap debt, would be even slower. In other words, we are surrounded by inflated expectations waiting for a day of reckoning. That will be a severe reality check. Let us look at some charts to substantiate our claim.

The highest market, in the US and globally

As you can see on both charts, S&P 500 representing the US market is at an all-time high, and MSCI World covering the entire world is also breaking records.

Source: Bloomberg.

Source: Bloomberg.

Second-highest market valuation in 130 years, using CAPE

Professor Robert Shiller’s cyclically-adjusted price/earnings ratio tells a clear story that we have quoted in previous articles. The US stock market has been more expensive only in the midst of the internet bubble of the 1990s. In other words, today investors are paying 75% more for each dollar of companies’ earnings than we have on average over the last 130 years. See chart below.

Cyclically Adjusted Price to Earnings Ratio (CAPE) for the S&P 500

Source: Robert Shiller.

Actually, the highest-ever market valuations considering lackluster growth

Like any ratio, the CAPE doesn’t necessarily tell the whole story. Since the valuation of the market is an expression of growth expectations, it’s interesting to compare it with underlying economic growth. Here, we will see that the current CAPE divided by ten-year average growth of GDP is substantially higher than it was even during the internet bubble.

Meanwhile, as John P. Hussman of the Hussman Funds, points out in his 3/6/17 letter to Fund holders, the valuation of the median component of the S&P 500 (50% are cheaper and 50% more expensive) “is already far beyond the median valuations observed at the peaks of 2000, 2007 and prior market cycles… making this the most broadly overvalued moment in market history.”

Source: 720 Global, and Robert Schiller.

Much weaker economic backdrop than 1990s

To fill in some details, we add this table highlighting some key metrics. What do we see? Not only do current valuations exceed the 1990s peak, but also the economic backdrop is much less favorable. Current GDP growth is weaker, as is the productivity growth. What’s more:

— Federal Debt more than tripled

— personal and corporate debt went up 170% percent

— the US government is running much bigger deficits

— corporate earnings have fallen over the last 3 years and are flat over the last 5 years compared with high single-digit growth back in the 1990s

— lastly, the Fed fund rate is little above 0%, while it was at 5.4% back then

Source: 720 Global

Corporate earnings growth and economy slowing down

Investors seem to have concluded that we have to pay more than ever for the same dollar amount of earnings. If earnings were consistently growing (or even better, growing at an accelerating pace) we might be less concerned. But growth is slowing, and the underlying economy is decelerating as well.

Source: 720 Global, Standard and Poor’s.

Source: 720 Global.

Less room to improve margins, too

As stock pickers, we like to look at margins that tell us how profitable companies are. They go up and down cyclically, as well as throughout the life of a company. Even when growth is slowing there is sometimes hope for better margins, which could lead to an acceptable earnings trajectory. Here, the picture is equally concerning. S&P 500 margins are also at their peak, making it harder and harder for companies to show further earnings improvement. On top of it, the majority of the margin expansion since the Great Recession came from lower cost of borrowing, which with record low rates can’t go much lower.

Source: Yardeni.com, Standard & Poor’s Thomson/Reteurs I/B/E/s.

Buybacks helped cover up slowing growth

Prices and margins are at all-time highs while growth languishes: bad enough. But the growth of earnings per share growth would have been even weaker if we excluded the benefit of unprecedented repurchase programs. Companies sometimes choose to spend their cash flow and borrow cheap money to buy their own shares and shrink the share count, creating an illusion of earnings per share growth. If buybacks take place when the stock prices are low and investment opportunities limited, they might be applauded by the investor community. Currently, though, we’re concerned by how highly the market values truly weak earnings performance.

Source: Business Insider.

Source: Hedgopia.com

Let’s get this growth going then!

You might say: “But we can cut the rates, start a monetary and fiscal stimulus, and growth will come back.” In theory, yes. The truth, however, is that over the last 9 years the US has been doing both at unprecedented levels.

Record low rates, record high debt, record easy money policies

Declining growth and fear of deflation have led the government and the Federal Reserve to deploy the biggest-ever fiscal and monetary stimulus. The rates hovered near zero, public debt ballooned, and the Federal Reserve has become the biggest buyer and holder of government’s debt. It’s a pattern that we have seen around the world – Europe and Japan are in the same predicament.

I. What happened to interest rates?

Looking at 150 years of rates policy, the chart speaks for itself. We have never had a period of zero rates before. In other words, there has never been a monetary stimulus of bigger proportions.

Source: ZeroHedge, Goldman Sachs.

II. What happened to government debt?

It’s been soaring; the government has been unable to resist the allure of more cheap debt. Lower taxes and the big infrastructure spending that we’ve been hearing about seem to be more of the same–  both lead to even greater indebtedness.

Source: U.S. Department of the Treasury, St Louis Federal Reserve

To put it in context, we haven’t seen government debt like this since WWII, when the country was building up capacity to face the biggest war the world ever fought.

Source: www.tradingeconomics.com

It’s not just government debt that concerns us: total debt is at staggering levels, too.

Source: Dent Research.

III. What about the Federal Reserve?

Since the late 1940s, there hasn’t been comparable participation in the market on the part of the Federal Reserve. The Fed expands its balance sheet by “printing” money and buying government bonds, mortgage-backed securities and other assets to boost the money supply, and stimulate growth. This chart ends in 2012, but the Fed’s balance sheet continued to grow further and peaked at pre-WWII era levels.

Sources: Federal Reserve Board, Bureau of Economic Analysis, Historical Statistics of the United States/Haver Analytics.

What have these strategies accomplished?

I. No deflation

The result of all of these unprecedented stimuli is twofold: deflation has been avoided, and asset prices have increased greatly.  The developed world temporarily won a battle, but probably not a war against deflation. Historically, as you can see on the chart below, the world economy has regularly experienced sharp deflations and sharp inflations. Ever since the US departed from a currency tied to precious metals, we were able to easily print more currency, and increase supply of money, thereby avoiding deflation. This is a powerful tactic in the midst of recession, especially if used sporadically and for a brief period of time.

Source: Deutsche Bank, GFD.

II. Meager economic results

In the last decade, prolonged stimuli achieved limited results in terms of growth. The result instead was a slow- growth environment. The Fed fears that any tightening of monetary policy may undermine that already weak growth, and the government is equally cautious tightening its fiscal policy. We find ourselves in a corner with limited options to move further.

Source: National Bureau of Economic Research, Bureau of Economic Analysis.

All asset prices enjoyed the ride up

To anyone claiming that equities are alone in this unprecedented bonanza of growth, take a look at the home price index. These charts, looking back to the late 1800s, also remind us that home values do fluctuate, and fairly dramatically.

Source: St. Louis Fed, S&P, Robert Schiller.

Source: Robert Schiller.

 Before the bubble bursts

An interesting phenomenon always occurs right before the reality check hits investors. Those who missed out on an 8-year long bull market finally feel compelled to join. They have a hard time picking specific stocks, which on the whole are expensive and not attractive, so these late-to-the-party investors buy the broad market funds. They just want a piece of the action. That’s why we have seen days of record inflows to index funds.

Lastly, despite flat earnings for the S&P 500 over the last few years, we have witnessed a big rally since last November. The enthusiasm around the new administration with its pro-job, pro-business narrative inspired a new wave of investors. As much we would like to see lower and simpler taxes along with more efficient government, we are concerned about the protectionist tone of the current government, its mixed record on execution, and lofty expectations for its success already baked into the market prices. We believe those business-friendly policies will be slow to show benefits. Also, the more revenue-neutral they are, the less of an actual short-term boost they can bring. Finally, the recent record of the current administration invites some doubts about the overall execution of the policies to begin with.

If all that new investor enthusiasm were arriving in the midst of a recession, we would take it more seriously. However, the monetary and fiscal arsenal has already been exhausted. Further, the US is experiencing record-low unemployment, along with wage inflation. Improvement from here will require more than another dose of the same medicine. If you think protectionist tendencies and stricter immigration policies worldwide (UK’s Brexit, the French presidential election’s tone) are something new, the 1930s provide a striking – and chilling — comparison.

2. Why do we believe asset prices need to come down?

Just because the asset prices are high, that doesn’t mean they have to come down, does it? Maybe Irving Fisher’s observation from 1929 will be right this time, and stocks have reached a permanent plateau. Wouldn’t that be nice?

In terms of lessons, the world has little new to offer; history may not repeat itself, but definitely rhymes more often than we are willing to admit. If that’s the case regarding the current economy, let’s see where we can find rhymes.

Our thesis: No matter what, asset prices are going down dramatically

After extensive research, we find two only two possible paths from the current situation — the proverbial fork in the road. As we mentioned earlier, the US is not the only country facing this dilemma. Europe, Japan, and many other big economies need to make a hard choice here, too.

Two potential options have both been thoroughly tried, documented, and examined.

Path #1 – tightening now

–normalized interest rates

–tightening of monetary policy

–central banks ending their participating in asset buying

–letting prices find their own natural equilibrium

–in sum, more responsible fiscal policy

Path #2 – more of the same, tightening later or never

– zero or negative interest rates

–more easy money policies with central banks buying even more bonds and equities to prop up prices (and keep rates low

–more fiscal stimulus – lower taxes, bigger spending, doubling our total debt once again

In fact, these two paths to lower prices end up looking identical. The slower version, #2, will eventually lead to path #1. It may take a while (defaults, debt restructurings, higher taxation, wealth transfers). We also know that if path #1 feels too hard, we tend fall back into path #2 again, and again (more bailouts, more easy money, more spending). We can keep kicking the can further down the road, but we can’t make it disappear.

In the real world, when a household defaults on its mortgage, car loan, and credit card debt, consequences are clear:  the borrower has to tighten the belt, move to a smaller house, take a bus to work. Governments have the luxury of postponing the day of reckoning. Usually the music stops when creditors are not willing to finance the government’s massive spending. In our case, the Federal Reserve and central banks have stepped in and financed that massive public debt with their expanding balance sheets.

However, the time has come for asset prices to drop, so let’s examine the scenery on our two paths.

The US followed Path #1 in the aftermath of the 1929 market crash, either by choice or inadvertently, because it didn’t quickly implement policy changes. Japan suffered a similar fate in the years following the bursting of 1989 asset price bubble. Greece was forced on the path of austerity by its creditors since the financial crisis. All three countries experienced a huge drop in both stocks and real estate. Path #1 meant drastic declines in the GDP, high unemployment, and deleveraging of the private sector, consumers and businesses.

In response to the dramatic slide in asset values, the central banks and governments of all three countries followed up with Path #2. The outcome? In each country, a combination of Path #1 and Path #2, with a return to Path #2, when #1 proved to be too painful. The US tightened in 1937, which led to a sell-off in equities (50%). Similarly, Japan danced around a more disciplined fiscal policy, then dropped the idea for now.

Result: From the top in September 1929 of 381 to mid-November the Dow Industrial Average lost half of its value, and by mid-1932, 89%.

Source: Bloomberg.

Result: Nikkei fell from almost 40,000 in 1989 to 14,000 in 1992, and finally half of that by 2003. A total 85%+ drop.

Source: Bloomberg.

Result: From October 2007 till June 2012, the Athens’ Stock Exchange Index fell from 5,335 to 476, a 91% drop!

Source: Bloomberg.

Stocks are not the only assets that fall; real estate declines are equally painful

It’s important to remember that real estate price do come down. In Japan they’ve dropped by over 80% in commercial real estate. Similar losses occurred during the Great Depression in the US. Brick and mortar don’t save you in a world where there no buyers for your asset, no matter what unprecedented price you paid for it.

Source: Haver, Ministry of Land, Infrastructure, Transport and Tourism, Bank of Japan.

The day of reckoning might be postponed: the asset prices react regardless

If a government has debt in the currency it controls, the day of reckoning may be long postponed (let’s watch the Bank of Japan setting a record in that department). The central bank will buy the government bonds and print money to pay for it. If this maneuver is managed well it will lead to Japan’s scenario. The danger is the Weimar Republic’s experience of galloping inflation. Sure, the debt gets wiped out, but so do all the assets, and the economy ends up in complete ruin. It’s the threat of this scenario that has inspired the gold craze of the last 15 years.

The zombie economy – mispricing and poor allocation of resources

 Japan’s experience is often referred to as “two lost decades” though it will soon become three. It led to mispricing of assets, poor allocation of resources, and what some call a “zombie economy” which maintains high employment, but without growth has no chance to unwind excess fiscal and monetary expansion.

All the stimuli disappoint. Why is nothing working?

Five years ago, Masaaki Shirakawa, then-Governor of the Bank of Japan, gave a lecture at the London School of Economics and Political Science entitled “Deleveraging and Growth: Is the Developed World Following Japan’s Long and Winding Road?” Speaking of the “two lost decades” in Japan, he blamed the first decade’s stagnancy primarily on the bursting of the Japanese bubble economy. The second decade he pinned on demographics. A population that is both ageing and declining in numbers, he believes, contributes to the decline in growth potential, a deterioration in the fiscal balance and a fall in housing prices. He also concurs with another central banker, Mervyn King (Bank of England) who said that “there is a limit to what monetary policy can hope to achieve.”

What role will demographics play?

This is a topic for another article, but the post-war baby boom may have helped us experience the longest bull market (if you count early 1980s as its true beginning) and the biggest asset inflation in stock market history. Now that generation begins to shift from working, spending, and investing to retiring and selling their stocks. Their 401k and IRA contributions will become withdrawals and they may downsize their homes.

Many studies suggest a 5-10 year hiccup in consumer demand before the peak of the next generation will step in the shoes of the Baby Boomer generation.  That hiccup started in Japan earlier, and is now taking shape in the US and Western Europe. It will soon affect China as well. Maybe there is a lesson there to be learned for economists, central bankers, and governments. Maybe traditional fiscal and monetary tools fail us when we are up against major demographic shifts.

Source: United Nations Bank of Japan.

3. How can we position ourselves now to take advantage of opportunities later on?

How does this bubble burst?

As much as we worry that less favorable demographic trends will turn into a major headwind for the next 5-10 years instead of providing a tailwind as in recent years, the catalyst for a near-term bursting of the economic bubble could come from many directions. Will it be the Fed raising rates? This would hike the cost of debt, thus possibly causing a decline in lending, which would prompt a drop in demand and produce another recession.

Or what if a major financial institution like Deutsche Bank were to fail, with its immense derivative book the size of a multiple of the German GDP? Could the Greek government default again? Are there more political surprises brewing in Europe, or the US for that matter Escalating military conflicts? We don’t know. What we do know is that bubbles always do burst.

The fallacy that “this time is different”

If you think there is nothing to be learned from the past, we’ll borrow Bernard Baruch’s advice from his memoir. In the midst of the 1929 craze, he would go back and re-read a classic book called Extraordinary Popular Delusions and the Madness of Crowds published in 1841 by Scottish journalist Charles Mackay. Mackay demonstrated how bubbles get created, and how quickly and unexpectedly they burst. Baruch took note and sold early. We don’t claim to be smarter than this ground-breaking financier. Nevertheless, we do see the facts, draw conclusions, and choose to be contrarian by patiently staying underinvested. This better positions our clients for the day when the market exhausts itself, and finally corrects. At that point, we will be ready to take advantage of the opportunities that will doubtless appear.

The best markets, the best investment periods, and the biggest fortunes all started with truly bad markets. As contrarians, we choose to cautiously avoid getting sucked into the momentum and enthusiasm-driven rallies of a very tired bull market. We are, on the other hand, looking forward to buying opportunities when the bubble unravels.

Where to hide?

Stocks and real estate are both vulnerable to a bursting bubble. Cheap money has distorted pricing across most asset classes. There are though some safer pockets of the equity markets, and those much more vulnerable.

Fixed income? If the rates do go up, long term bonds will be under pressure, and obviously lower quality bonds will disappoint in a recession.

Gold? If we were to experience a Weimar Republic-style hyperinflation, gold would be the right asset. The difference between now and 1920s Germany is clear. Central bankers are not creating inflation in goods and services. Instead they are fighting deflation at all costs, while creating inflation in asset prices. We could envision a small exposure to gold as an insurance against prolonged irresponsible fiscal and monetary policy.

Cash, treasury bills, and short term bonds, ideally under 1 year with very short duration (sensitivity to rate changes) are the safest place to wait out this peculiar time. While they may not be earners, cash and cash equivalents will most likely hold the same face value in times of distress. In other words, the same $100 bill that would buy only two Starbucks shares in 2006, would buy four in early 2008, and more than ten shares at the market lows in early 2009.

We intend to patiently hold on to those $100 bills until we can get the most for the money.

 

Bogumil Baranowski

4/12/2017

Disclosure: This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

Highlights: Higher highs, earnings season, Fed rates unchanged, car loan record delinquencies, political commentary

 Portfolio-specific commentary (12/31/2016-2/22/2017) Year-To-Date

Healthcare (biotech) and selected technology

 Improved sentiment helped our biotech holdings YTD, and our higher-than–the-S&P-500 exposure made a meaningful difference in our performance. We have a long-term view on the sector, and remain optimistic about its prospects, especially for selected holdings with the most attractive positioning.

Some of our technology holdings benefited from an upbeat earnings season (Mobileye), and M&A activity (Ultratech).

On the other hand, we saw weakness in our energy sector, where we have higher-than-the-S&P 500 exposure. We feel comfortable with our picks in the sector, and look forward to their satisfactory performance in the long run.

 Big-picture commentary

 Higher highs for the stock markets

After experiencing an especially nervous market not long ago, when stocks would quickly sell off on any bit of negative news, we are now witnessing what some call the “Teflon market.” Despite all the noise coming from Washington investors remain very optimistic, pouring money into the market and counting on economic growth. Both the Dow Industrial Average and the S&P 500 are up 5-6% YTD (2/23/2017), and recently hit all-time highs. UK, France, Germany, Japan, Brazil are climbing to new highs as well.

Earnings season – encouraging growth, but peak valuations

 With almost all earnings reports for the 4^th quarter behind us, we can tell that this will be the first time in 2 years that we have seen two consecutive quarters of earnings growth for the S&P 500. Estimated 12-month forward earnings per share for the index have reached a new high ($133.50 Source: Factset), but the 12-month forward P/E also reached a peak level that we haven’t seen since 2004 (17.6x).

Two thirds of companies beat earnings expectations – with technology and health care leading the pack — while telecom services and utilities had the most disappointing results. Eight sectors reported y/y EPS growth including utilities, real estate and financials, while 3 sectors reported y/y declines with telecom services being the weakest.

 Fed leaves rates unchanged

In February, the Federal Reserve kept the rates unchanged. Remember that in December, we saw a 25-basis point hike, which was only the second increase in more than 10 years. It sets a new trend that shouldn’t be a surprise, but many may have long forgotten the world of normal rates, so it may prove to be a rude awakening for some.

We welcome further rate increases, and the end of easy money policies. We trust it will lead to a long-awaited reset in asset prices, return expectations, and debt levels across consumers, businesses, and governments.

We also believe rates increases may be a bigger determinant of the markets’ direction than new tax and trade policies, or a wave of deregulation. Any further rate increase from such low levels implies a very high percent increase in the cost of debt for all participants. It’s hard to imagine it won’t affect their behavior, and prompt an adjustment in levels of borrowing and spending.

 Car loan record delinquencies

 We like to call out, now and then, an intriguing new market dynamic that deserves more attention. Quartz recently published an interesting article on auto loans – “American car buyers are borrowing like never before—and missing plenty of payments, too” (February 21, 2017). Here are some highlights.

Last year, Americans bought more new cars than ever before. Is that meaningful? Car sales represent a fifth of all retail spending. US outstanding auto loan debt reached a new high, $1.2 trillion, 9% up y/y, and 13% higher than the last peak in 2005 (inflation-adjusted). Wages haven’t gone up much since the Great Recession. Lending has been the main growth driver. Interestingly enough, nearly a quarter of auto loans are subprime loans which carry an average 10% annual interest rate. This may look compelling to investors seeking yield, but around half of auto loan asset-backed securities (ABS) feature subprime collateral. Auto loans are a tiny phenomenon versus mortgages. In 2007, Americans had $10 trillion in mortgages with $7 trillion securitized, compared to $1.2 trillion in auto loans, with under $100 billion securitized.

Forbes (February 17, 2017) recently reported that newly delinquent car loans reached an 8-year peak. This doesn’t go unnoticed. Car makers have been hinting at sales pressures, poor appetite for cars, dwindling demand, seeing sales go from “record to rocky.”

 With rates heading up, and other metrics at peak level (total loans outstanding, percentage of cars bought with financing, average loan amount, average selling price) it’s not hard to envision a turn in that trend.

Will it be contained to only one sector, will it spill over, is it a good indicator of the overstretched consumer? The jury is still out on the subject, but we have an inkling that we might know the answer. Surprisingly enough, the biggest US car maker is trading at a multi-year high.

There is a disconnect there somewhere…

Political commentary

 It’s hard to escape the daily deluge of political headlines. In earlier letters, we listed some of the potential policies that may affect the consumer, the labor market, and businesses. We don’t share the market’s enthusiasm. We are patiently waiting for specifics, and we remain cautious in terms of our expectations. We believe that if some of the earlier-hinted measures do materialize, the beneficial impact, if any, will take time to become more visible.

Lastly, with the US stock market up over 10%% (on top of previous highs) since the presidential election, a lot of that theoretical future growth in profits appears to be more than priced in.

 Looking for opportunities

During periods of new market highs, we may not be big buyers of new positions, and we may not be adding aggressively to existing holdings. We spend this peculiar time reviewing our investments, while carefully and deliberately examining potential future acquisitions.

The process remains especially difficult given that we don’t know where the potential market weakness will come from, or where it will hit the hardest,– thus creating the best buying opportunities. Holding higher-than-usual cash levels keeps us to some extent immune to a market sell-off, and better positioned to act when the prices of securities become more compelling.

We have been generously compensated by the market for our patience before, and we believe this time will be no different.

 

Yours truly,

François Sicart, Allen Huang & Bogumil Baranowski

 

Disclosure

 

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

 

January, 24th, 2017

 Highlights: Trump’s policies, strong labor market, markets flat but still at record highs

 Portfolio-specific commentary (12/15/2016-1/15/2017)

Energy & Financials

 We saw a reversal of an earlier rally in both sectors, both the broad market and our holdings. Our smaller-than-S&P 500 exposure to financials left us on the sidelines of the recent declines. Our mix in the energy sector (different from the overall markets) turned out to be also helpful. We notice that sectors started to trade less uniformly than before, with some stocks falling behind, some climbing higher. This more varied price reaction may create opportunities.

Gold

Our gold exposure allowed us to capture a recovery in gold prices since December low, which we had seen after a sell-off from mid-year highs.

 Big-picture commentary

 Trump’s plans

We don’t know the specifics or the timing of various new policies, but given the likely direction  — less regulation, lower taxes, and possible foreign cash repatriation – those should help businesses reinvest, hire and grow. What may be seen as negative is the uncertain direction of the trade policy. With a more protectionist approach, we may see winners and losers among businesses, and potentially higher prices for end consumers.

Businesses won’t prosper if the consumer doesn’t do well. What we find encouraging is the tax reform, which could leave more cash in people’s pockets. The pro-employment narrative of the current administration may help further improve labor market conditions. Of concern is the potential impact of healthcare reform: its timing, execution, and cost to businesses and consumers.

Strong labor market and climbing wages

The end of 2016 marked a solid performance for the U.S. labor market, with paychecks growing at the fastest pace since 2009 and with job gains above 2 million for a sixth year (2.2 million in 2016 vs. 2.7 million in 2015). This amounts to 75 consecutive months of job growth, a modern-day record, with the number of employed people at all-time high. Wages went up 4.7% year over year in December and joblessness rated ticked up to 4.7%. In 2016, wages were up 2.9% versus a 2.3% decline in 2015, and 2.1% decline in 2014. The four-week average jobless claims dropped to the lowest since 1973.

Know-nothing market

 After a post-election rally, since mid-December the Dow Jones Industrial Average has traded in the tightest range in its 120-year history. The CBOE Volatility Index has been dropping since November, and reached 11.50, which brushes against its historically lowest levels.

Markets at their record levels

Major US indices — the Dow, S&P 500, and Nasdaq — are all at record highs. Looking around the world, in local currency, the UK market and German markets are also at or near all-time highs. Even the Mexican stock market has reached new highs. Japans is also close to its 18-year high. China still happens to be substantially below its 2015 peak.

Strength in the dollar makes the picture more interesting. In dollar terms, the markets with the biggest drops from a 52-week high are Turkey, Malaysia, and Mexico. The declines range from 20% to almost 30%, with Turkey falling the furthest.

 Dollar a little weaker

After a spike to the 15-year high in December versus EUR, 30-year high versus GBP, and 10-year high versus JPY, the dollar lost some of the gains in January. As we discussed last month, US interest rates are expected to continue rising after a December Fed rate hike and further planned increases this year. This upward trend, along with hopes for stronger growth may continue to support the dollar’s strength for a while.

Looking for opportunities

We’re clear about what kind of companies we look for and what kind of prices we would like to pay. However, with current high market levels (in terms of both absolute prices and valuations) and few clear contrarian opportunities, we spend more time researching ideas rather than investing. In the long run, the market has the wonderful tendency to offer great buying opportunities for those who patiently wait for the right circumstances and price. Thus, we wait.

Yours truly,

 

François Sicart, Allen Huang & Bogumil Baranowski

 

 

Disclosure

This report is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.

 

Insatiable appetite for stocks (over-sized demand) driven by baby boomers funding their retirement accounts has boosted the stock market for decades. Now a dry spell in new IPOs (shrinking supply) has helped propel stocks even higher to historic levels. Both of those trends are about to reverse. Baby boomers have already started upping their retirement account withdrawals (falling demand), and pent-up supply of innovation may inundate the market with a fresh wave of IPOs in the years to come.

We have just lived through historically unique circumstances

We already have pointed out some big macro trends that have supported the financial markets for years and are bound to turn in coming years. In particular, economic growth, almost everywhere, has been aided by swelling government debt. We can think of it as “borrowed growth,” facilitated by a decline of interest rates to record-low levels and excessively easy money policies driving market valuations higher.

All of those factors are at historic extremes, and have less and less room to continue in the current direction. Although these forces may already have run their course, momentum has helped propel the market ever higher despite five consecutive quarters when the S&P 500’s earnings declined — the longest such run since the Great Recession (just interrupted by anemic growth in q3 2016).

That’s not the whole story though.

Source: The Leuthold Group

The demographics at work – baby boomers in shopping mode

The stock market, like any free market, is driven by supply and demand. Who are those buyers of all the stocks, bonds, etc.? Are they the 20-year-olds looking for their first apartment with few roommates, often burdened with car loans, credit card loans, student loans? Are they the 30-year-olds with kids at school and a second mortgage? Probably not. They tend to be older, more established, and getting closer to retirement – the famed baby boomer generation. Their earnings power is at its peak, and they are taking advantage of all possible tax deferred retirement plans. They are on the demand side, and the numbers are staggering! We are talking about more the $14 trillion stashed away in traditional IRAs and 401(k) plans alone according to Time.com (1). The amount saved outside of the retirement plans could put the total even higher. Is that meaningful? The US stock market is worth over $20 trillion, and US bond market around $40 trillion, while baby boomers hold half of the assets according to the Congressional Budget Office. It’s not only a US story. The Telegraph quotes Pinch, a book by David Willets, which claims that half of Britain’s wealth is owned by baby boomers, (2). The majority is owned by those over 65.

Source: Wall Street Journal

The biggest shift in demand has already began

We know now who the buyers have been historically.  What we are curious to know is whether they plan to remain buyers for long. Between 1946 and 1964, 78 million people were born in the US, and they started turning 70 this year. When they retire, they stop saving, and start living off their retirement nest eggs. Is it already happening? The Wall Street Journal in mid-2015 reported that 2013 was the first year when investors pulled more money out of tax deferred accounts than they put in —  $11.4 billion, to be exact vs. $12 to $22 billion net contributions in previous years (3). That trend will only accelerate in coming years. The article mentions that the outflows will continue through 2030, after peaking in 2019. Needless to say, with the market at record highs and of the biggest bull markets behind us, this may be a compelling time to increase those withdrawals.

Source: Wall Street Journal

Even if they are not sellers, baby boomers grow increasingly conservative

We might be enjoying what will soon be the longest-ever bull market (yes, we are catching up with bull markets of the 1990s and 1920s!), but the baby boomer generation has recently witnessed some major downturns in the market. Memories of the 2008/2009 recession, and the biggest market sell-offs in decades are still fresh. Similarly, the burst internet bubble of the late 1990s alarmed many investors, and hasn’t been forgotten yet. Needless to say, the closer we get to retirement, the more conservative we become — as we should. Our investment horizon shrinks, and we care less about doubling our assets over the next 5-10 years than about keeping enough to cover our growing expenses. With that in mind, we should expect baby boomers to move away from stocks, and increase their bond and cash holdings to reduce exposure in case of a market sell-off. This doesn’t bode well for the stock market, does it?

What about the supply? We know there are buyers, but has there been enough to buy?

Every two weeks, over 150 million people in the US (working full-time and part-time) receive a paycheck. Many automatically deduct and put some cash away in their IRAs and 401(k)s to invest in increasingly passive investment funds. In effect, they buy a little bit of almost anything out there that is publicly traded, and large enough to be bought in big quantities.

Dry spell on the tech IPO front

To satisfy that investing appetite, we’d need more new companies of size going public, but where have they been lately? The number of US IPOs (“Initial Public Offerings”) has fallen to the lowest level in 7 years, according to FactSet.  Some blame market volatility, some poor performance of previous IPOs. If we look at emerging tech IPOs, CNBC reported in October that 2016 is the weakest year for that category since the financial crisis, and potentially second slowest for venture-backed companies since 1980 (4). There are no big billion-dollar tech IPOs on the horizon. As an example, Uber and Airbnb are enjoying high valuations and unlimited private capital, and are in no rush to go public.

No IPOs and venture capital crashing

According to CNBC, first quarter of 2016 saw a 25% drop in VC funding, the steepest decline since the dot-com bust in early 2000s. (5) With smaller pipeline of VC-funded start-ups, the near-term prospects for tech IPOs don’t look much better. At Sicart Associates, we never rush to buy hot IPOs, preferring to see them prove themselves before we step in. With limited supply of new companies though, we are experiencing a shortage of newer businesses to choose from.

Innovators with grey hair

Not long ago I was having a quick lunch between dives in Antigua and admiring some oversized yachts in the marina, when someone told me that the biggest one belonged to the creator of Excel. I thought to myself – Excel? That’s not exactly the hottest, newest invention of the day.

But neither are the tech companies that get all the attention and trade at all-time highs these days! Apple and Microsoft are 40 years old, which means they were around before parents of most millennials even met. Amazon and Netflix are over 20 years old, Google is not far behind. Facebook is 12. They all innovate and continue to change our lives, but they are by no means new to the game. Instead, these few highly prized companies focus on trying to prove they can still grow despite their maturity and immense size. Investors seem to be following along for lack of other compelling tech options.

Has innovation taken a pause then?

So on the one hand, former innovators are decades-old companies now.   On the other hand, attractive new business is scarce, constrained by a slump in the VC market, a weak IPO backdrop, and concentration of funding on the so-called billion dollar unicorns. You could conclude that innovation has never been weaker, especially when you look at the productivity growth which is usually driven by innovation. According to official labor statistics, 2011-2015 has been a five-year span with the slowest annual output per hour of work growth since 1977-1982 — far below the 1950s.

Source: Labor Department

“The idea that innovation is slowing down is… stupid” – Bill Gates

Yet what may seem like pauses in IPO activity and productivity growth may be deceptive, masking the pace of true innovation whose benefits we are yet to see. The current dry spell for IPOs and headwinds for VCs may be coming to an end.

In an interview in The Atlantic (6), Bill Gates said: “I want to meet this guy who sees a pause in innovation and ask them where have they been. The pace of innovation today is faster than ever.” He also reminds us that when innovation is happening fast enough, it sometimes shrinks GDP by disrupting industries (example: the Internet damaging the newspaper industry) or increasing costs (example: medical technology).

“Take the potential of how we generate energy, the potential of how we design materials, the potential of how we create medicines, the potential of how we educate people, the way we use virtual reality to make it so you don’t have to travel as much or you get fun experiences,” Bill Gates added.

Rosy future for innovation

Artificial intelligence, automation, genetics – these are all fields booming with innovation. The Wall Street Journal reports that “science is stepping up the pace of innovation” (7).

Meanwhile World Economic Forum reports that “the world is about to experience an exponential rate of change through the rise of software and services.” (8) WEF further identifies six megatrends:

–people and the internet (wearable and implantable technologies will enhance people’s “digital presence” allowing them to interact with objects and one another in new ways)

–computing, communications and storage everywhere (this will lead to ubiquitous computing power being available, where everyone has access to a supercomputer in their pocket, with nearly unlimited storage capacity)

–the internet of things (smaller, cheaper, smarter sensors at home, in clothes, cities, transportation etc.)

–artificial intelligence and big data (with more data software can learn and evolve, and help with decision making)

–the sharing economy and distributed trust (assets can be shared, which leads to new efficiencies),

–and finally digitization of matter (physical objects can be printed which transforms industrial manufacturing and creates new opportunities).

WEF industry insiders’ survey tells us that tipping points in each of 21 identified transitions will occur in the next 10 years – among them is the first artificial intelligence machine on a corporate board.

If that’s the case, the next 10-20 years seem far more promising for venture capital, IPOs, and public investors looking for new investment opportunities.

 Conclusions

With the early 21^st century’s longstanding bull market moving around to the rear-view mirror, this may be a good time for reflection on the long-term dynamics driving the appetite for stocks and their prices.

Baby boomers’ long-term appetite for stocks and the shortage of big IPOs may have boosted the markets beyond the obvious macro tailwinds. Both those trends are about to reverse. Baby boomers will be cashing out, while a pick-up in innovation may translate to a new wave of IPOs.

As contrarian investors we pride ourselves on pointing out major shifts in long-term trends. These are two that might define the investment backdrop for the next 5-10-20 years.

Perhaps there is a silver lining behind those two reversing trends. With more subdued demand, and probably more abundant supply of new companies, we might be finding more of what we are always looking for: promising investments at attractive prices.

Bogumil Baranowski – December 12th, 2016

References:

1. “Why a $2 Trillion Tax Bill Is Coming Due for Baby Boomers” (Times.com, June 27, 2016)
2. “Baby-boomers own half of Britain’s wealth” (The Telegraph, January 27^th, 2010)
3. “Money Flows Out of 401(k) Plans as Baby Boomers Age; Withdrawals from 401(k) retirement plans exceed new contributions, a shift that could shake up U.S. retirement industry” By Kirsten Grind (WSJ, June 15, 2015)
4. “Why you shouldn’t expect any more billion dollar tech IPOs anytime soon” (CNBC, October 7^th, 2016)
5. “Venture funding for startups just suffered the biggest crash since the dot-com bust” (CNBC, April 14, 2016)
6. “Bill Gates: ‘The Idea That Innovation Is Slowing Down Is … Stupid’; New ideas are coming at “a scarily fast pace,” (The Atlantic, March, 12^th, 2014)
7. “Science Is Stepping Up the Pace of Innovation – Big advances in astronomy and genetics” by Alison Gopnik (WSJ, Jan 1, 2016).
8. Deep Shift Technology Tipping Points and Societal Impact, World Economic Forum Report, September, 2015.

 

 

This presentation and its content are for informational and educational purposes only and should not be used as the basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but not a representation, expressed or implied, as to its accuracy, completeness or correctness. No information available through this communication is intended or should be construed as any advice, recommendation or endorsement from us as to any legal, tax, investment or other matters, nor shall be considered a solicitation or offer to buy or sell any security, future, option or other financial instrument or to offer or provide any investment advice or service to any person in any jurisdiction. Nothing contained in this communication constitutes investment advice or offers any opinion with respect to the suitability of any security, and has no regard to the specific investment objectives, financial situation and particular needs of any specific recipient. Any reference to a specific company is for illustrative purposes and not a recommendation to buy or sell the securities of such company.