The Best Time is Now

What’s the best time to start investing? The best time is always now.

Sitting under a tree this summer, hiding from the heat of the sun, you might have thought about the best time to plant a tree. Or, like I did, quietly said thank you to whoever planted it decades or centuries ago. A Chinese proverb tells us that the best time to plant a tree was twenty years ago, and the second best is now. Investing is the same.

We have seen big market rallies and significant corrections in the last two and half years. We saw interest rates fall to zero and quickly rise again. We saw demand for many goods and services evaporate, then come back with great force and look for a new normal more recently.

It’s no wonder we got asked more often than usual if it’s a good time to invest. We love that question!

We see investing as a lifelong pursuit and, in the case of many of our clients, a multigenerational pursuit. Not unlike planting and growing trees! Whether you invest on your own or with the help and guidance of a professional, it’s important to see investing as something one can do a year in and year out.

It’s true that in some years, potential new investments look more compelling than in other years, but showing up every day and looking is the only way to find out what to buy and when to buy.

When we buy stocks, we intend to hold them for a long time, ideally forever, if possible. That’s similar to planting a fruit-bearing tree. I’m thinking of olive trees that can live for hundreds or even thousands of years and bear fruit for most of their life.

Investing isn’t just buying and selling stocks or bonds; it’s also tending to current investments. We spent a good amount of time watching what we hold. Again, not unlike a good gardener. Not all investments prove to be as long-lasting and productive as olive trees, and we need to part with them sooner.

With stocks, it doesn’t pay to be too quick to judge. Some investments may take a while to start to perform and make a positive contribution to the portfolios. Again, it’s not that different from a fruit-bearing tree that may take years until the first harvest and even longer for the best harvest.

At the same time, in investing, the first price move up may invite anxious holders to start selling prematurely. We prefer to wait and take our time as even bigger gains may be ahead. Patience is very hard to practice when investing, but the payoff makes it all worth it in the end.

The outcomes aren’t often linear or regular. A stock that hasn’t moved in a while may start its sudden ascend out of the blue. It’s rare to see a clear upward trending line in investing; leaps and bounds are more likely.

There is a certain discomfort included in this lifelong pursuit. The best opportunities appear when others panic. These might prove to be the most difficult times for anyone to consider buying stocks, yet given the lower prices, it might be the best time. On the other hand, the worst investments can be made when others succumb to euphoria. Again, these might be hard moments that will test the most disciplined investors.

What’s most important, though, is to see investing not as something you do now and then, when it’s easy and pleasant, it’s rather a permanent ongoing activity, a choice.

Anyone who follows our frequently mentioned mantra: earn, save, invest, eventually realizes that once idle capital accumulates, it’s worth putting it to work. That’s what investing really is – making your money work for you.

Sudden wealth through inheritance or a liquidity event can thrust an individual or a family into the world of investing with little preparation but not much choice to opt out.

As a civilization, we have a longer history planting trees than buying stocks, but the principles are the same. Next time you are enjoying the shade of an old tree, think of investing and remember that the best time to start is now.

Happy Investing!

Bogumil Baranowski

Published: 9/27/2022

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.

First Half 2022 Review

Never a dull moment — that’s the best way to describe the last two and half years in public equity investing. We’ve had a flavor of a late bull market (early 2020), a panicked pandemic sell-off (spring 2020), a quick market recovery (2020-21), followed by yet another correction (late 2021 to summer 2022).

It feels like a very long journey, yet in some ways, we are exactly where we started. Interest rates, 10-year treasury rate, and unemployment rate are all back to pre-pandemic levels; many stocks erased the pandemic gains, too.

S&P 500 and Nasdaq in mid-June were a mere 10% above the pre-pandemic early 2020 high, while the Dow Jones was almost exactly where it was 2.5 years ago (Source: Bloomberg).

As much as in 2021, we saw many stocks trade close to their multi-year highs, today in mid-2022, it’s not the case. Some securities rose year-to-date; some came under pressure, while others experienced a big 80-95% drop. Volatility returned to the market and produced what we found to be a refreshing variety of outcomes for stocks.

There are many more potential investment ideas worth considering than in two and a half years.

Inflation

Some statistics may suggest that the last 2.5 years didn’t happen, but one metric stands out. It is definitely not where we are used to seeing it – inflation. US Bureau of Labor Statistics reported that the US inflation rate reached 9.1% in June, the highest read in 40 years (November 1981). It was driven by energy, which rose 40% y/y, but food alone increased 10% as well. All items less food and energy were up a little under 6%.

Inflation might be more difficult for weaker, low-margin businesses, where costs represent a higher portion of sales; these are businesses we tend to avoid. All in all, inflation is a tidal wave that affects everyone, consumers, businesses, and governments. If left unchecked, it can be a very disruptive force.

It’s no surprise that the Federal Reserve and other central banks around the globe finally took notice and started raising rates.

Monetary easing and fiscal help of the last two years propped up the demand but didn’t do much for the supply constraints – some long-term in nature, some caused by pandemic dislocations. We believe higher rates should eventually be able to curtail demand to match up with supply and ease the inflationary pressures.

We also witnessed foreign exchange shifts with the dollar strengthening against the euro (reaching parity for the first time in twenty years), the pound, the yen, and emerging market currencies, with Turkey and Argentina dropping the most. This has further implications, especially for countries relying on imports and dollar-denominated debt.

Why is the dollar the strongest in a generation? There might be many reasons: 1) The US is in better shape than other parts of the world 2) the dollar, which is one side of 90% of foreign exchange transactions globally, is considered a safe haven in uncertain times 3) the Fed has been moving aggressively with interest rate hikes compared to other big, developed economies.

The stronger dollar might be a mixed blessing for US companies, especially those with big international sales.

More opportunities ahead

We have been browsing and researching closely more stocks than we have in a while. Among the growing group of stocks whose prices are almost exactly where they were 2.5 years ago, we see bigger, better businesses than before Covid. Those companies, though, trade at the lowest valuations we have seen in years or ever. We get a lot more, but we pay a lot less. It doesn’t mean they won’t get any cheaper, but it means there are many more stocks worth considering than 6-12-18 months ago. There is definitely more to look at and consider, even if we proceed slowly.

Two tech worlds

The previous darlings of the market, many of them broadly defined tech stocks, got divided into very distinct groups. The first consists of large, more mature, established, and profitable companies, and the other are newer, formerly exciting, but still unproven, and money-losing growth stories. If Facebook (or Meta) could represent the former, Peloton or Carvana could be a proxy for the latter. Both groups came under pressure, but the first dropped in price by some 35% on average, the latter closer to 80-95%.

Looking for a new normal

Beyond the ups and downs, it seems that everyone is looking for a new normal. Supply and demand have been out of whack at both extremes. There was the moment we had all the supply but no demand – hotel rooms and airplane seats in 2020; later, last year, we also had all demand and limited supply – in homes, cars, and more. Businesses tried to catch up with demand and look for it in new places. Sales and ad spending moved online, and consumers migrated from formerly busy metropolitan downtowns to the suburbs, and even rural areas as sales and services moved online.

How much of what we saw was a permanent shift, and how much was a temporary phenomenon soon to fade away from memory? We are yet to see. Some companies saw record growth, followed by a decline in demand. We saw oil prices at $60 (pre-pandemic), then at $20 in March 2020, and $110 in May 2022. The conflict in Europe further exaggerated the pandemic’s ups and downs.

Long-term Goals

Our long-term goal remains the same for all the assets we manage. We intend to both preserve and grow the capital over time. We seek to double our clients’ wealth every 5-15 years, which translates to a 5-15% annual rate of return over the long run, but we would like to accomplish it without exposing the portfolios to the risk of a permanent loss of capital. Of course, performance cannot be guaranteed, and past performance is not indicative of future results.

Our strategy can be described as a long-term patient contrarian. All securities are selected through an in-house research process. Our investment horizon for each individual holding is usually 3-5 years.

We intend to hold between 30-60 stocks, mostly US equities, but we may invest in foreign securities as well. We don’t use any leverage; we don’t own any derivatives. We may supplement the strategy with exchange-traded funds (some of them may use leverage or derivatives).

We don’t have a predefined portfolio composition target. We may hold cash at times, but we prefer to own businesses, and when the opportunities abound and prices are right, we will likely be close to fully invested.

What we wrote before applies today: “as much as we pay attention to the overall market trends, we like to look at our performance independently from the benchmark. As long as the businesses we own report improving fundamentals, and the market eventually prices them accordingly, we are happy.”

The Fed and the Market

After two long years of a zero rate policy, the Fed swiftly (four hikes since March) brought the rates back to where they were right before the pandemic. Why not slower, why not earlier? We may continue to wonder; the point is they eventually had to climb higher from a clearly unsustainable pandemic zero level.

As much as we can argue whether low or high rates are better, it’s the speed of change that’s been disorienting for many. More so because they are rising from nothing to something, thus the cost of borrowing can go up many times over very suddenly.

The policy shift is a balancing act between maintaining growth and employment while keeping inflation in check.

Interest rates, or cost of money, is one of many inputs we believe are worth watching while investing. We have found that rising rates are the biggest strain for the most vulnerable, weak companies, which we tend to avoid anyway. That’s not all, though. The higher cost of money seems to create a tidal wave that affects the entire economy and affects businesses, consumers, and governments.

What we have witnessed these last six months is an adjustment, a correction in behavior given the higher cost of borrowing. We think it’s refreshing and might help purge some questionable investment options that have appeared over the last two years. With zero rates, everything goes; with higher rates, there is a natural hurdle rate.

We wouldn’t give rising rates all the credit here, but they did play a role together with slower economic growth and inflation in shifting the investor and consumer sentiment from overly optimistic to definitely much more cautious or even pessimistic.

It’s a backdrop to our individual investment choices, and we don’t let the tail wag the dog here, but we are definitely watching the new direction of the monetary policy (or a resumption of the pre-pandemic trend?), and the reactions to it among both businesses and consumers.

The Market and the Economy

As much as the Fed might be making waves in both the stock market and the economy, we also like to remind ourselves that the market is not the economy, and the economy is not the market. The economy represents all the economic activity; the market represents all the listed public traded companies.

The economy goes through its ups and downs, corporate earnings respond to it, and the stock market attempts to price in both the good and the bad ahead. In some ways, the market tries to predict the future. In March of 2020, the major indices lost about 1/3 of their price (Source: Bloomberg); months later, the economy had a short-term reading of about 1/3 decline year-over-year (Source: Bureau of Economic Analysis). At that point, though, the market was already on the rise.

One could wonder if the stock market is a good leading indicator. It would be too simple if it was. A famous economist, Paul Samuelson, once said: “the stock market had predicted nine out of the last five economic recessions.” He was right about that. The market tends to panic too many times to be a reliable indicator. Those panics, though, offer buying opportunities.

The economy is slowing down after accelerating in late 2020 and 2021. We went from a hard stop (in Q1 2020 US Real GDP dropped 5.1%, and 31.2% in Q2) to full speed (up 33.3% in Q3 2020, and 4-7% the next five quarters) to looking for the new normal (Q1 2022 and Q2 2022 down 1.6% and down 0.9%). (Source: Bureau of Economic Analysis).

It’s been a very wide range of economic growth in those last two and a half years; down 30% and up 30% are clear outliers and remind us of the shocks caused by the pandemic and the policies that followed. The high single-digit growth rate we saw through most of 2021 was also a reflection of elevated demand. It was a matter of time when we might see a regression to the historical average, or a 2-3%, which is what we saw through most of the previous decade.

We are watching the current economic activity with great curiosity and, even more so, corporate earnings. We believe they should give us a better idea of sustainable supply and demand beyond the last two years. As we mentioned earlier, let’s remember that many businesses are coming out of this period a lot bigger, better, and stronger than before, and they have our attention.

What’s ahead?

We believe the US economy is still the biggest, healthiest, and most diversified in the world. Given its depth, size, and liquidity, the US stock market seems to remain the most appealing home for the most innovative, new companies, even if they originated in Europe, Asia, Africa, Australia, or South America. At the same time, US companies are global and benefit from long-term growth and prosperity around the world. They operate under US laws, follow US disclosure requirements, and promote a shareholder-friendly culture, making them appealing investment choices for us. We are optimistic about the US, and the US business, while near-term, we remain cautious about the stock market as a whole. We are happy with our stock portfolio of selected, vetted, well-researched businesses.

What do we expect going forward? We build the portfolio for any possible scenario, and our goal always is to be the least wrong with our investment choices. Given the level of uncertainty from inflation, economic slowdown, interest rates to new policies, and now also, the Ukraine-Russia conflict, we are not surprised to see renewed volatility in the markets, and volatility can be a friend of a disciplined, patient investor.

Performance

In a rising market, everyone wants to be fully invested; in a falling market, everyone hopes to be completely out of the market. We always proceed with caution. We might have lagged in the second half of the 2021 market rally, but our stock selection has paid off so far in 2022. We often say that what we don’t own matters as much as what we do own.

We kept a steady course when we saw FOMO-driven speculative spirits took over the markets last year.

We have been happy with the holdings we bought, and their performance shows that stock selection mostly met or even exceeded our expectations.

We remain optimistic about the long-term growth prospects of the US and the world economy.

The last two and half years have been a whirlwind of euphoria and despair. I think it’s fair to say that we have lived through two decades of economic history in two and half years.

If one can look beyond the noise, we see many companies gain share and get stronger. We saw the adoption rate of technology in work, business, and education take a massive leap. We saw consumers change their behavior and rethink where and how they want to spend time and money.

Slow and steady wins the race remains our mantra as we look ahead toward new investment opportunities.  

 

Happy Investing!

Bogumil Baranowski

Published: 8/18/2022

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 Ode to the Market (and Speculators)

I had an inspiring call with a young investor recently. I’m always open to taking a call with anyone curious about investing. I’m still as passionate about investing as I was two decades ago. If anything, I find more reasons to be. Our call made me think that the stock market no matter how volatile, imperfect, or disturbed it seems; it’s a truly beautiful invention – let me explain.

I enjoy those calls because I get to relive the moment when I picked up my first investing book, and I could never look at stocks the same way. It’s One Up on Wall Street by Peter Lynch. Mr. Lynch shared many ideas in his volume, yet one struck a chord with me the most. He said — stocks are small pieces of businesses. Yes, they have a few letter symbols and prices, but what’s truly exciting about them is the business they represent. I had a few dozen finance professors until then at various universities — they showed me lots of theories, academic research and more. Still, none said what Mr. Lynch said so simply – stocks are small pieces of businesses!

My best guess is that they were painfully burnt by the dot-com bubble, where they likely lost their savings and openly disdained any talk of the stock market in class. It’s a casino where no one can win – that’s what they told me. As a contrarian at heart, you won’t be surprised that this was exactly the field of inquiry I chose.

I loved the idea that anyone can buy shares of any publicly traded company. The stock market doesn’t ask or care who you are – young or old, rich or poor, where you came from, where you are going. I oversimplify here; not all public markets might be open to foreign investors, and there might be some hurdles to clear, but a US investor can buy any US stock with even a small amount of money, and any other investor can do so in their domestic market, and likely in the US market, too. They can thus become a shareholder like any other shareholder all the way to the CEO or founder of such a company. For me, it was an earthshattering discovery then, and it still gets me talking about stocks today!

The moment I buy a share, I become partners with those who started it, if they are still around, and with anyone else around the world who, for one reason or another, believes that this company can do well and wants to be a part of its success. It’s quite a blessing that we get to do that!

The stock market is a place where those shares are traded. It used to be a physical place, where shares were traded in a physical form with trade tickets written and exchanged and share certificates getting moved in boxes from place to place. I visited the New York Stock Exchange on a few occasions, but on my first visit, I saw the last of paper tickets and floor traders – an end of an era. It’s all digital now, but the concept remains the same. Each share still is a small piece of a real business.

In that market, though, anyone is welcome, and people join for various reasons; some want to hold their shares for a day or mere minutes, others for years, and some don’t want ever to sell, and choose to pass them on to the next generation or a favorite charity. The choice is yours.

The time horizon of the participants though splits the stock market enthusiasts into at least two groups: speculators and investors. In my mind, the first one represents those who care more about the price action and less about the underlying business. The latter, the opposite, they are all about the business and have little care or worry about any short-term price action. They know they own something – a profit-making business.

Benjamin Graham, the father of value investing, famously said: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” As you can guess, the speculators do the voting; the investors do the weighing. I’m under the impression that the market activity is sometimes dominated by the former or the latter, and hence the market as a whole can resemble a voting machine or a weighing machine.

I would add that these are the moments of either extreme euphoria or extreme panic when the speculators take the lead. They seemingly don’t care to know what they hold, or they do know it’s really worthless in the long run; hence their interest and commitment are relatively fleeting. They usually leave as quickly as they came. Investors are the ones that stay. They never really leave. They hold the companies they like for the long run and don’t get easily spooked by market sell-offs. They also equally strongly resist joining any madness at the market top. Slow and steady would be the best way I would describe them.

The market itself continues to impress me, and I’ve been watching it for a quarter of a century and as a professional participant and investor in my own name, and our clients’ names, for almost two decades.

There are times when speculators create an overhyped market in almost anything, including profitless companies without a sustainable business model. These are companies that simply give away $100 bills charging $50 and think that somehow they can pave their path to success with ever bigger losses. Venture capital firms made a bet on them and managed to take them public, where speculators bid them up even higher. It happened last year, and it happened dozens of times before in the history of the market. Remember, though, speculators are not here to stay. All they care about is a rising price. The moment it falls, they run.

Time after time, I have witnessed companies with no real business-to-show-for see their prices rise. Also, time after time, I noticed that the very same market patiently allows speculators to dance away, only to see them panic and sell.

Who is left? Investors. They weigh; they don’t vote. They already knew those companies are worth 5 cents on the dollar at best, possibly zero.

Last year in November, a myriad of companies, from sporting equipment to online car dealerships, and more, with no real, sustainable profit-making businesses, traded at eye-popping valuations. It was the time of fear of missing out; you only live once, suspension of disbelief – anything goes!

Over half a year later, the market spoke again, and those companies finally trade exactly where they should — 90% down or lower. How much is a profitless business with no path to profitably worth? We think, and we know – zero, short of a miracle turnaround; hence, the market gives them 5 or 10 cents on the previous dollar, still just in case something unlikely saves them. Remember, not all speculators ever leave; some haven’t had enough pain and still hold on with hope. I sometimes think that those 95% losers end up at the bottom of someone’s portfolio, and they just forget to sell it, and if they all did it, the stock would be right where it belonged from the beginning – zero.

Looking back at this remarkable half a year, I want to share this Ode to the market. Speculators, inflation, interest rate hikes, talking heads on TV, none of it matters. The market, in the end, plays the same role it did when Ben Graham watched it with great admiration a century ago, devoted his life to his study, and inspired generations of others who followed.

All this to say, the market will do its job despite all the noise and disturbance, and so will we. We look for quality businesses, just as Peter Lynch told us, hold them, and let the speculators come and go. If anything, their rollercoaster ride of emotions allows us to buy stocks at even lower prices and sell them at even higher prices than if the whole market was full of level-headed, calm, and collected investors.

Thank you, Dear Market, and Thank you, Speculators.

 

 

Happy Investing!

Bogumil Baranowski

Published: 8/4/2022

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.

Where is the Bottom?

We’ve had days and weeks recently when stock prices only pointed downwards. The major US indices fell some 20%-33% from their highs recorded late last year. It’s no surprise that we are all wondering where the bottom could be. Let’s see what we can find out.

When I hear about market indices and averages, I think of a lake I grew up visiting as a kid with my cousins. Our grandpa would warn us at times. He’d say that one can drown even in a lake only inches deep on average. He said so because that particular lake had seemingly never-ending vast ankle-deep shallows, but then there was an old river valley in the middle. It had steep walls and dropped to 20 feet or more. As kids, we were curious and found the edge of it many times. The water there was cold, and you could feel the current that could take you out to the middle of the lake like a feather.

On average, it might have been a shallow lake, but it was not the complete picture. The same the markets might go up or down at times, but it hardly ever is all we should know.

The indices can comprise anything from 30 to thousands of stocks. They are constructed in various ways, and their composition is subject to change. They are manmade, not god-given. Their daily price and movement may give some idea of the market’s general direction, but it’s an imperfect picture.

As you remember, we don’t manage our portfolios to any particular index. We prefer to hold 30-60 well-selected companies, each with its own specific story. They are not immune to market gyrations, but given that they tend to have strong balance sheets and sustainable earnings power, they usually march to their own beat. They might fall behind when the broad market rises quickly, but they may hold their ground better when the market drops. They are slow and steady rather than fast and furious.

The fast and furious stocks drove the markets higher in 2020-2021. Many had little profit to show for. Their valuations expanded, and their stock prices reached what we thought were eye-popping levels. They seemed to promise growth beyond anyone’s imagination. These are tales we heard before, and we had our suspicions that eventually, the reversal to the mean will bring them back in line and closer to reality – Has that happened already?

The Profitless Tech UBS stock basket dropped from 100 to 60 in March 2020; then it rose to 220 by early 2021; it hovered at 200 through most of 2021, only to take a nosedive back to 60 most recently, a 72% drop. It looks like a big air bubble that inflated and burst right after, only to be back to square one.

UBS Profitless Tech

Source: UBS Profitless Tech

Another way to look at the fast and furious stocks of the last two years would be the valuation. The chart below shows a group of internet stocks that enjoyed what we thought was an incredible boost. The market was willing to pay 2x-4x as much for each dollar of their earnings as in previous years (see chart below). It felt to us like a paradigm shift. Somehow any previous models and assumptions seemed to not apply anymore, and those stocks deserved a much higher valuation. That bubble burst as well.

Source: Altimeter.

Is all the air out? In some pockets of the market, maybe, but then looking at other hyped-up “assets” of the last two years, we might think there is more air to let out.

Out of curiosity, we looked at the total value of cryptocurrencies. These new assets with no profits, no revenue, and not much to show for other than a digital record also enjoyed a heyday. The tracked value of all cryptocurrencies touched $3 trillion last year. That’s a ten-fold increase from the levels recorded in the prior years. $2 trillion of that value vanished already, with little under one trillion remaining. Some reversed their stance and argued that now cryptocurrencies are worth zero, if they are right, then that bubble hasn’t burst completely yet.

We often say that what we don’t own matters as much as what we do own, especially in a bear market. We had no interest in cryptocurrencies and no interest in profitless technology companies either. We still don’t.

Where is the bottom? If the biggest critics of cryptocurrencies are right and they are indeed worthless assets, the bottom is a trillion dollars away; they are 2/3 of the way there. For profitless tech and internet stocks, we reached a bottom that those stocks reached before both in prices and valuations (see earlier charts). Is it THE bottom? We are yet to see.

There might be more air left in various market segments; there might be more market volatility all around as businesses, consumers and governments learn to operate with higher inflation, rising interest rates, and economic slowdown or a recession.

As much as tech stocks led this market correction, there are big swaths of the market that held up just fine. A good proxy for them could be a high dividend yield index or ETF (exchange trade fund) that track quality businesses with dividend income. Those stocks have been rangebound and seemingly barely moved since May 2021. Looking at their YTD performance, they are still down, but only some 9%, which is much less than any previously hot flying stocks.

High Dividend Yielding Stocks

Source: Bloomberg, Vanguard High Dividend Yield / FTSE High Dividend Yield.

We look for clues in the earnings release, not daily price actions. We worry less about earnings beats or misses in a particular quarter. We are more focused on long-term sustainable growth and profits.

We never knew where the bottom of the lake was as kids, we might not know exactly where the bottom of the market is today, but we are very encouraged to see renewed skepticism among investors. We think it’s a healthy break from last year’s euphoria and sell-offs create buying opportunities for patient and disciplined investors. As we wait and search for the bottom, we expect to find plenty of new holdings among stocks that are being thrown out like the proverbial baby with the bathwater. They could make a very respectable contribution to our portfolios’ performance in the next few years. We proceed slowly and gradually, though, as always.

Happy Investing!

Bogumil Baranowski

Published: 6/15/2022

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.

UBS Profitless Tech basket tracks the performance of emerging high-growth tech and tech-enabled companies which have yet to complete a full year with positive earnings. The basket has been optimized for liquidity with initial weights capped at 4%. Created on May 18, 2020 – rebalanced and reconstituted annually.

Vanguard High Dividend Yield ETF tracks the FTSE High Dividend Yield Index. The index selects high-dividend-paying US companies, excluding REITS, and weights them by market cap.

Hot or Cold

Have you ever used those old-school hot and cold faucets? Some older hotels may still have separate faucets, one with scorching hot water and the other with bone-chilling cold water. If you burn your fingers in one, you can at least cool them down in the other. A happy middle would be preferable, but it’s not always available. The stock market sentiment seems to have only two options, too: hot or cold, and rarely something in between. Let me explain.

Time after time, it’s fascinating to watch how the market sentiment swings from despair to euphoria and back. The last two years took investors on a real rollercoaster ride of emotions. In February 2020, I attended a conference in Florida. Companies presenting shared their peak results and looked forward to even better results ahead. Coronavirus was a distant problem far away on the other side of the globe. The bottom seemed to have fallen out only a month later, and the stock market took a 32% dive.

Doom and gloom forecasters took the stage on TV, spreading chilling predictions. The market started to recover, though. The S&P 500 rose as high as 40% above the pre-pandemic high. A very impressive feat as the world worked its way out of lockdowns and stay-at-home orders. The market euphoria fed on the consumer excitement or vice versa. Many shopped for anything from grills and pool equipment to new cars and houses. It felt like a now or never moment for both investors and buyers. We heard the mantra: you only live once, and the fear of missing out overtook many.

Quality stocks rose, but also companies with no profits or hardly any revenue. If that wasn’t enough, digital assets with neither profits nor revenue rose in price, including cryptocurrencies and NFTs (non-fungible tokens). Some of them represented as little as funny digital images of a colorful roll of toilet paper. One could find it amusing since that household staple in its physical form became quite a hot commodity in the middle of the pandemic. There was no cloud in sight, and the market reached new highs getting hotter by the minute. Yet something stopped again.

Benjamin Graham, the father of value investing, wrote about Mr. Market. This imaginary character resembles a manic depressive with extreme mood swings wanting to buy or sell. Sometimes he is optimistic, other times pessimistic, switching from hot to cold and back at a moment’s notice. Benjamin Graham explained how Mr. Market might be knocking on our door with an offer, it could be high or low, but it’s up to us to decide when and how we act on it.

The last six months might have felt like a cooling period. Stocks fell from their highs, especially those with extremely high valuations and little or no profit. Then digital assets experienced more cold shoulder treatment from earlier enthused investors. We saw some collapses and crashes in crypto markets.

It may all seem disorienting and disturbing, but all noise and temperature swings aside, what drives stock prices, in the long run, is the underlying value. The value comes from the earnings power of a business. How much money is left after all costs are covered – the profit. Outside the stock exchange, if you were to buy a business, a pizza restaurant, or local cleaners, you would look at the last five years of profit history. You’d want to know if those profits are sustainable or if they are growing. You’d be curious to know if the customer base is fairly loyal, too. Finally, the cost structure would be equally interesting to understand. What does it cost to run this business?

The daily, weekly, or even monthly price gyrations aside, the stock market follows the same logic as purchasing local cleaners. We remind ourselves of that every time an overheated market reaches new highs or an overchilled market drops to new lows. The fundamentals, the profits are all that matter.

Those fundamentals are somewhere in between the two extremes; Mr. Market might be jumping up and down, but it’s up to us to decide how and when we act on it. There are times to sell, raise cash, wait, and there are times to buy and put more capital to work. We don’t have to precisely call the markets’ tops and bottoms. We don’t believe anyone can do it. We can do what’s second best, and gradually sell toward the top and gradually buy toward the bottom while carefully watching the fundamentals rather than daily prices.

That’s exactly what we have been doing for the last two years and the previous decades. We believe that slow and steady wins the race. Mr. Market used to go from hot to cold a hundred years ago when Benjamin Graham sat in his Manhattan office, and it does today.

Graham famously wrote: “Business conditions may change, corporations and securities may change, and financial institutions and regulations may change, human nature remains essentially the same.” This was true back in 1922 when railroad era companies like American Locomotive (the leader in steam engines on wheels) still belonged to the Dow Jones Average, and it is today with Apple Inc. (one of the leaders in smartphones) in the index.

Hot or cold, optimistic or pessimistic, euphoria or despair, we keep a steady course, and we hear Graham’s words: “Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”

 

Happy Investing!

Bogumil Baranowski

Published: 5/25/2022

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.

Against Our Nature

I walked into a snake pit. It was among the more memorable moments of the last two years. On one of our early pandemic hikes in the Appalachian Mountains, my wife Megan and I found six rattlesnakes basking in the sun. They blended in so well, and we were blinded by the sun. Despite that, it only took my brain an instant to register a snake-looking shape, and my body froze, my heart started pounding, and my breathing sped up. It was a true fight or flight, a life or death moment. A million years of evolutionary conditioning jolted me away from imminent danger into safety. It’s part of our nature. Yet, in investing, we have to go against our nature and deeply ingrained instincts, time after time. Why is that? Let me explain.

Investing is a fascinating yet peculiar pursuit. When our gut tells us to hide, the best buying opportunities likely abound. When the fear of missing out overtakes us, and we feel that we should chase a hot stock at any price, it might be the time to wait and pass. As the stock market resumed a rollercoaster ride in the last few months, it’s a good moment to revisit our instincts and see where they serve us and when they can get us in trouble.

For those investors who gave in to their instincts, it’s been a very trying time. Those who panicked and sold all in March 2020 missed out on one of the fastest market recoveries. Others who surrendered to the fear of missing out and bought the hottest stocks in November 2021 saw dramatic losses in the next six months.

Whenever I’m in a forest, I often think about how I am here today because of my countless ancestors that jumped and ran when they saw a threatening shape in the bushes. It’s a natural response in moments of imminent danger.

In investing, though, that eternal logic is flipped on its head and confuses many repeatedly. Let’s explore it a bit more.

How do you think one can make money owning stocks? We want to buy them low and sell them high while we potentially collect dividends in between.

Our nature would make us sell at the bottom, though, and buy at the top — the exact opposite. Selling at the bottom resembles running away from the noise in the bushes; we do it out of fear. Buying at the top may feel like joining a happy celebration that you don’t want to miss out on. This kind of buying and selling happens in the elusive comfort of the crowd, with others right by your side, which is also an environment in which we usually feel safe. It’s all appropriate behavior almost everywhere, but in stock investing.

Why would a good, healthy, growing businesses ever sell at a low, attractive price? Most often than not, it actually trades at a full price or happens to be overpriced.

The best buying opportunities arise when investors panic and sell. They react as I did to a snake pit. They jump and leap in the opposite direction. The crowd runs one way, yet a handful of calm, collected, disciplined, and deliberate investors quietly buy.

Not every falling stock is an opportunity; it would be too easy! Only sometimes can some of them be promising buy candidates for discerning stock pickers. It’s that very time when we go against our nature, and thus, against the crowd, we make the biggest strides in our investing pursuits.

In times of enthusiasm and euphoria, we let the crowd run wild while we quietly step aside and wait. Not giving in to the fear of missing out when others happily bid up stocks to unreal levels is indispensable in successful stock investing.

Needless to say that some of our everyday responses to our primal instincts might be disproportionate anyway. When somebody cuts us off on the highway, when an ATM swallows our card, when we miss a plane, our brain and body respond as if it was a fight or flight moment, but it usually isn’t. It’s a healthy revelation that it’s not all a life or death experience.

Even more so in investing, though, it’s helpful to pause, catch a deep breath, and give it some serious thought. It helps to realize that we might need to go against our nature and the crowd, override our instincts, and do exactly what Warren Buffett suggests: “Be fearful when others are greedy. Be greedy when others are fearful.”

And when we go on a hike in the woods, we still watch where we step.

 

Happy Investing!

Bogumil Baranowski

Published: 5/18/2022

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 True Cost of Things

I was on a video call last week. We were using someone’s else link, and 40 minutes into our conversation, we were cut off. My host realized that his free video calling plan only allows limited use per call. I know he upgraded to a paid plan since, but that experience reminded me of a more significant phenomenon. We are quickly learning the true cost of many services we use, and it has important consequences for how we invest. Let me explain.

As investors, we have an opportunity to get to know many businesses all around us, especially if they are already publicly traded. I’m often positively surprised by the extent of disclosure of public companies. I imagine few people have the time, the interest, or the need to read it, but if you are serious about your investments, there is plenty to learn.

One phenomenon that we observed over the last ten or maybe even twenty years is the birth of freebies in the internet world. We all know well the free samples we can get at a local supermarket, anything from gourmet cheese to a slice of fresh fruit. The internet changed a lot how we can access a variety of services. The cost to add an incremental user dropped substantially.

The funding coming from venture capital firms allowed many companies to enjoy a large audience without charging a dollar for the service provided. It was all done in the name of fast growth and with the hopes of reaching scale, adoption rate, or stickiness that will allow the company to start charging something down the road. With expanding services and user base, the costs usually run up, while insufficient revenue makes turning a substantial profit difficult.

With the proliferation of smartphones, we saw an even bigger growth in the number of services we use. There are apps for almost anything from cooking to dating, banking, communication, and more. We have seen many specialized professional apps helping doctors, engineers, lawyers, investment professionals, etc.

As consumers, we got used to getting almost everything for free. We don’t feel like paying for our email, messenger, online searches, weather reports, news, entertainment and more. In some cases, companies discovered a workaround. They reinvented an old solution used by media companies before, from newspapers to radio and television. The service might seem free, but it’s the consumers’ attention that’s auctioned off to the highest bidder and sold as advertising space. This path proved highly profitable for a handful of tech giants.

Not everyone successfully followed, and many others try to charge for premium services and introduce many levels of service, enticing users to pay up. Researching many companies in that space as potential investment targets, we noticed how difficult it could be to introduce a paid service. It’s even a more significant challenge to pass through price increases to existing paying customers.

The other troubled model we observed included offering proverbial $100 bills for $50. With flawed unit economics, no matter how big and how fast a business grows, there is no path to profitability. We saw challenges at some meal kit companies that shipped ready-to-use ingredients to our homes. As consumers, we took advantage of those offerings; as investors, we stood away. There was also a real estate company disguised as a tech unicorn locking in overpriced long-term leases only to turn around and rent back office space with no commitment and at a usually much lower price.

With billions of VC funding, a lot of magic is possible for a brief period of time. The start-up founders have been praised for growth at any cost, and consumers were enticed to believe that we can get not only free lunch but also a free ride, free office, free music, and more. Some investors might lose sight of what’s real with all the smoke and mirrors.

Something has changed recently, though. It might have overlapped with the pandemic shifts in consumer behavior. We think it probably accelerated a change that was bound to happen eventually anyway.

Among the winning companies, we witnessed big leaps in the adoption rates of a variety of online services, from streaming to video calling and more. The importance and relevance of those offerings in the eyes of consumers must have changed as well. How do we know? We saw several service price increases in the last two years.

Some might argue that this renewed pricing power comes under the guise of general inflation. Everything is more expensive, so it’s easier to accept price increases for our favorite streaming service or work essential video calling app.

Maybe it’s the inflationary environment; maybe it’s the scale, the importance, the adoption rate. Perhaps it’s all of the above. In the end, it’s the result that matters, and we are seeing how customers are starting to embrace what we like to call the true cost of things. They might be reluctant to pay or pay up – old habits die hard. Still, with this new phenomenon, some companies finally have a chance to enjoy higher revenues and improved profitability.

Others might have failed the test and will fade away or need to change course dramatically. Venture capital firms grew again a bit more reluctant to fund growth at any cost — as they do every so often.

From an investment perspective, we see the potential for improved earnings and real, sustainable upside in many current and future businesses that offer valued services and discover a lasting pricing power. We are keeping an eye on them, and we intend to seize all opportunities that may arise as consumers reluctantly discover the true cost of things.

 

Happy Investing!

Bogumil Baranowski

Published: 4/28/2022

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.

When the Appetite for Risk Disappears

It was 2010, and I was sitting at an IPO (initial public offering) lunch in Manhattan shortly after the 2008-2009 financial crisis. This was one of the companies going public soon after a dry spell of the previous two years. It had a big market share, highly profitable business, a strong balance sheet, a growth story to share, and most of all, a very reasonable valuation. You’d think it was a stockpicker’s dream. The interest was tepid at best, though. Investors seemed to have lost all their earlier appetite for risk and… returns for that matter. Reminiscing about that IPO, and looking at the last two years, and especially the abrupt year-to-date investor hesitation both in public and private markets, I started thinking about the ups and downs of the infamous – appetite for risk. What is it? Why does it matter?  

Here at Sicart Associates, we have a habit of following some more interesting IPOs, and we’ve had a record number of them in the last two years. We always have a great appetite for returns but no appetite and rather limited tolerance for risk, especially unnecessary risk. We know well that there is no such thing as free lunch in investing, though. There is a level of risk we are willing to accept, but only if the returns more than compensate us for it.

IPOs are usually younger companies that became big enough and hopefully mature enough to have their shares offered to the general public. As a matter of fact, almost all companies we have bought year-to-date weren’t even public at the time of the earlier mentioned IPO lunch. They have all grown to become well-established leaders in their respective industries. The recent investors’ risk aversion offered some compelling buying opportunities for us.

In our opinion, some IPOs may be too expensive or not compelling enough at first. Down the road, when the enthusiasm fades, price comes down to earth, and the business solidifies, they may become investable from our perspective. We take the time to get to know them, and we wait for an opportunity to buy them. It’s not rare to see a once-hot IPO trade at half the price or a fraction of the valuation only a few short years after its initial listing.

That particular 2010 post-financial crisis IPO caught our attention. We ended up owning it later on. After a bit of a rollercoaster ride, it got acquired at a large premium by one of the major players in the industry. They were willing to pay almost ten times the price the company was listed at only eight years later — was the appetite for risk back up again?

What was striking about that IPO lunch was the difficulty faced by a quality business finding interest among public investors only two years after the 2007 hot IPO market. It was also only a decade after the dot-com bubble when a company didn’t need to have an actual business or a dollar of sales and could still fetch a multi-billion dollar valuation. The appetite for risk tends to go from hot to cold and back.

In May 2007, CNN reported, “Risk abounds in hot IPO market.” Thirty companies a month would get listed at the time. Levels of debt and profitability were secondary. The bull market was strong. House flipping was a quick path to riches. The appetite for risk was high.

If we were to compare 1999 with 2007, the former seemed to have reached an even higher level of risk appetite. Interest rates were cut, and the capital gain tax was reduced – talking about pouring gasoline on the fire. The Internet browser was invented, and the dot-com bubble was getting hotter and hotter. It was the era of price-per-eye ball valuations and massive growth in the use of the Internet. Lycos, a web search engine and portal, was the fastest company to go from inception to IPO (2 short years) and reached a $12 billion valuation in 2000, only to sell for $36 million ten years later. Sales and profits didn’t matter, and the life of dot-com companies was measured by its burn rate. In other words, how quickly the company will burn through the capital, it raised. That money went to Super Bowl ads, high-end office chairs, and more.

Nasdaq Composite rose 400% between 1995 and 2000, only to fall 78% in the next two years. Overnight, the epitome of risk appetite — venture capital became no longer available, and only a handful of dot-com stocks with more conservative management and credible businesses survived, among them Amazon.com.

It’s worth noting that Amazon survived, but still, its price dropped some 90%. Jeff Bezos, at the time, opened his annual letter to shareholders with a single yet powerful word: “OUCH!” One of my grad school finance professors must have been among those who lost their shirts buying Amazon shares at the peak because we never heard the end of his criticism of this online everything shop.

There were other heavily bruised dot-com survivors. Priceline lost a digit and fell from $94 to $4, only to rise from the ashes and become a big player in the online travel world as Booking.com in the following two decades.

Now, the Internet changed the way we live, work, do business, educate, inform, communicate, and even meet future spouses – there is no doubt about it. So many new opportunities, efficiencies, and connections became possible, but also so many businesses became less relevant, shrunk, and had to reposition or vanish.

Innovation has been changing the world from the invention of the wheel to railroads, phones, cars, radios, computers, the Internet, and more. When investing in innovation gets disconnected from fundamentals and disciplined investment process, it may prove to be an all-risk, and no return or all loss proposition, though.

One could argue that the dot-com and 2007 IPO participants were rational buyers, speculators rather than investors. Someone explained to me once the housing bubble era rationale, which may as well apply to any bubble-era speculation. Those flipping homes had a thirty-day investment horizon. They wanted to sell the property higher before the first mortgage payment was due. Similarly, some or many IPO buyers in the bubble era days might have wished they  got in and got out quickly enough to book a profit and avoid the downfall.

It reminds me of a hot potato game, where players toss an object around while the music is playing, and whoever holds it when the music stops losses.

History shows that the music usually stops when the proverbial appetite for risk peaks. It’s impossible to tell at the time but easier to pinpoint looking back.

The “hot potato” speculators sleep with a thumb on the “sale” button. We do the exact opposite. We say that we’d be happy to hold what we own even if the stock exchange choose to close for a few months or years.

The last two years of pandemic investing have been ones for the books. We had a big market sell-off, a rally, and a more recent mild correction. With interest rates at zero (only rising lately), lots of fiscal and monetary help, COVID-driven distortions in supply and demand, the appetite for risk flourished on many levels from many hot IPOs (in 2021, there were 2-4 times as many IPOs as in most previous years), meme stocks, to SPACs (special purpose acquisition corporation) to cryptocurrencies, NFTs and more. Some even argued that the pandemic turned more people into thrill-seeking digital speculators looking for excitement in gamified stock trading apps.

When the appetite for risk goes up, investors not only seem to care less about the sales and profits of the investments they buy, but they also are willing to accept less liquidity in their investments. They are willing to lock in the uncertainty for many years, investing in exotic-sounding private deals and adventurous real estate investments. The term “alternative investments” gets thrown around yet again. Suddenly, a whole swath of allegedly new investment assets appears that would otherwise be of no interest to any discerning investor. Talking heads on TV proclaim the rising appetite for risk among investors.

It’s impossible to tell what the rest of 2022 will look like. What we do know for sure though is that there are always some quality businesses out there joining the ranks of publicly traded stocks. They are offering valued services or goods and figured out a way to turn a profit. They have a long runway ahead of them and a loyal and expanding customer base. The key to success is figuring out the price we are willing to pay and the patience and discipline to hold them long-term.

Warren Buffett once said that it is wise for investors to be “fearful when others are greedy, and greedy when others are fearful.” At times for most investors — no amount of risk and uncertainty is too much to accept; other times, no amount of risk and uncertainty is small enough to stomach.

We like to share that we always have a great appetite for returns but no appetite, and rather limited tolerance for risk, especially unnecessary risk. This investment approach allows us to identify and capture the long-term upside of good businesses and avoid the downfall and pain of highly risky investments. It doesn’t mean we will avoid drawdowns and volatility. We accept it. We know there is no free lunch in investing.

We remember well that the appetite for risk comes and goes leaving behind painful losses for some and buying opportunities for others — slow and steady wins the race.

Happy Investing!

Bogumil Baranowski

Published: 4/6/2022

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.

Reflections on the Shape of Stock Market Bottoms

Bob Farrell, the iconic one-time investment strategist at Merrill Lynch, formulated Ten Basic Rules of Investing, which have since become a “must” reference for students of the stock market. One of these pronouncements stated that “Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.”

Recently I resolved to test this observation against my recollection of stock market bottoms I have personally experienced. My partner Bogumil Baranowski, more digitally adept than I, helped with the images in this article. It turns out that while Farrell’s rules constitute a useful warning, they cannot really help anticipate the exact shape of bottoms. Here are a few examples that stick in my mind…

[Please note that, for graphic quality, we have charted weekly prices. This eliminates the drama of the last few days of a bottom, which can be more prominent, especially when declines end in selling climaxes.]

1969-1970: Recession as a Surprise

Source: Bloomberg.

The economic recession of 1970 was relatively mild and affected mostly the domestic sectors of the economy. Still, the stock market reacted rather emotionally, coming as it did after the “roaring 1960s” and at a time when economists and politicians had begun to believe that we had conquered the economic cycle. The V-shaped stock market bottom was relatively clean and responded well to traditional stimuli. The S&P 500 Index recovered to its 1969 high about one and a half years later.

1972-1974: The Double-Bottom Stock Market

This was my first hands-on experience of a bubble blowing up and then bursting. A small number of large, successful companies had weathered the 1970 recession quite well. Many were diversified internationally and exhibited growth characteristics that seemed independent of the traditional U.S. economic cycle. They wound up being labeled the “Nifty Fifty” and were heavily promoted by banks’ wealth departments as one-decision, recession-resistant stocks that investors would never need to sell. As expected, their valuations in terms of price/earnings (P/E) ratios skyrocketed but in time the bubble burst, as they always do. It took the S&P 500 more than four years to match its 1972 high, while several of the Nifty Fifty stocks took much longer to recover. Some never did.

Source: Bloomberg.

After a major adjustment to much lower valuations, the market touched a double bottom in the following September and December. Even the stocks which had not participated in the bubble eventually reached record-low P/E ratios. Meanwhile, the materials-related companies that had been boosted by the first whiff of inflation also came back to earth (together with their earnings) as a result of the subsequent global economic recession.

1980-1982: One Long Recession, but in Two Acts

Source: Bloomberg.

By 1980, inflation had become a growing concern, and early, timid efforts to tame it had threatened to cause a fairly typical but still-mild recession. But in 1979, two situations had occurred that would exacerbate these tendencies. First came the fall of the Shah of Iran, a major oil producer. That incident triggered the second oil shock in recent memory, following upon the 1960 creation of OPEC, and Paul Volcker’s nomination to the chairmanship of the Federal Reserve. Volcker undertook to break the back of exponentially-rising prices – even at the cost of a deep recession.

The second oil shock triggered a capital spending boom in energy-related sectors, which appeared in aggregate economic figures as the beginning of a recovery. However, Volcker’s muscular monetary policies soon threw the economy back onto a recessionary path.

In the 6 months between January and July 1980, the U.S. GDP declined 2.2%. But, after the energy-related growth bump in the 16 months between January 1981 and November 1982, the GDP lost another 2.7%. At the time, it appeared to me as one long recession, during which interest rates reached historic highs, and the stock market’s P/E ratio again touched its historical, single-digit low of late 1974.

My memory of the 1980-1982 decline is one of an excruciating wait that felt like an elongated  U-shaped bottom if one when values were steadily appearing at unhoped-for prices. In the midst of the decline, I sent a letter to our clients entitled: “Happiness is a dull portfolio” – a statement that was vindicated a year later, after the recovery got underway.

1987: A One-Day Bear Market, No Recession but Eventually Everything Suffered

Source: Bloomberg.

Throughout the early months of 1987, the economy gave signs of weakening while stock market valuations became increasingly stretched. I had just launched the Tocqueville fund and was very reluctant to invest the inflow of cash, instead of maintaining significant reserves. After a few months, some shareholders, many of whom I knew personally, began to complain that they were not participating in the ebullient stock market. I finally gave up and invested a significant portion of the liquid reserves.

Then, on what has come to be known as Black Monday (October 19, 1987), the Dow Jones Industrials Average of the stock market lost almost 23% in hours! Nassim Taleb, author of the well-known book The Black Swan (Random House, 2007) had not yet written: “It is far easier to figure out if something is fragile than to predict the occurrence of an event that may harm it.” So most investors were taken by surprise. The wave of selling was such that the “tape” was hours late, and actual stock prices would not be known for many hours, sometimes days. Once final prices were printed, however, it looked like the Fund’s portfolio had held up quite well, and I thought we were geniuses. But with further reflection, another explanation became clear:

When investors must sell in a panic (whether for psychological reasons or because of margin calls if they bought on credit), they sell what they can offload most easily. That usually means the more liquid shares of the larger companies.

Our Fund had been mostly invested in shares of smaller or medium-sized companies, which were below the radars of those panicked investors. As a result, these shares survived the first selling wave quite well. In the following weeks, however, this segment of the market played catch up (or down, rather), and by the end of the year, our Fund had declined almost as much as the stocks making up the index. The market did not recoup its 1987 loss until mid-1989.

2000-2001: The Dot.Comedy

Source: Bloomberg.

The 1990s were a period of intense speculation in the segments of the market linked more or less closely with the nascent Internet. By the end of the decade, companies with a .com suffix, real or implied, with or without earnings, were selling at valuations never before imagined.

We found it be fairly easy to escape the carnage that ensued: the likes of AOL and shares of other companies promising to change the world through the Internet eventually collapsed. Like the Nifty Fifty in the 1970s, they did not reclaim their 2000 highs until several (7, in this case) years later – for those that survived. But, if you resisted the clamor of clients wanting to “participate” and avoided these fanciful investments, your portfolios performed fairly satisfactorily through the entire cycle.

2007-2009: Generalized Junkyard

The advent of what became known as The Great Recession vindicated Hyman Minsky’s hypothesis that “stability breeds instability,” usually through increasing risk acceptance, financial leverage, and speculation.

In the years leading to 2007, real estate speculation had reached new highs, with banks and other financial intermediaries entering into “sub-prime” financing. Some of the less ethical even encouraged mortgage borrowers to lie about their financial condition. By 2008, the speculative bubble and associated Ponzi-like schemes collapsed, causing major bankruptcies and necessitating the bailout of some major financial institutions.

 

Source: Bloomberg.

There had been some scary financial accidents before (for instance, Long -Term Capital Management’s collapse in the late 1990s). However, in my memory, this was the first time that a financial crisis prompted an economic recession that engulfed every sector of the market and the economy into its downward spiral. It may well be the prototype for future crises and recessions.

After recovering to its 2007 high in 6 years, the stock market responded well to monetary and budgetary stimulus in the following decade, up to the early 2020s. But the economic recovery was uneven and hesitant, both domestically and globally.

Geopolitics and De-Globalization

Just as the global economy was beginning to recover from various COVID waves, Russia invaded Ukraine, further aggravating supply chain problems and threatening both an acceleration of inflation and, more recently, a serious economic slowdown.

In the last few decades, financial crises and resulting economic recessions have tended to originate at the periphery of the larger economies. This phenomenon began with the Asian crisis of 1997, which started with the relatively unobserved Thai currency, the bhat.

The globalization trend that has characterized the widespread post-WWII boom has benefitted the world economy by spreading growth to previously under-developed economies and lowering costs (through imports or offshoring) for developed economies. However, in the wake of the Russian invasion of Ukraine and the hardening of U.S. relations with China, it seems probable that this trend will reverse to one degree or another. Most countries will attempt to become more self-sufficient as regards important resources or strategic products. This scenario implies slower growth of the global economy.

Another scenario that concerns me involves the continued strength of the U.S. dollar coupled with a return of U.S. interest rates to more “normal” (higher) levels. On the surface, such a combination may seem counterintuitive. Raising rates to combat an economy’s inflationary tendencies should eventually slow down that economy and raise the specter of recession, which normally should weaken the country’s currency.

However, we live in a complex and paradoxical environment. Financial and currency markets have been unusually volatile, and the U.S. dollar has behaved as a haven currency, continuously edging up in value as many other currencies have tended to weaken. If this trend persists despite an opposite prognosticator consensus, we may temporarily experience a combination of higher rates and a strong dollar. Many developing countries and other stressed foreign borrowers have borrowed in U.S. dollars at floating interest rates. They would then face the double whammy of higher currency and interest repayments.

As I mentioned earlier, financial crises in recent years have tended to originate at the periphery of major economies, where transparency is elusive, the role of the U.S. Federal Reserve more diluted, and the size of consequences is often difficult to anticipate. It seems like a good time to prepare for the unexpected and look for signs of stress in the less-monitored areas of the globe.

François Sicart – 4/4/2022

 

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.

 

 

Second Half 2021 & YTD 2022 Review

Two Years Behind Us

If we look back at 2020 and 2021, stock investments have had clear turning points. Until late February 2020, it looked like yet another decent year ahead with strong fundamentals and peak economic performance. Some could say that it was too good to be true for too long. That’s why we entered 2020 with a fairly cautious stance.

We took advantage of the buying opportunities presented by the March 2020 sell-off. We enjoyed the stock price and business recovery of our holdings through the end of 2021.

That period though was not all smooth sailing for investors. In the first half of 2021, we saw high-flying growth stocks take a break from the rally, only to catch up in the second half of 2021.

As we kept up with our holdings and considered future potential buys, carefully studying each earnings report, we started to notice a shift around summer 2021. We witnessed more disappointment among enthused investors. This new phenomenon continued through the end of the year and further into 2022.

As we are putting the finishing touches on our update (3/2022), the market seems to have hit a temporary invisible wall. It doesn’t mean that there are no compelling opportunities to add to our portfolio, quite the contrary. The renewed volatility already drove down the prices of a good number of potentially interesting companies.

We decided to act and gradually buy some new holdings.

With the latest COVID wave mostly behind us, we are witnessing a quick shift in policies towards fewer restrictions. If that direction continues, we believe businesses, consumers, and workers can hope for some new normal ahead. That’s something we are yet to see and define as we move past the last two very unusual years.

We wrote last time, “although we have seen some unexpected stock market heroes in the last year and a half, it has been one of the most challenging times to navigate.” Late 2021 and early 2022 might have been a refreshing pause in the rally that proverbially lifted all boats. The path forward may not be that obvious. We are always keeping a steady course, and we aspire to be the least wrong. We remain prepared no matter which scenarios play out in the end.

Long-term Goals

Our long-term goal remains the same for all the assets we manage. We intend to both preserve and grow the capital over time. We seek to double our clients’ wealth every 5-15 years, which translates to a 5-15% annual rate of return over the long run, but we would like to accomplish it without exposing the portfolios to the risk of a permanent loss of capital. Of course, performance cannot be guaranteed, and past performance is not indicative of future results.

Our strategy can be described as a long-term patient contrarian. All securities are selected through an in-house research process. Our investment horizon for each individual holding is usually 3-5 years.

We intend to hold between 30-60 stocks, mostly US equities, but we may invest in foreign securities as well. We don’t use any leverage; we don’t own any derivatives. We may supplement the strategy with exchange-traded funds (some of them may use leverage or derivatives).

We don’t have a predefined portfolio composition target. We may hold cash at times, but we prefer to own businesses, and when the opportunities abound and prices are right, we will likely be close to fully invested.

The second half of 2021

In the first quarter of 2021, we saw a rally in small-cap stocks, while large caps, and especially technology stocks, hesitated. In the second quarter and through the second half of the year, small caps traded sideways, while large caps and technology stocks steadily rose.

Around summer, though, as earnings started to come in, we noticed a peculiar shift. There was a growing number of companies that benefited from strong fundamentals and price momentum earlier in the pandemic but were facing some headwinds now.

In many cases, investor enthusiasm pushed the stock prices ahead of fundamentals. The consumer demand remained elevated, but year-over-year comparisons were less impressive. The market proved to be unforgiving to some of those stocks. It created several buying opportunities for us.

It also set the stage for what we saw late in 2021 and early 2022. The market started to cool off from the earlier rally. We witnessed some record-setting daily big drops in a number of stocks that were market darlings only a few short months earlier.

In our mind, it was a sign of the fundamentals prevailing yet again. The actual earnings power mattered more than promises of growth and the excitement of rising price momentum.

We are yet to see if it’s a long-lasting pause in the market rally or a chance for more pockets of weakness in various market segments. As long-term holders and patient, disciplined buyers, we always welcome price volatility and panicked selling.

Finally, it’s worth noting that the market valuations came down. As earnings rose, the stock prices dropped. It’s too early to say that the market as a whole looks compelling, but we believe there are definitely more opportunities around than in a while.

What we wrote last time applies today: “as much as we pay attention to the overall market trends, we like to look at our performance independently from the benchmark. As long as the businesses we own report improving fundamentals, and the market eventually prices them accordingly, we are happy.”

Interest rates on the rise

Things finally got interesting on the interest rate front.

Last time, we mentioned the staggering fiscal and monetary help that came unleashed when the pandemic hit. We also added how the Fed’s monetary support never paused. Later in 2021, the Fed started to get ready to back away a bit. The inflation fears set the stage for some potential interest rate hikes going forward.

1-year treasury rate spiked in late 2021 to over 1%, it was around 0% for most 2020 and 2021, and for reference reached over 2.50% in mid-2019, after a steady but slow 5 year-long rise from near zero territory between 2009 and 2015.

1% may feel like not a lot, but when we take into account that it was at 0.05% in May 2021, that’s a 20x higher cost of borrowing for one year for the US treasury and everyone else, too.

The closer we navigate around zero, the smaller changes can make bigger waves in the cost of credit and asset prices.

The 1-month treasury rate remained close to zero, but the 3-month rate spiked from almost zero to 0.35%.

The tide seems to be turning just as US inflation reached 7.48% based on a 12-month change in CPI (February 2022). That’s a level US consumers and businesses haven’t seen since the early 1980s.

As much as we consider ourselves bottom-up stock pickers, we pay close attention to the macro environment we operate in, and both inflation and rising rates have been on our minds lately.

Supply, demand, inflation

In the first half of 2021, we saw supply chain constraints, demand recovery, and inflation gathering speed.

In the second half, supply chain issues continued, but in some segments, we started to see normalization. The demand continued to evolve, too. In some cases (cleaning products among them), it remained elevated but hasn’t grown year over year as much it did in the previous year.

Businesses also faced input cost increases from commodity to labor.

Pricing power came to the forefront of our attention. Can the businesses raise prices, and will the consumer accept it? We’ve been paying more for anything from a basic grocery basket to rent and movie streaming at home.

Inflation has an impact on consumer psychology. When it reaches a certain level, it starts to affect the shopping decisions. Consumers may accelerate some purchases or choose to forego others completely.

We are yet to see how many of the recent challenges are long-lasting and how many will pass as the supply and demand find a new firm footing beyond the pandemic years. The same applies to inflation.

 What’s ahead?

The US economy is still the biggest, healthiest, most diversified in the world. Given its depth, size, and liquidity, the US stock market seems to remain the most appealing home for the most innovative, new companies, even if they originated in Europe, Asia, Africa, Australia, or South America. At the same time, US companies are global and benefit from long-term growth and prosperity around the world. They operate under US laws, follow US disclosure requirements, and promote a shareholder-friendly culture, making them appealing investment choices for us. We are optimistic about the US, and the US business, while near-term, we remain cautious about the stock market as a whole. We are happy with our stock portfolio of selected, vetted, well-researched businesses.

What do we expect going forward? We build the portfolio for any possible scenario, and our goal always is to be the least wrong with our investment choices. Given the level of uncertainty from inflation, interest rates to new policies, and now also, the Ukraine-Russia conflict, we are not surprised to see renewed volatility in the markets, and volatility can be a friend of a disciplined, patient investor.

What could we have done differently?

In a rising market, everyone wants to be fully invested; in a falling market, everyone hopes to be completely out of the market. We always proceed with caution. We might have lagged in the second half of the 2021 market rally, but our stock selection has paid off so far in 2022 (3/2022). We often say that what we don’t own matters as much as what we do own.

As much as at times last year we looked back and thought that we wished we had been more invested right away after the 2020 sell-off, we found some redemption in early 2022; we are glad today that we kept our steady course through 2021 and haven’t given in to FOMO (fear of missing out).

We have been happy with the holdings we bought, and their performance shows that stock selection mostly met or even exceeded our expectations.

We remain optimistic about the long-term growth prospects of the US and the world economy. 2020-2022 markets reminded us how challenging and unpredictable the markets could be. They convinced us further that patience and caution are the best way forward.

Happy Investing! |  Bogumil Baranowski | Published: 3/16/2022

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.

Beware of Economic Forecasts in Investing

www.sicartassociates.com/always-the-wrong-question

As a group, economists (or practitioners of what is often called “the dismal science”) have failed to anticipate some of the most severe recessions and best economic recoveries of the last century. Even as a professed contrarian, however, I cannot defend their forecasting record. I would also take with a grain of salt the advice of investment strategists who base their recommendations on what economists expect the economy to do. Paraphrasing Goethe, “when ideas fail, [big] words come in very handy.”

The Economy and the Stock Market Are Two Different Animals

Crestmont Research (www.crestmontresearch.com) produces a wealth of stock market and economic data primarily focused on medium and long-term cycles, which I have often used in these letters. Their latest update contains a table that shows the lack of correlation between America’s GDP (Gross Domestic Product) and its stock market over the years: the stock market appears to move independently from the growth of the economy as measured by the Gross Domestic Product (GDP).

 Stock Market P/E Ratios and Interest Rates Tend to Move in Opposite Directions

Another document, from BigTrends.com, illustrates how bond interest rates tend to have an inverse relationship with the Price/Earnings ratio of the stock market, which is the main determinant of short- and medium-term moves in stock prices. Both are generally influenced by the rate of inflation, as the returns on both the stock and bond markets must rise when higher prices erode the purchasing power of money.

This is particularly relevant to today’s environment: on many days, we have seen the stock market rise because some strong economic statistics were released. But, as we write, interest rates still stand near historic lows. It appears that the investment crowd has been ignoring the fact that a faster-growing economy might strengthen the resolve of the Federal Reserve to let interest rates rise to more natural (less manipulated) levels and that higher rates tend to depress stock prices through a downward adjustment in the Price/Earnings ratios of shares. If the economy further strengthens, and unless corporate profits actually go through the roof, a stronger economy might not actually be good news for the stock market. So, we have to ask ourselves: “Could corporate profits go through the roof?”

Profit Margins Are Already at a Record

The chart below, from another source of very valuable statistics – Yardeni Research, Inc. — clearly shows that, after moving in a fairly stable range until the early 2000s, corporate profit margins have shot up in the last several years.

Several factors seem to have contributed to this increase in reported profitability.

First, the composition of the American GDP has changed, with lighter industries growing faster and making up a larger share of the pie. Because they use less materials and sometimes direct labor, they tend to have higher gross margins and more relatively-fixed overhead. This gives them greater operating leverage –  profits tend to grow faster than revenues when sales increase.

Second, during the uncertain times that we have confronted in the last several years, corporations have naturally tended to underinvest, especially in projects with long-term horizons. This reduces depreciation, which comes as an annual charge against reported income, thus boosting reported profitability.

Additionally, while the purchases do not necessarily show up in aggregate, economy-wide sums like the GDP, corporations have been buying back large numbers of their shares in the open market.

“All told, buybacks may exceed $870 billion for 2021, according to Silverblatt’s data. That would eclipse the record of $806 billion from three years earlier when companies used repatriated funds from the federal tax overhaul.” (Bloomberg)

Buybacks reduce a corporation’s number of outstanding shares and, as a result, increase its reported earnings per share. This will be reflected directly in the performance of capitalization-weighted indexes such as the S&P 500, especially since some of the largest-capitalization companies, which have not reinvested all their cash flows in their businesses, have been the most active in buying back their shares. The buybacks create a disproportionate effect on the behavior of major indices, prompting the stock market to perform better than the GDP in recent quarters.

Finally, even the real economy has benefitted from the pandemic in a somewhat perverse way. Liquidity injections from the Federal Reserve have enriched the wealthier, stock-owning segment of the population, while income-supporting budgetary assistance has helped poorer households and small businesses. Since opportunities to spend that extra money were limited by the pandemic, overall savings have built up, which are being released into the purchase of goods and services now that these restrictions are being loosened.

 

The Paradox of Inflation

William E. Simon, Secretary of the Treasury during the Nixon administration, once remarked that the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it. We have enjoyed what causes inflation (more liquidity, government spending, and an ebullient stock market) for the last several years and must now face the consequences of the phenomenon itself. If history is any guide, those results will come in the form of diminished spending power and higher interest rates that will depress stock market and real estate valuations.

 

A De-globalizing World

No one knows how the Russia-Ukraine situation will evolve, but its sequels will most probably affect the global economy for an extended period of time. We believe that supply chains will be disrupted for longer, and some may be permanently shut off; financial flows will be redirected and become less fluid and more expensive; several commodities, including agricultural ones, will remain more expensive.

Geopolitically, one of the main goals of Russia’s original saber-rattling and natural gas blackmail to Europe was to disrupt NATO’s unity, which is why I had assumed that an all-out invasion might be unnecessary.

For the moment, the way things have been going, Mr. Putin’s war seems to have actually reinforced NATO’s solidarity. But when the immediate fears abate, I suspect that the internal tensions of many global organizations – including NATO, the United Nations, and the European Union — will resurface. In sum, the globalization of the world economy, which was one of the motors of post-WWII economic prosperity, may recede or need to be re-invented.

 

* * *

 

I have often referred in these pages to Hyman P. Minsky, a professor of economics at Washington University in St. Louis and a distinguished scholar at the Levy Economics Institute of Bard College, who introduced The Financial Instability Hypothesis in 1992.

This hypothesis essentially posits that stability is destabilizing. If the economy or financial markets remain stable (for example, within a well-established uptrend) for an extended period of time, the attitudes of economic and financial participants change as they become more willing to accept risk (debt) and speculation.

To me, the most important implication of the hypothesis is that economic recessions or financial crises do not need an immediate trigger to happen: they are due to the very nature of free markets and crowd psychology. What has been labeled a Minsky Moment refers to the onset of a market collapse brought on by the reckless speculative activity that defines an unsustainable bullish period. It cannot be precisely predicted, but one can prepare for it.

Today, as inflationary pressures linger, especially on the cost side, recessionary forces may also become more prominent. As usual, good investors should remain alert and prepare for both.

Good luck and clear minds…

 

François Sicart – March 7th, 2022

 

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.

Can We All Be Contrarians?

The major US indexes sold off in the last few weeks. This inspired a whole range of reactions. Many panicked, some froze, and others quickly acted and bought selected stocks. The last group is usually smaller and follows Warren Buffett’s famous wise words: “be fearful when others are greedy and be greedy when others are fearful.” If we define a contrarian as someone who tends to go against the crowd, I start to wonder if we all can be contrarians at the same time? Can we?

When I was growing up in the 1990s Poland, you had to save to buy anything from a TV to a car. Friends and family could help, but consumer credit wasn’t readily available. I recall that interest rates were high, inflation was roaring, and uncertainty abounded. Interestingly enough, that is a set of circumstances that most US investors, especially those my age, have never experienced personally. However, they might be getting a very subtle taste of it these days.

Years have passed, today’s Poland and even more so the US have definitely different shopping habits than those I grew accustomed to. The motto is: buy now and pay later. More and more goods from small items to cars are available through monthly payments. Cars are available through various financing methods; many don’t even give you the actual ownership of the vehicle. What’s more, it seems it would take an excellent knack for numbers and a robust financial calculator to figure out the actual total cost to enjoy that car over the next few years.

My cautious view on consumer credit shared by the majority when I was a kid has become a contrarian view in today’s world. Was everyone a contrarian then, and a few are today?

Maybe what we do as money managers, investment advisors, investors is less about being contrarian and wisely and selectively opposing the views of the majority, but rather about keeping our principles permanent no matter how much the world around us gets lured by greed and tormented by fear.

A calm, collected, disciplined approach of evaluating businesses based on their fundamentals and buying based on value can be applied in the midst of a market euphoria as it is in the darkest moments of a market crash.

The same investment principles might have led us to buy an underappreciated railroad stock some 150 years ago, a promising retailer 50 years ago, and an asset-light cloud-based high, margin technology-driven company today. The principles remain the same.

What we do is as important and as simple as what  Morgan Housel (a prolific financial writer and author of The Psychology of Money) described recently as “Outperforming by merely ‘doing the average thing when everyone else around you is losing their mind.’”

I recently took a closer look at a company that we have known for years. It’s a stable, high free cash flow business that got caught in the pandemic rollercoaster ride of rising demand, input cost inflation, and supply chain headaches. What intrigued me the most were the clear and wise principles that frame and shape the management’s decisions. All I need is a few years’ worth of annual reports and financials, and an evening or two later, I can tell you the vivid story of the business and present it as a clear series of choices the leadership made.

Over the last decade or two, many companies like this one have taken advantage of low-interest rates and credit availability. They decided to borrow to pay excessive dividends and conduct share buybacks at very high prices. It’s all usually done in the name of a quick rise in per-share profits and the stock price. Short-term stockholders applaud and get a quick boost, while the company is left with debt and very few options to maneuver in times of distress.

This company continued to follow the same principles that many others followed not long ago. Because it remained set on its course, it suddenly found itself as a contrarian. Again, it’s not that it choose an opposing view to others, but rather the others made choices that are at odds with the ones of this particular company.

When the US stock indexes came under pressure in January 2022, we watched how our holdings performed. We realized again, what we often shared before – sometimes what we don’t own matters as much or more as what we do own. Our portfolios of 30-60 stocks aspire to weather the market storms better than the broad market indexes. Is it always the case? No, but it often makes enough of a difference and allows us to sleep better.

With prices of many stocks falling, we immediately started searching for buying opportunities. We looked at the fundamentals, the actual earning power of a business, and the newly discounted prices that we would need to pay. The indexes were down 10-15% or so. The true treasures appeared among stocks down 40%-60%, not just in the previous four weeks but also in the last few months.

Many of them were down for likely the right reasons, but we believe some look disproportionately punished by the negative investor sentiment that started to prevail. As many of our clients rightly assumed, we went shopping. We gradually and cautiously acted on the new opportunities that appeared right in front of us.

Does a 10-15% sell-off mean there won’t be another one sometime soon? – No, but the panicked sellers left enough buying opportunities behind that we couldn’t ignore them. Will the prices get even more attractive in the future? – Maybe, but that’s why we buy some and leave room to add earlier. It’s been our practice for years.

Were we contrarians buying in the sell-off? Judging by the majority view that led to the sell-off, we held an opposing view, maybe even a minority view. Among the like-minded investors, we were all contrarians, though. After a number of phones calls and emails with friends and colleagues who share the same investment principles, we discovered that others were looking and shopping, too. We hold the same timeless principles in that particular group of disciplined investors (no matter how small it’s become), and we are definitely all contrarians!

 

Happy Investing!

Bogumil Baranowski

Published: 2/3/2022

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.

Always the Wrong Question

One of these days, after a spectacular decade of progress, the stock market will encounter a serious air pocket. The investing crowd will then ask the perennial question: “What caused the market collapse yesterday?” But, as usual, this will be the wrong question. The intelligent inquiry would really be: “Why did the market rise so much before yesterday’s crash?”

The Minsky Hypothesis

Over the years, I have become increasingly attracted by what is called the “Hyman Minsky hypothesis” and have referred to it in several papers. Hyman Minsky was a professor of economics at Washington University and a distinguished scholar at the Levy Economics Institute of Bard College. His theory was that economic “stability breeds instability:” as people feel good about current economic prospects, they tend to consume more, take on more debt, and, increasingly, speculate.

The idea that stable economies sow the seeds of their own destruction — and that this is just the nature of free markets — sounded a bit too Marxist for the western economic establishment, and Minsky was not particularly popular until the financial crisis, and Great Recession of 2007-2009 seemed to vindicate his views.

What intrigues me most about the hypothesis is that it implies that financial crises and economic recessions need not be prompted by a specific, immediate trigger. Rather, instability builds slowly but steadily as economic actors and investors are lured by apparent stability or momentum into undertaking more financial leverage (debt) and accepting (or ignoring) more risk. In doing so, they are often abetted by so-called “experts” who are best at rationalizing what people want to hear.

The Case of the 1970s’ Inflation

The mid-1970s are remembered as a period of double-digit price inflation, followed by the first severe recession of the postwar era. The recent uptick in prices and interest rates has revived curiosity about that period, which was followed by a stock market decline of over 45% (as measured by the Dow Jones Industrial Average between January 1973 and December 1974).

Experts of the day were prepared to find multiple causes for the accelerating inflation that continued into the next decade (after a recession-induced pause in the early 1970s). One was the collapse of the Bretton Woods system and Nixon’s shock devaluation of the dollar under the Smithsonian Agreement; another was the 1971 abandonment of the gold standard followed by the quantum increase in the price of oil after OPEC’s oil embargo (1973).

However, the following chart illustrates that inflation had clearly begun to accelerate years earlier, in the mid-to-late 1960s. In fact, it could be argued that the later developments were perhaps the result of rising inflation and its corollary – the depreciating purchasing power of the US dollar.

A Wall Street Flashback to the 1960s

If inflation actually appeared before these supposed “trigger” events, some explanation can probably be found in instability that had slowly built up in prior years, as Minsky had foreseen. And the 1960s, which are now often referred to as the “Go-Go Years,” were indeed rife with ample liquidity, mounting financial leverage, and speculation. According to the SEC, assets of stock mutual funds doubled in the five years from 1960 to 1965 and doubled again from 1965 to 1970, peaking at $56 billion in 1972. (ICI Securities Law Procedures Conference, Washington, D.C. – 1997)

John Brooks’ The Go-Go Years (Wiley Investment Classics, 1999) tells “the story of the growth stocks of the 1960s and how their meteoric rise caused a multitude of small investors to thrive until the market crashed devastatingly in the 1970s. It was a time when greed drove the market, and fast money was being made and lost as the ‘go-go’ stocks surged and plunged.” (From the book’s flap copy)

One example gives a feeling for the atmosphere of the 1960s. Investors Overseas Services, Ltd. (IOS) was founded in 1955 by financier Bernard Cornfeld. By the 1960s, it employed 25,000 people who sold 18 different mutual funds door-to-door all over Europe. In the following decade, the company raised $2.5 billion, due in part to its “Fund of Funds,” which invested in shares of other IOS offerings. Though popular, the Fund of Funds eventually turned into a Ponzi-type operation, paying investors promised dividends from newly-raised capital. After efforts at refinancing and a bailout from another troubled financier, Robert Vesco (who utilized IOS money to bail out his own ventures), IOS went out of business. Cornfeld was tried and acquitted, and Vesco fled to Havana.

To put into perspective the size of these ancient events, $1 billion in 1960 would have been the equivalent of $9.4 billion in today’s dollars. When I joined Wall Street in 1969, the New York Stock Exchange traded about 12 million shares on a good day. Even this kind of volume was overwhelming for the existing infrastructure and forced the NYSE to restrict trading to four days a week. (In comparison, today’s technology and logistics allow for a daily trading volume that approaches and often exceeds one billion shares.)

To understand how the apparent stability of the 1960s fed the instability of the 1970s, it should also be remembered that, except for cyclical slowdowns and minor or short-lived recessions, the post-war economy had experienced a long period of growth and stability. The economic establishment became complacent as a result, with several popular economists actually claiming that we had conquered the economic cycle. One of the few contrarians was Paul Volcker, who was then President of the New York Federal Reserve before becoming Chairman of the whole Federal Reserve System. Volcker had become concerned very early with the inflationary trends inflamed by the “guns and butter” economic policies of President Lyndon Johnson and his successors throughout the Vietnam war years.

Experts Always Rationalize the Recent Past and Project it Into the Indefinite Future

Amidst this complacency, a recession hit the United States in 1970. The stock market, as measured by the S&P 500 index, fell 35%.  However, the overall economic recession was relatively modest and, importantly, was mostly domestic in nature. Experts, in particular from the largest wealth management banks, were prompt to concoct a new investment theme. Noticing that a number of companies had survived the recession and the stock market declined relatively well, they started promoting investment in the so-called “Nifty Fifty,” arguing that these recession-resistant stocks could be bought and held forever, regardless of the price. (Source: USA Today, 4/1/2014)

Post Mortem: In the 694 days between January 11, January 11, 1973, and December, December 6 1974, the Dow Jones Industrial Average benchmark lost over 45% of its value, but the Nifty Fifty stocks fell even further. The market, as measured by the Dow Jones Average, did not recapture its 1973 high until the early 1980s. Many of the Nifty Fifty took much longer to recover, while some never did.

Fast Forward to 2022

The fundamental question facing investors today is whether the current acceleration of inflation will be “transitory,” as the Fed seemed to believe until recently, or more sustained, as skeptical economists have argued. Personally, I tend to see inflation as a trend that is not easily halted or reversed. But, in periods like the current one, I tend to revert toward the Minsky view of the world.

Greed, risk-taking, and speculation are not easy to measure. Equally, the level at which exuberance becomes intolerably irrational is subtle. These attitudes usually announce themselves by a series of anecdotes rather than by concrete data. Still, the anecdotes are now accumulating – slowly but increasingly difficult to ignore. As usual, they seem to be rationalized by self-anointed “experts.”

Consistent with their past record, growing numbers of strategists, asset-allocators and wealth managers have joined the FOMO crowd, feeding their clients’ “Fear Of Missing Out.”

For a while, with interest rates close to zero, the philosophy became TINA – “There Is No Alternative” (to equities, i.e., the stock market). Then, as the US stock market was irrepressibly carried higher by a handful of very successful, though very expensive companies, the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) came to the fore. They could be considered the modern-day version of the 1970s Nifty Fifty.

More recently, investment experts have steered their clients to more exotic “alternative” investments: private equity, private credit, etc. One of the main attractions here is that, contrary to the structure of the stock market, precise valuations are unavailable or hard to fathom in the near term. This situation promotes the promise of better eventual returns as a trade-off for the lack of liquidity in the near term – a splendid way to tie up investing clients’ funds.

Money has been diverted to assets such as real estate, art, wine, etc., increasingly fusing investment greed and lifestyle aspirations. But then, the internet took over from the experts. Now, websites and chatrooms promote products such as cryptocurrencies, NFTs (Non-Fungible Tokens, or digital pictures of an original product), memes of fashionable stock tips, etc. Most of these new products attract millions of small, inexperienced investors, but, occasionally, they are also endorsed by investing stars, who know how to capitalize on a new trend when they see one.

If you still doubt that there is too much money sloshing around and getting “invested” mindlessly, just read this recent headline:

January 8, 2022

A reality star who says she made $200K from selling her farts in Mason jars is pivoting to selling them as NFTs

On pornographic grounds, one might understand the idea of paying real money for the packaged farts of a sexy influencer. But pictures of the jars???

The Rewards of Being an Early Skeptic

Bernard Baruch (1870-1965), the famed speculator whom historian Thomas A. Krueger described as one of the country’s richest and most powerful men for half a century, famously said:

“I made my money by selling too soon.”

Times like now seem like good ones to emulate his investing style…

François Sicart – January 12, 2022

 

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.

New Year’s Resolutions

As 2021 is coming to an end, and a brand new 2022 is right around the corner, many of us start to think about New Year’s Resolutions. What do we want to accomplish next year and beyond? Traditionally many look for ambitious goals: make that many dollars, lose that many pounds, read the many books by year-end, and more. In life and investing, success often comes not from a lofty goal with a fixed deadline but rather the process built on helpful habits that lead to favorable outcomes. Let me explain.

The three most popular New Year’s Resolutions cover healthier eating, more exercise, and saving money. Right after better food and more physical activity, our attention falls on money.

In my book, Outsmarting the Crowd, I write about the mantra – earn, save, invest. I explain how the money will grow over time if you underspend your income and invest what’s left. The opposite is true as well; if you outspend your income over a lifetime, there is only excess debt and financial stress waiting for you on your journey.

This is a well-known truth, the same as the need for a better diet and more exercise. Those truths can be seen as almost trivial. It doesn’t make following them any easier, though. The challenge lies in creating little repeatable habits that build the right process.

This year, I enjoyed reading three great books on habits: The Power of Habit by Charles Duhigg, Atomic Habits by James Clear, and Tiny Habits by BJ Fogg. Maybe I was thinking ahead of my New Year’s Resolutions; perhaps I noticed how my daily habits, routines changed since the pandemic sent many of us home last year. Whatever the reason, each taught me something new about the habits in our lives.

If there is one important lesson that they all have in common is to make the desired habit as easy and as repeatable as possible. If it’s an exercise routine, let’s make our journey from bed to the walking, running, or hiking trail as simple as possible. If it’s saving money, let’s automate it and forget it. Taking the pain points out of the process was the biggest revelation. Somehow, I thought that the more ambitious, the harder the habit, the better, but that’s not a good place to start. There will be days and months when we just don’t feel like doing whatever we intended to do; making the hurdle as low as possible is key.

It reminds me of companies that never want to break their dividend-paying record, and in leaner years, they cut the dividend to a single cent. It may be nothing, but it allows them to keep the habit. When the profits recover, there is no question whether they should resume the dividend or not, the dividend policy is in place, and now it’s all about raising it from that single cent. That’s how we can think of earning, saving, and investing. As long a cent trickles in, the habit is alive.

There might be days when no stock looks appealing and worth buying, yet, we still show up, read, research, cultivate the habit, keep the process going because the best opportunity might be right around the corner. If we are not looking, we won’t find it.

As tempting as it may seem to find ambitious goalposts and fix them at a particular point in time, it may not serve us well either in investing or in life.

When I think of my New Year’s Resolutions, I focus on habits that build the process that can lead to favorable outcomes: healthier, happier, more prosperous life. Most of all, I wonder how we can make them as easy as a single-cent dividend –a small deposit into the bank of wellness, well-being and wealth.

It keeps the good habits alive and compounding!

Happy Holidays! Happy Investing!

Bogumil Baranowski

Published: 12/23/2021

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.

Immune to Ridicule

In the early years of my investing career, one particular stock attracted the most ridicule. I remember how various junior analysts would mention it to the more senior analysts and portfolio managers. It was the epitome of a bad idea, a fad, a laughing stock even. My contrarian bone must have been already developing at the time. Somewhere in the back of my mind, I thought, what if they are wrong?

From a near bankruptcy over a decade ago, the business persevered. The stock rose from $8 in March 2020 to $170 today and reached a $10 billion valuation (Source: Bloomberg). It’s not a tech company; it didn’t give us a self-driving car, a miracle drug, or a comfortable ride to Mars. It sells the same product it started with 20 years ago. The business not only made a comeback but grew and turned a nice profit, too. Some even believe that a former alleged fad gained a cult following of sorts, and if that wasn’t enough, the brand became a premium brand.

What’s amusing about investing is that you rarely know when the story is really over, and the least likely heroes offer the biggest payoffs.

What happened? The big operational changes from three years ago paid off and helped them navigate through a tumultuous pandemic reality. What’s more, that very pandemic lifestyle shift brought more people to the brand and the product. Comfortable ugly shoes were apparently precisely what we needed the last two years! Who would have thought?

What stock is it? Crocs! – a company famous for its bright-colored rubber clogs. I have never owned a pair, but I owned and recommended other shoe brand stocks in the past. Some have done well, some struggled. I’ve always had an affinity for consumer products and services, and I knew that finding a genuinely lasting niche in that space was quite a feat for any company that tried.

Crocs became a definition of a fad in the eyes of many investors. The company experienced quick success, a hot IPO with a fast-rising stock, not unlike many other recent hot IPOs. They couldn’t keep up with the demand and expanded aggressively. The 2008/2009 recession brought an end to it. In the first years on the stock exchange, its price rose five times; it lost almost 99% in the following two. It was a $1+ stock flirting with bankruptcy.

I remember walking past their Manhattan store, wondering how much longer they would be around. Customers seemed to have fallen out of love with their products as quickly as they initially embraced them. This is nothing unheard of, especially in shoes, apparel, or any other consumer product categories.

That’s what we call a fad. Fads come and go. Some companies can be too quickly dismissed as fads, while others can be mistakenly taken for having a cult following, while they turn out to be short-lived fads.

From an investment perspective, it’s a dangerous territory that could also be full of great potential and opportunities. Any analyst trying to recommend Crocs when it was a $1 stock would have been ridiculed. The company wasn’t out of the woods five or even ten years after the 2008/2009 recession, and it only closed its manufacturing and rethought its retail footprint in 2018. It was a treacherous path of many attempted revivals.

When March 2020 came with the abrupt market sell-off, Crocs’ stock price dropped below $10, still 1/6th of the 2007 record high price (Source: Bloomberg). The brand and the company weren’t on my radar, and I still remembered it as one of the most ridiculed stocks ideas I have ever heard of.

Many years have passed, I almost forgot about it. Only recently, I came across it on three different occasions. First, I saw a few people wear their shoes, and then someone mentioned it in a newsletter as an unlikely turnaround story. Finally, I read a headline about this unexpected pandemic winner. I took a fresh look, and I was intrigued by it, but more as an investment case study that could offer some great lessons rather than an actionable stock pick.

I have never owned Crocs, and as a firm, we never invested in it either; we have no immediate intention to invest in it now either. There is nothing contrarian about it anymore, but it didn’t stop us from learning something from this experience.

Reading up on Crocs and its remarkable, even unbelievable journey, I thought of those days over a decade ago when seasoned investors ridiculed the stock and fashion aficionados ridiculed the shoes. I’ll think twice next time I hear someone laugh at an investment idea or product.

There might be some surprising winners where few dare or care to look for the simple reason of being ridiculed for it! Being more immune to ridicule is an excellent lesson for any stock picker young, and seasoned. Over the years, we owned many stocks that at times earned us some smiles. We trusted our judgment, though, and pursued some unlikely stock picks. Next time you see a stock in your portfolio that makes you smile or even laugh think of Crocs – we might just be on to something.

Happy Investing!

Bogumil Baranowski

Published: 12/9/2021

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.

PSYCHOLOGY, VALUE AND THE NEED FOR PATIENCE

 

During the pandemic, I have been using my forced time out of the office to review in detail my investing experience of the past fifty years – hoping to gain some enlightenment from this broad view.

My first observation is that, contrary to public complacency induced by twelve years of the current bull market, there have been some serious breaks in the progression of the major indices over this time span.  I experienced these firsthand, and a partial review is very enlightening.

The Pain and Opportunity in Bear Markets

For one thing, I remember well some of the S&P 500 losses that are easily ignored by newcomers to investment as well as by veteran investors. Among those, four stand out:

    Start and End Date        % Price Decline                     Length in days

11/29/1968 – 5/26/1970                   36%                                         543

1/11/1973 – 10/3/1974                     48%                                          630

3/24/2000 – 9/21/2001                      37%                                         546

10/9/2007 – 11/20/2008                    52%                                         408

(Source: Crestmont Research)

This is a small sample to remind the reader that while market declines averaging 43% and lasting longer than a year are somewhat rare, they cannot be viewed as “black swan” events.

Moreover, losses of that magnitude are not recouped rapidly. For example, it took 1.7 years to recover the market peak of 1968, while the Nifty Fifty loss of 1973-1974 took 3.8 years. And after the bursting of the 2000-2002 dot.com bubble, the market did not break even until 4 years had passed. More recently, the losses of the Sub-Prime crisis were only erased after 3.1 years. (Source: www.awealthofcommonsense.com) I should add that declines in some sexier indexes have often been more severe, such as the 77% loss in the tech-heavy NASDAQ Composite Index after the dot.com bubble burst. It took almost 15 years (!) to be recouped.

Obviously, there have been many “corrections” of up to 20% or more over the years. But despite the often-dramatic media headlines and sensational TV “breaking news” that they prompted, I attribute those to the normal volatility of investment markets, and to the investing crowd’s bipolar nature. I generally treat these milder episodes as opportunities to fine-tune our portfolios rather than as reasons for panicky overhauls.

Another observation from this retrospective exercise is that we all tend to measure market fluctuations from bottom to top and from peak to trough.  But to get a rational appraisal of the investment performance over a full cycle, we should measure the market progress from peak to peak.

Still another remark is that cash reserves in portfolios provide only a partial safeguard in declining markets. If your stock selections have been strategic, you may do a bit better than the majority of investors, but when the broad market goes down, all portfolios are nevertheless likely to suffer.

Cash should not be viewed as a sanctuary, but becomes very important when the market has already declined and buying opportunities abound. This may seem like an obvious point — but it is only if you have ready cash that you can seize these opportunities. At such times, those who are fully invested have to sell (probably devalued) holdings from their portfolios in order to to purchase attractive stocks that have become irresistibly cheap.

From Value-Contrarian to Contrarian-Value Investing

I sometimes mention that over the years, I have evolved from a value-contrarian investor to a contrarian-value one. This is a nuance, but a significant one. Historically, “value investing” has been nearly synonymous with “contrarian investing.” This made sense, because the stock market is effectively an auction market. If buyers become less aggressive and sellers become more so, the result should be lower prices (hence better value) for the commodity being auctioned.

In more recent years, however, the notion of “value” has become more diffuse. When Benjamin Graham articulated his value-investing philosophy, it was essentially a balance-sheet notion: a company’s readily saleable (current) assets minus total liabilities represented the minimum value of the business in a possible liquidation. If you could buy the company’s shares in the stock market for less than that amount, you made a great purchase.

Since then, powerful inexpensive computers and readily-available databases of corporate financial statements have rendered these value calculations easier and faster to make. The advantage of original value investors has diminished as a result. In addition, the make-up of corporations has evolved from traditional physical product-related activities to lighter, more service-oriented ones, including more immaterial assets such as goodwill, research, or patents, which are harder to evaluate in current dollars and cents. As a result, the focus of valuation has evolved from assets to earnings and, more recently, to estimates of future earnings and growth rates.

Fortunately, technology and the global environment in which businesses operate may have changed, but human nature has not. Hence my own increased emphasis on contrarian investing, which brings me to the meaning of the P/E, or Price-to-Earnings, ratio.

The P/E Ratio: Where Psychology and Value Meet

The P/E is simply the ratio of a stock’s Price over its company’s Earnings per share. Since the dollar price of a stock in the market really tells you nothing about what you are buying, the cost of a share is often expressed, for comparisons, by its P/E ratio, which shows how much you are paying for one dollar of a company’s profits.

Ed Easterling, author of Unexpected Returns: Understanding Stock Market Cycles and President of Crestmont Research, writes “History shows that the change in the market P/E ratio over decade-long periods often doubles or halves investor returns in the stock market.” And, truly, whereas corporate earnings for the whole stock market tend to move up cyclically but in a relatively moderate trend, it is the ups and downs of P/E ratios that command the preponderance of stock market movements. Crestmont Research has on its website a graph that illustrates quite clearly that this volatility reflects the rising optimism or pessimism of the investing crowd – as illustrated by the ups and downs of the market P/E. The site has a wealth of (free) educative statistics and I encourage the reader to visit it: www.crestmontresearch.com.

P/E Ratios Say Something About Subsequent Returns

I should point out that the above remarks apply to the market as a whole. It is possible for stock pickers to uncover stocks of individual companies whose earnings progress will dwarf the negative performance of broad indices. Still, it is an elusive challenge: the chances of identifying enough such pearls to build a properly diversified portfolio are slim. More importantly, it is rare that periods of outsized operational overperformance last forever, and even minor disappointments can be very costly when they occur. Also, when operational success is widely recognized and becomes extrapolated into the future by more investors, these companies’ valuations in the market, i.e. their P/E ratios, reflect higher expectations and become increasingly vulnerable to the slightest shortfall.

It is only prudent to be aware of the broader market environment and also to retain sufficient cash reserves to take advantage of more numerous opportunities when they become available. Such occasions may not be frequent, but in my experience, they provide opportunities to make a difference in long-term patrimony-building.

A few historians and analysts have documented the stock market returns in the 3-to-11 years following various levels of initial P/E ratios. It makes sense that, if you buy an investment whose price already incorporates high expectations, as reflected by the Price/Earnings, your future returns will be reduced accordingly, as the ratio will tend to decline cyclically. Most historical studies vindicate this view. Steve Blumenthal (blumenthal@cmgwealth.com) regularly compiles updates of several such studies. He summarized his September 10 review as follows:

Logic tells us that coming returns will be negative for the S&P 500 Index over the next 11 years.”

I should stress that this prediction does not suggest that the stock market will go down without interruption for 11 years in a row. It merely indicates that, based on historical precedents, the average annual return on the S&P will probably be close to zero over this kind of longer period. Valuation is not a timing instrument, and that average will probably encompass shorter up and down cycles. But acknowledging the possibility or likelihood of intermediate trends should not prompt us to forget the lessons of history and common sense. Don’t succumb to FOMO (Fear Of Missing Out) as stories of instant and easy fortunes multiply! Instead, keep a steady focus on the goal of building your own patrimony over time.

François Sicart, November 11, 2021

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.

Time Traveler’s Portfolio

With almost every other tech billionaire building a space rocket these days, it dawned on me that time travel compared to space travel remains still completely undiscovered. There is no cryptocurrency, SPAC (special purpose acquisition company), VC fund (venture capital), or ETF (exchange-traded fund) that invests in time travel (that I know of). Not yet, at least.

If I were a physicist, I’d be curious what kind of laws of physics we need to bend to make it happen. If I were an engineer, I’d be researching durable and light materials to build a time machine. Since I’m an investor, it should be no surprise that I’d like to know what kind of portfolio I’d take with me on this journey!

Humanity has shared tales of time travel from ancient Hindu, Buddhist or Japanese myths to more recent Washington Iriving’s 1819 Rip Van Winkle or H.G. Wells’ 1895 The Time Machine or the Hollywood’s Back to the Future 1980s Trilogy and more.

It’s already the fall of 2021; we are a few months short of two years with a global pandemic impacting our lives, economies, and investments. With debt ceiling talks, trillion-dollar spending plans, new taxes, inflation, political shifts worldwide, climate change, COVID variants, and more, uncertainty abounds. It might be a good time to zoom away with a time machine, and take a longer-term view forward and back, and see if we can make wiser decisions about what’s right in front of us: today.

Time travel can potentially have both directions. Physicists still seem to be arguing which direction is more likely. To sharpen our investment thinking, in our discussions, we sometimes indulge in mental experiments. We like to take some ideas to their logical limits, which can reveal something new about our approach. Time traveler’s portfolio serves that purpose.

If we were going back to the past, what kind of investments would we take with us? Stocks, gold, cash, real estate, let’s even consider cryptocurrencies for a minute. If we go back a hundred years or more so, five hundred years, whatever skills we acquired in this life might have no value in the past. Even a farmer or a writer trained in today’s technology and language might have difficulty finding gainful employment at our new destination. Bringing a small fortune, a nest egg with us, makes a lot of sense.

We’d be ready to dismiss cryptocurrencies in a heartbeat, they weren’t around yet, and they would be of no value to anyone. Real estate, let’s say we can take a timeless property title with us back; it could potentially work and serve as shelter or source of income. If it’s a high-tech online retailers’ warehouse, though, it would need to be repurposed.

What about cash? If we ignore the fact that future dates are printed on today’s money and choose a currency that’s been around unchanged long enough to matter still, we could be ok or even better off. Today’s dollars are worth a fraction of 1921 dollars. In other words, each dollar today would buy around 15x as much a hundred years ago. If we travel further back, before the current dollar, we might have trouble finding takers for our cash, though.

Stocks are promising but tricky. The successful ones tend to grow in value over time, which means that if we take today’s shares with us back in time, they’d be worth a lot less. Who would want to buy today’s Apple shares and bring them back to the day when Steve Jobs only started his company? We could be creative and take some shares of companies that experienced a past success but faced a slow demise more recently. This way, we’d buy their shares cheaply today and be able to sell them for much more in the past. That’s an arbitrage worth considering. We might have to make a few stops on the way and pick up Kodak or Polaroid on the way. Neither is around anymore, but both experienced their glory at some point.

What about gold? Interestingly enough, we might be able to travel to almost anytime in the past, at least the last few millennia, and do just fine with gold. Whether it’s the Middle Ages, Ancient Greece or Rome or Babylonian or Egyptian times, few would say no to gold, and that’s food for thought.

What about the future? If we were to transport ourselves a hundred years to 2121 or a thousand years to 3021, what portfolio would we’d take with us? When I think of cryptocurrencies, I think about how technology changes quickly. I picture myself with a VHS cassette and a floppy disk in my time machine, neither would be very handy today. Will the same happen to cryptocurrencies? Something new and better will replace them? Or will they be long forgotten as a short-lived phenomenon of the past? I’d think twice about taking this bet.

Real estate is peculiar when it comes to the future. I always thought that if I buy a house, a mall, or a warehouse, I still have one home, one mall, one warehouse after a hundred years. They don’t mushroom over time the way corporate profits can. Hopefully, I kept my purchasing power in the process while paying property taxes and maintaining the asset. With real estate, best case, it’s still around and usable a hundred years later. Having said that, traveling around Europe over the years, and parts of the US, too, I have seen so much formerly valuable, desirable, coveted real estate that’s abandoned, forgotten, and unusable today – ghostly structures of past manufacturing plants or castles among them.

If not crypto, not real estate, what about cash? We know how paper currencies of today are built to lose value over time. Inflation slowly or not so slowly erodes our dollars’ purchasing power, euros, and hundreds of currencies that aren’t with us anymore. We are also running the risk that the currency we take with us will no longer be used once we arrive at our destination. My grandparent’s house had a drawer full of paper money that turned worthless over time. Poland changed currencies many times over. French francs, Italian lira, Spanish peseta aren’t around anymore. Picking the right paper money might be challenging, and hoping it maintains much of its purchasing power over a hundred or a thousand years might be wishful thinking.

What about stocks? No matter how we pay for services or goods, businesses will provide those and charge for them. They may come and go and reinvent themselves in between.

Isn’t it interesting that we can make better assumptions about the future by looking back? There is a mutual fund that bought 30 stocks in 1935 and hasn’t bought anything new since. The businesses they owned, merged, sold, had spin-offs; in other words, they transformed, but the wealth invested in them continued and grew. This fund is a bit of an extreme, and stock investing doesn’t get more passive than that. If we were to travel to the future, it would be great to have someone keep an eye on our holdings, an investment firm that values longevity and continuity over generations. Our fortune, nest egg, would be in good hands, waiting for us at our future destination.

What about gold? It has a millennia-long track record of keeping purchasing power over time; the odds are it will continue in the future. A bar of gold has technologically made no progress in 5,000 years. The edges might be sharper, but a bar of gold is a bar of gold and will be very much the same bar of gold 5,000 years from now.

Lastly, we don’t have to pick one asset to take on our past or future trip. We can have a collection of assets. Going back in time, we might want to bring gold, very selected stocks, and wisely chosen cash. Going forward in time, we’d want stocks, gold, or even better, an investment philosophy perpetuating portfolio over time, and on longer trips into the future, we’d pass on cash and very reluctantly consider real estate.

I know; it’s just a mental experiment. I used to think that interest rates could be only positive; there is no room in economic theory for negative rates. The idea itself undermines the very foundation of money, capitalism, investment. Why would I pay someone to borrow money from me? Yet, that’s exactly what anyone buying negative-yielding bonds today is doing. Our central bankers are defying the laws of economics or common sense, for that matter. Why wouldn’t we one day defy some laws of physics and jet back and forth in time? When the day comes, you’ll know what kind of portfolio you’d want to bring with you. And with this fresh perspective of a time traveler, maybe we can make wiser choices right here, right now – today.

 

Happy Investing!

Bogumil Baranowski

Published: 10/28/2021

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.

THANKS FOR THE MEMORIES!

Famous quotes are difficult to attribute. Mark Twain may never have said that “history does not repeat itself but that it often rhymes.”   Winston Churchill may have been paraphrasing George Santayana when he wrote that “Those that fail to learn from history are doomed to repeat it.” Still, with these maxims in mind, I have tried to recall a few investment episodes from my own experience when I learned something that would help me avoid future mistakes.

Some of these episodes were (or should have been) foreseeable. At the very least, common sense should have told us that trees do not grow to the sky. I would place these events in the Bubbles category. Examples are the “Nifty Fifty” craze of the 1970s in the United States, the outrageous valuations of Japanese equities and real estate during the 1980s, the dotcom folly of the late 1990s the U.S. sub-prime crisis of 2007 along with its aftermath, the Great Recession.

Other episodes have been less predictable, like the 1987 stock market crash in New York: I classify those as Minsky Moments, due more to the bipolar nature of investment markets than to traceable causes or events.

As Robert Armstrong, who writes the Unhedged column for the Financial Times, remarked on September 21, 2007, “In financial markets, prices lead and explanations follow.” Stock market historians and chroniclers often make a distinction between “smart” and “dumb” money, implying that the “smart” money is in the hands of Wall Street professionals while the dumb money belongs to the ignorant private investor crowd. In fact, the striking characteristic of many identifiable bubbles is the role that reputed experts and “professional” investors have played in justifying and bidding up exuberantly overpriced investment concepts.

THE NIFTY FIFTY EPISODE of THE EARLY 1970s

One memory is the role of advisers from leading banks in promoting shares of the early -1970s so-called Nifty Fifty companies as fool-proof investments because they had survived unharmed the relatively mild recession of 1970. Since it is easier to sell something that has already worked well, this feat was paraded by many professional advisers as proof that some companies, because of the resilience of their growth and the strength of their balance sheets, were recession-proof. Consequently, they claimed that these “one-decision” stocks should be purchased at any price and held forever.

No need to remind readers of what followed. Well-known names of then-successful companies with overpriced shares destroyed the dreams of many gullible investors. Xerox, traded for 49 times earnings in late 1972 before falling 71% from its 1972 high to its 1974 low. Avon, which had sold as high as 65 times earnings, fell 86% while Polaroid lost 91% from its high at 91 times earnings to its 1974 low.

Of course, those are among the worst examples of mindless investing in stock market leaders, but most of the Nifty Fifty suffered badly and many never recovered.

THE JAPANESE ASSET BUBBLE of THE 1980s

In the 1980s, Japan was eating America’s economic lunch. Its economy was growing fast, partly as a result of a very expansive monetary policy. Meanwhile a major speculative boom developed in real estate and the stock market on the heels of a highly productive and successful export sector. At the same time, US industrial companies were struggling from stagnating productivity and an overvalued dollar.

Between 1985 and 1991, commercial land prices rose more than 300%, while residential land and industrial land price jumped 180% and 162%, respectively. In 1984, the Nikkei 225 index had largely moved within the 9900–11,600 range. But as land prices in Tokyo began to rise in 1985, the stock market also moved higher. In 1986, the Nikkei 225 gained close to 45% and the trend continued throughout 1987, when it touched as high as 26,000 before being dragged down by New York’s stock market Black Monday. Still, the Nikkei’s strong rally resumed and continued throughout 1988 and 1989, closing near 39,000 at the end of December 1989.

Ben Carlson, now with Ritholtz Wealth Management, states that in the 1980s, share prices increased 3 times faster than corporate profits for Japanese corporations. I think this should serve as a reminder that major market fluctuations generally are more a matter of crowd perceptions than of underlying fundamental values.

Finally, by August 1990, after five monetary tightenings by the Bank of Japan, the Nikkei stock index had plummeted to half its peak. But even though asset prices had already collapsed by early 1992, the economy’s decline continued for more than a decade. This decline resulted in a huge accumulation of non-performing assets loans, causing difficulties for many financial institutions. The bursting of the Japanese asset price bubble contributed to what many call Japan’s Lost Decade.

THE DOT.COM BUBBLE of THE 1990s

This episode is recent enough that many of today’s stock market participants do, or should, remember it.

In the late 1990s, the investing crowd discovered the magical promise of the internet, much as the speculators of yesteryear discovered radio in the 1920s. Just like radio then, the internet was a revolutionary discovery that would change how the world operates. But, just as for radio in the 1920s and beyond, while the innovation was a phenomenal societal and commercial success, only few investors made durable fortunes on it, and those mostly several years later. As far as I can remember, most other sheep-like investing followers lost money on the dot.com bubble when it burst.

In the five years between 1995 and its peak in March 2000, the Nasdaq Composite stock market index rose 400%, only to fall 78% from its peak by October 2002. So, assuming my math is correct, if you timed the bubble perfectly, you earned only 10% in seven years. A majority of investors, however, were drawn in by the allure of the poorly-understood promise of tech and underestimated the challenges of bringing its innovations to commercial success. Naturally, they lost money.

THE SUBPRIME CRISIS AND GREAT RECESSION of 2007-2008

With a little help from Wikipedia, this is a quick summary of what I remember from that episode.

Subprime (lower quality) home mortgage were marketed to  clients with low solvency, and therefore with a higher risk of default, who would not have had access to traditional mortgages. Their interest rate was higher than for personal loans, and bank commissions were more burdensome, which made them more attractive and easier to sell for banks and other financial intermediaries – at least for those with a predilection for quick profits rather than long-term value creation.

In that low-interest-rate environment, everyone wanted to share in the fat margins and large new market being opened by subprime mortgages: many brokers and marketing teams “initiated” new loans on behalf of actual banks without proper due diligence on the solvency of the borrowers.  Indeed, they often actually encouraged those clients to paint a rosy picture of their finances. The loans were then typically resold by banks to other, less-informed institutions.  Eventually, thanks to the creativity of investment bankers and the complacency of rating agencies, mortgages were aggregated in such a way that a package of mortgages with disparate levels of reliability could be sold to the public as an instrument with a superior safety rating. Additionally, In the US, the purchase and sale of housing for speculative “flipping” purposes spread and was accompanied by high leverage, which amplified the ballooning of debt. Often safeguards of prudence and ethics were abandoned.

Eventually, though, the progressive rise in interest rates by the Federal Reserve increased the delinquency rate and the level of foreclosures. From 2004 to 2006 the interest rate went from 1% to 5.25%. The rise in house prices, which had been spectacular between 2001 and 2005, turned into a sustained decline and foreclosures due to the non-payment of debt grew dramatically. Many financial entities experienced liquidity problems and difficulty returning  money to investors or receiving financing from lenders.

The mortgage crisis resulted in numerous financial failures, bank nationalizations, constant interventions by the central banks of major developed economies, deep drops in stock prices and general deterioration in the global economy. The US entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009. Its economy  did not return to the December 2007 pre-crisis peak until May 2014.

THE 1987 “BLACK MONDAY”

I launched the Tocqueville Fund in early 1987. By that time, the S&P 500 index of the US stock market had taken only five years to nearly triple from its 1982 recession low. At 18x, up from 8x at the 1982 bottom, the index’s price-to-earnings ratio had been multiplied by 2.3, and thus had accounted for a major portion of the advance. At 18 times earnings, the index had not yet reached the 33x multiple at the top of the 1999 dot.com bubble or the “new-age” 36x of early 2021, but it was high by historical standards and enough to make me worry about valuation.

As a result, I kept most of the money from the initial subscriptions into the fund in cash and liquidities. Soon, the early shareholders, who were largely colleagues and friends, caught the FOMO (Fear Of Missing Out) bug and started calling me to say that, if they had wanted to own a money-market fund, they would have invested in one.

Listening to the “voice of the people,” I finally invested much of the fund’s assets in selected stocks … shortly before the fateful Black Monday of October 19, 1987. Then, in one day, the Dow Jones Industrials index fell nearly 23%.

On that day, I was in London making a presentation to a group of institutional investors, who surprisingly all showed up in spite of probably having seen on the hotel lobby televisions, as I had, what was happening in New York.

Back in my room, I called my partner Jean-Pierre Conreur in New York to ask him what he was doing in that financial tempest. He answered: “Not very much, because the tape is hours late and we have no idea of where stock prices are. I am just making lists of companies whose shares we might purchase when the markets function again.” For many stocks, we would only know prices days later. The only thing I could do was to call clients to reassure them that we were watching the markets closely and we were in charge, ready to act when things stabilized.

When the one-day crash was absorbed, we reviewed the various accounts under our management and they were down a bit, but much less that the leading indexes. I felt we were geniuses! But I forgot one thing: in a panic and faced with the need to sell in a hurry, investors sell what they can and that is large stocks with presumably liquid markets, even in a downdraft. Our portfolios, importantly, were in smaller, somewhat less-liquid shares and were initially bypassed by those who’d been forced to sell.

However, by the end of the year, only two months later, our portfolios had caught up with the debacle: they were down less than the market, because they held mostly value stocks with strong balance sheets, but still down for the year. We would have done much better with the cash we had held until I succumbed to the pressure of the “crowd.”

The interesting thing is that subsequent studies of the crash could not trace any immediate cause or trigger. Several excesses should have warned investors to be cautious: economic growth had slowed while inflation was rearing its head. After tripling in value In the five years preceding October 1987, stocks were generally overvalued, with the overall market’s price-earnings ratio above 20 and estimates of future earnings trending lower. Debt levels had increased fast with the ebullient stock market (for example, leveraged buyout activity mushroomed from less than $3 billion annually to more than $30 billion in 1987). The dollar had been declining after the Louvre currency accord, and interest rates had been rising.

However, Nobel-prize winning economist Robert J. Shiller surveyed 889 investors immediately after the crash regarding several aspects of their experience at the time. According to Shiller, the most common responses were related to a “gut feeling” of an impending crash, perhaps brought on by “too much indebtedness.”

But most of these opinions were garnered with hindsight. The truth is that investors were aware of the issues facing the stock market but had become complacent, lulled by innovations such as portfolio insurance (using computer programs and derivatives), which gave them a false belief that it would prevent a significant loss of capital if the market were to crash. In other words, everything was set for a “Minsky Moment” (when a long period of economic and financial stability transforms into a sudden bout of instability) but its timing, as always, remained elusive.

LESSONS OF HISTORY

It may be presumptuous to draw definitive conclusions about financial history from the limited sample of my fifty years on Wall Street. But the few financial bubbles that I witnessed were long to inflate and then exacerbated and extended by economic recessions that were either concurrent with or the consequence of these financial excesses and complacency.

In contrast, the 1987 crash was generally unanticipated or, at least, its early warning signals were largely ignored. It was not accompanied by an economic recession and, maybe for that reason, it was exceptionally short – though still quite painful for investors.

The criteria for asset under- and over-valuation change from period to period. But all financial crises are caused by preceding ebullient markets fed by speculation and the crowd’s fear of missing out on widespread gains (or at least increased complacency in the face of “irrational exuberance.”) The timing of the reckoning is elusive, but seems to be unavoidable in time.

This is why, over time, I have evolved from my training as a pure value investor to my current emphasis on contrarian investing. The economic environment and technologies change, but human nature remains fairly constant in its bipolarity.

Today, again, experts are arguing that an overextended bull market fueled by zero or negative interest rates, computerized/algorithmic trading, SPACs, memes, Bitcoin, FANGs, etc. is justifiable regardless of valuations. The names and concepts may have changed, but experience tells me that the human characteristics of the investing crowd have not.  I may not have seen it all, but I have witnessed much of it before and I have survived and reasonably prospered.

François Sicart – October 4, 2021

 

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.

Penny Wise, Pound Foolish

Pennies, cents, pounds, dollars, euros – it’s sometimes curious how we think of money. A while ago, I remember someone sharing with me a tale of old Wall Street. With a lot of self-made fortunes, many investors tended to be penny-wise but at times pound foolish. The smaller amounts were easier to relate to, they felt familiar, and the larger ones were so disproportionately big that the right penny habits didn’t capture them. Doesn’t it happen to us all now and then?

As simple as it may seem, it would be ideal to be wise with both pennies and pounds. Maybe even wiser with pounds than pennies? Who would know it better than the famous billionaire investor who literally turned his childhood newspaper route cents into over a hundred billion dollars in various holdings? I can’t help but think of his story of not selling his Berkshire Hathaway shares back in 1964 because the price was a few pennies short of what he expected.

Berkshire was a terrible business, as Buffett admits in his letter: “Berkshire – Past, Present and Future.” It was meant to be a short-term holding, and only about 7% was owned by Buffett Partnership. Because Berkshire’s CEO purchase offer short-changed Buffett with an eighth of a point, which in old Wall Street speak meant 12.5 cents (at some point, it was the smallest amount a stock could change in price), Buffett ended up buying more of Berkshire. He writes: “I became the dog who caught the car.” Berkshire’s textile business became a very costly distraction for the following 18 years, when the mills were finally closed.

All this trouble for 12.5 cents! Buffett called it a “monumentally stupid decision.” Penny wise, but pound foolish.

I get asked now and then about budgeting and tracking your expenses. I am a big fan. How can we start to be wise with dollars if we haven’t figured out the pennies, I always wonder? That’s the only way to get a grip of your spending, no matter where your monthly budget falls. I credit my grandma for instilling in me the importance of pennies and cents. I can see how they add up and grow. Buffett’s longtime business partner, Charlie Munger, said that the first $100,000 is the difficult part of building wealth. He advised: “I don’t care what you have to do—if it means walking everywhere and not eating anything that wasn’t purchased with a coupon, find a way to get your hands on $100,000.” In the book on Munger “Damn Right”, we read: “Making the first million was the next big hurdle. To do that, a person must consistently underspend his income.”

Before we get to bigger numbers, it seems that a million is what we can all agree on. It’s one with six zeroes. When we leave the cents, the dollars, everything gets a lot more confusing.

What’s a trillion dollars? How many zeroes is that? Apparently, we can’t even agree on that! As defined on the short scale, a trillion is one million million (ten to the twelfth power or one with twelve zeros). That’s what we use both in American and British English. Continental Europe, where I received most of my education, a million million is “only” a billion. I bet that U.S. policymakers would be relieved if they knew that their trillion-dollar spending plans translate as “only” billion-dollar plans in the long scale. Let’s not share it with them. On the other hand, the half a dozen trillion-dollar tech companies that we have in the U.S. today would be rather sad to lose their gilded status and be referred to as “mere” billion-dollar companies (again!). Speaking of billions, some may still remember a failed libel lawsuit filed by a famous billionaire over being called only a millionaire.

I remember watching an interview with a Brazilian billionaire Eike Batista who made a fortune in oil, gas, and mining. He expected to be the richest person in the world in no time. With lots of leverage, gigantic speculative bets, he got as high as the eighth spot on the world’s richest list. A year later (about a decade ago), he was reported to have a negative one billion net worth down from $35 billion. His experience made me realize that there is no amount of money that can’t be lost.

Bill Hwang from Archegos Capital, or as the media described him, “the greatest trader you have never heard of” managed to lose $20 billion in two days only earlier this year. His net worth might have seemed as “liquid as a government stimulus check,” as Bloomberg wrote, but was used to build a $100 billion portfolio with borrowed money. The market turned, and the highly leveraged trade quickly went south.

Both former billionaires openly shared on many occasions how they grew up in modest circumstances—both knew well how to count pennies. Neither of the two investors was in dire need of quick gains anymore, though. Warren Buffett reminds us often that: “It’s insane to risk what you have to get something you don’t need.” We learn from another investor, and author Vitaliy Katsenelson that “You cannot use logic and reason with a person who wants to get rich fast.”

When we make small spending decisions, we seem to be well versed in the amounts we are dealing with. We all saved a few dollars on groceries here and there. We are all probably guilty of driving an extra mile to buy gas 10 cents cheaper. We all might have gotten offended when we saw a cup of coffee priced a few nickels higher than we are used to. It gets a little tricky when the amounts get bigger. We buy cars looking at the monthly payment, or we buy homes looking at the monthly mortgage. We forget to look up and see the full price tag or the million-dollar mortgage behind it – the true cost.

I see how investment decisions can be taken with equally insufficient care. Highly speculative derivatives are bought for cents per contract but amount to million-dollar losses taking away a lifetime of savings. Big, quick, abrupt choices are made with large amounts only because they seem harder to embrace, and the true risk escapes our imagination.

In the last year and a half of market and economic recovery, we have witnessed a more than usual size and frequency of riskier behavior. Hard-earned savings have been spent and invested in less careful ways at times, and if that wasn’t enough, they were supplemented with borrowing.

We all probably have been more than once penny wise and a touch pound foolish at some point, but the same way Buffett looked back and learned from his mistakes, maybe we all can get a bit wiser when our cents turn into dollars. It would be ideal to be wise with both small and large amounts.  Maybe even wiser with the larger ones. If we treat our dollars with the same care and patience that we treat our cents, we’d be better off in the end; at least, that’s what I plan to do!

 

Happy Investing!

Bogumil Baranowski

Published: 9/23/2021

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.

Nostalgia isn’t what it used to be

The title of this paper is stolen from an autobiography by renowned French actress Simone Signoret. It has only marginal relevance to my subject here, but I have long dreamed of using this catchy phrase.

In any case, I was reorganizing my library this week and came across many books that I had not opened in years. Among them was a little booklet published by The Free Press under the aegis of New York University, entitled “The Rediscovery of the Business Cycle.” It was in fact the text of a lecture given by Paul Volcker in 1978, when he was still President of the New York Fed and one year before he became Chairman of the whole U.S. Federal Reserve system.

The lecture is interesting on many fronts.

First, it clearly shows Volcker’s overwhelming concern with inflation, which was raising its menacing head at the time, and which he would courageously vanquish later at the cost of a painful recession (1980-1982). But in addition he describes the complacency of most economists of the period, who essentially thought that postwar economic management and countercyclical policies had definitively conquered the traditional business cycle. Famous last words!

Particularly interesting is the distinction Volcker made between the traditional business cycle of about 3 years, and a longer cycle of maybe 17 years or more that would be hard to measure or anticipate precisely.

The traditional business cycle could be largely traced to the fluctuations of inventories in an economy that was essentially physical (as opposed to today’s increasingly digital one). The longer cycle was more elusive and, without going into the specifics of modern behavioral economics, it was clearly associated in Volcker’s mind with the vagaries of human nature and the psychological biases of the crowd.

In fact, though I am not sure of the chronological relationship between the two, his remarks reminded me very much of Hyman Minsky’s hypothesis, which I have mentioned in previous papers, that long periods of economic and financial stability automatically lead to instability (and crises) by inducing people to assume more risk. Since Minsky saw no need for specific shocks to prompt such crises, they were difficult to anticipate precisely, but you could become aware of their eventual likelihood as excesses built up.

Of course, it also reminded me of the “black swan” analogy enunciated by Nassim Taleb in the book of that title. For Taleb, a “black swan” is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences.

Someone once joked that economists call a black swan any event that they failed to foresee. But it is telling that Taleb’s first book, which introduced the theory, was entitled Fooled by Randomness, implying that the world is full of unpredictable events if you only anticipate what you are familiar with (white swans).

As I was rehashing these thoughts, John Mauldin, of Mauldineconomics.com, re-issued a paper he had authored in 2006 (just before the 2007 financial crisis and the ensuing Great Recession). It is entitled Ubiquity, Complexity and Sandpiles.

One of the interesting examples in this paper is the parallel with a sandpile where one would add sand grains one at a time. Most of the time, nothing would happen (stability) and then, suddenly one grain would cause an avalanche that would partly or entirely destroy the pile.

The timing and the severity of the avalanches are unpredictable. But mathematicians have identified some areas in the sandpile (“fingers of instability”) where a network of vulnerabilities develops and could work in domino effects to cause an avalanche. We, as investors, should be able to discern some vulnerabilities in markets or economies as excesses develop. But we are still far from being able to predict the exact trigger and timing of the next crisis or recession.

All this also reminds me of an acronym that became popular in the 1990s: VUCA (volatility, uncertainty, complexity, ambiguity). The acronym was coined at the United States Army War College to describe the less-predictable world that emerged after the end of the Cold War. Ours is also an era of increasing volatility, uncertainty, complexity and ambiguity. But as French mathematician and philosopher Blaise Pascal said in his Pensées: “It is not certain that everything is uncertain.” One thing I feel pretty certain about, though, is that when we misbehave – either through bad deeds or through laxness – a time comes when we must pay the piper, i.e., accept the consequences of our thoughtless or rash actions.

Over the past decade, in the aftermath of the Great Recession (2007-2009) and particularly during the COVID-19 pandemic, governments have given their populations ample reasons to become complacent, if not irrationally exuberant. In a K-shaped economy, where different sectors recover on sometimes diverging paths, segments of the population have been affected differently.

After a decade of gains, regardless of the many problems facing the world today, the relatively small percentage of the population that owns most of the nation’s savings invested in the stock market is very comfortable, feels entitled to more gains and is willing to accept more risk to achieve them.

In addition, many investors have come to believe that, no matter what happens to the market, the Fed will “have their back”. Many members of this segment of the US population also have access to credit at record-low interest rates to finance housing and other heavy purchases. As a leading stock market strategist said last week, “There are very few bears left”, implying that there is no reason to expect significant corrections as long as there are no sellers.

Much of the rest of the population often owns little in the way of liquid savings and investments and therefore must depend mostly on wages and salaries to sustain its standard of living. But in the last couple of years, this group has received significant support from the government in the form of unemployment assistance and other income-maintenance programs.

For many individuals who had lost jobs, these programs have sustained a minimum level of income. As a result, the United States now seems to experience a worker shortage, even though the economic recovery is not complete, as businesses have difficulty bringing back the workers they furloughed or laid off.

All in all, the COVID episode has capped a decade of irregular recovery with what cynics might call a relatively “comfortable” crisis. But the Federal Reserve’s monetary profligacy and the record size of the government’s fiscal support cannot be sustained indefinitely. When they diminish or reverse, the moment to pay the piper will have arrived.

Many observers have concluded that all these budget deficits, increased debt and money-printing can only lead to higher inflation. Based on decades of history, they also argue that there are only two ways to erase unsustainable government debt: through default or by reducing the value of a country’s currency (and obligations) through inflation. Unlike Volcker’s example in the 1980s, I doubt that many of today’s politicians would have the courage to risk a national default. So, inflation seems a logical outcome of our current conundrum.

On the other hand, my partner Bogumil Baranowski, upon learning the subject of this paper, pointed out that my tentative prediction (inflation) was more in line with the recent consensus than it was contrarian, and he suggested investigating the possibility of an opposite (deflationary) outcome.

Indeed, a minority of economists (such as Dr. Lacy Hunt of Hoisington Management) argues that when you finance a debt-laden economy with more debt, each new layer of additional debt becomes less effective at stimulating demand, until recession and perhaps deflation ensue. The investors who follow these economists’ logic are those buying bonds even at today’s record-low interest rates.

Celebrated Italian theoretical physicist Carlo Rovelli once wrote: “The very foundation of science is to keep the door open to doubt.” (Seven Brief Lessons on Physics, Penguin Books, 2016) This precept is valuable for investors as well. But either way, the complacency and fear of missing out that have driven investors to increasing recklessness in recent years should not remain costless forever.

In the stock market, except for brief interludes, there are only two directions: up or down. Fortunately, even though both scenarios facing us (inflation or deflation) are unlikely to end painlessly, for those who have prepared and possess liquid reserves for the aftermath, outsized buying opportunities should emerge in time — as they have in previous crises.

 

François Sicart – September 1, 2021

 

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.

2021 First Half Review

A Year Like No Other

When we discussed 2020, we emphasized the importance of patience and timing. We started 2020 with a cautious stance. Our patience paid off when in March 2020, we witnessed one of the fastest market corrections on record. We acted quickly and deployed capital buying securities available at multi-year low prices. It was a brief but hugely attractive window of opportunity for disciplined investors. We have been reaping benefits since.

In the last year and a half, the equity markets have recovered, so has the economy. We also have seen signs of inflation. With big vaccination programs in the US, Europe, and increasingly around the world, we saw a wave of more relaxed rules and restrictions, which sped up the business recovery.

This is not the whole story, though. International travel is still subdued, Delta variant fears are still looming, while a large portion of the population remains unvaccinated. At the same time, uncertainty remains elevated, and consumer confidence recovery took a pause.

Although we have seen some unexpected stock market heroes in the last year and a half, it has been one of the most challenging times to navigate. The path forward doesn’t look that obvious either. We are keeping a steady course, and as always, we aspire to be the least wrong. We remain prepared no matter which scenarios play out in the end.

Long-term Goals

Our long-term goal remains the same for all the assets we manage. We intend to both preserve and grow the capital over time. We seek to double our clients’ wealth every 5-15 years, which translates to a 5-15% annual rate of return over the long run, but we would like to accomplish it without exposing the portfolios to the risk of a permanent loss of capital.

Our strategy can be described as a long-term patient contrarian. All securities are selected through an in-house research process. Our investment horizon for each individual holding is usually 3-5 years.

We intend to hold between 30-60 stocks, mostly US equities, but we may invest in foreign securities as well. We don’t use any leverage; we don’t own any derivatives. We may supplement the strategy with exchange-traded funds.

We don’t have a predefined portfolio composition target. We may hold cash at times, but we prefer to own businesses, and when the opportunities abound and prices are right, we will likely be close to fully invested.

The first half of 2021

After a whirlwind of a year, the first half of 2021 could be seen as two distinct quarters. The first quarter or even the first five months showed some hesitation among the high-flying tech stocks, which had a great run in 2020. Their businesses proved to be less exposed to lockdowns than the more traditional economy. The rest of the equities had a chance to catch up, especially smaller companies and those considered value rather than growth. The latter months of the first half of the year gave Nasdaq, the tech index, an opportunity to catch up. The hare became the tortoise only to hop forward again.

As much as it is intriguing to watch the various segments of the market fall behind and play catch up, it’s been much more interesting for us to watch earnings as companies have reported more quarters of improvement and recovery. As investors, we pay attention to the fundamentals while we patiently wait to see the market appreciate promising trends. We believe that it is the fundamentals that matter in the end. On this front, we were happy to see that many of our holdings not only recovered but also exceeded the metrics from before the pandemic.

As much as we pay attention to the overall market trends, we like to look at our performance independently from the benchmark. As long as the businesses we own report improving fundamentals, and the market eventually prices them accordingly, we are happy.

The Fed came to the rescue… and never left!

Discussing 2020, we emphasized the unprecedented rescue that came from the Federal Reserve. The US stock market dropped some 30% in March 2020, which actually matched the lowest read in the economic activity during the pandemic. In other words, the market made a fairly accurate estimate of the impact of COVID lockdowns.

The policymakers didn’t stand still. The Fed added trillions to its balance sheet lowering the cost of borrowing and providing additional liquidity. It led to asset appreciation all around from stocks, real estate to even used cars. The Fed’s generous policy facilitated the numerous multi-trillion government spending plans. The shortage of yield in a near-zero rate environment fired up investors’ appetite for risk. It invited a record stock and debt issuance among US companies. It’s the most unusual phenomenon given that with higher risk, higher uncertainty, one would expect risk aversion, and caution.

As much as the Fed’s intervention in 2020 could be explained by an unprecedented economic debacle, it’s a lot harder to understand why a year and half later, the Fed is still keeping the proverbial pedal to the metal. The monthly asset purchases conducted by the Fed continue. Only now, we are hearing some signs of a possible shift in policy as the market distortions become more blatant and harder to ignore. The red-hot U.S. housing market has been one of the side effects of a low-rate environment.

Fiscal stimulus with trillion-dollar spending plans hasn’t slowed down either. At least for now, both monetary and fiscal policies seem to ignore the economic and market recovery and inflationary pressures.

Supply, demand, inflation

Price stability or low inflation has been a goal of central bankers ever since the hyperinflation era in Europe of the 1920s. Then later the 1970s in the US brought renewed inflation headaches, which brought back monetary discipline. In the last fifty years, though, both in the US, and Western Europe, inflation has become an almost forgotten boogeyman. It was less the case for those who grew up in Eastern Europe or South America and witnessed the havoc wreaked by inflation in their economies, savings, and asset prices.

In the first half of 2021, the US recorded the highest levels of inflation in decades (with a 4.9% read). Prices rose, and in some cases, as in, for example, the used car market, they jumped so high that old cars were selling at the same prices as new cars. It’s impossible to analyze these renewed inflation fears without a context. Economics 101 teaches us about supply and demand and the level of prices. The last year and a half, and possibly more so 2021, have been a time of pandemic-related supply constraints, on one side, and demand propped up by monetary and fiscal policies and boosted by post-pandemic “you only live once” spending habits. With a lot of money chasing fewer goods, it was a matter of time when we saw prices rise.

We find it helpful to distinguish two sources of inflation. The first one might be indeed short-lived, but the bigger inflation tailwind might be here to stay. Once the supply and demand normalize, frenzied used cars and home buying calm down; we’ll see what a sustainable price level could be. The bigger issue is the overhang of the massive multi-trillion dollar spend and print policies of 2020-2021, which builds on earlier crisis responses from over a decade ago. If those never slow down, pause or reverse, there isn’t much that can help us escape inflation in the long run. That is just the nature of any print and spend policies ever tried by humanity since we embraced the concept of money and debt five millennia ago.

If policymakers experience a sudden change of heart, the Fed could slow down asset purchases or even clear its balance sheet, while the Federal government could normalize its spending. If that were to happen, it is not unlikely to even see some deflation.

We try to keep an open mind and remain flexible with our investment choices, watching the outcomes of these gargantuan policy moves.

What’s ahead?

The US economy is still the biggest, healthiest, most diversified in the world. Given its depth, size, and liquidity, the US stock market remains the most appealing home for the most innovative, new companies, even if they originated in Europe, Asia, Africa, Australia, or South America. At the same time, US companies are global and benefit from long-term growth and prosperity around the world. They operate under US laws, follow US disclosure requirements, and promote a shareholder-friendly culture, making them appealing investment choices. We are optimistic about the US, and the US business, while near-term, we remain cautious about the stock market as a whole. We are happy with our stock portfolio of selected, vetted, well-researched businesses.

What do we expect going forward? We build the portfolio for any possible scenario, and our goal always is to be the least wrong with our investment choices. Given the level of uncertainty from inflation, interest rates to new policies coming from the new US administration to ongoing COVID health, and economic risks, we’d be surprised to see no renewed volatility in the markets. We always welcome small and large shake-ups of that nature since they offer compelling buying opportunities.

What could we have done differently?

In a rising market, everyone wants to be fully invested; in a falling market, everyone hopes to be completely out of the market. We acted quickly in March, April 2020; we added a number of holdings since. It’s an impossible task but had we known that the monetary and fiscal response would be so big, and so long-lasting that we would experience the quickest economic and market recovery on record, we would have rather been 100% invested. With worldwide lockdowns, and no vaccine in sight, we operated with the visibility that we had, and it’s unlikely we would have been more aggressive at the time.

We have been happy with all the holdings we bought, and their performance shows that stock selection met or even exceeded our expectations.

We remain optimistic about the long-term growth prospects of the US and the world economy. 2020-2021 markets reminded us how challenging and unpredictable the markets could be. They convinced us further that patience and caution is the best way to forward.

 

Happy Investing!

Bogumil Baranowski

Published: 8/2/2021

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.

Words Do Matter

I remember standing in front of Casino de Monte-Carlo in Monaco when I was a kid. I enjoyed looking at some of the cars parked in front of it. I have visited this sovereign city-state three times since. I like the windy roads, the vistas, the weather. I don’t recall ever being inside a casino in my life, though. I have never gambled in one, but I consider myself a lifelong investor, a stock picker, a business owner. It worries me how much the vocabulary, the words around investing, start to sound like something one would overhear among roulette players or slot machine enthusiasts. I believe that words do matter, and the more investing sounds like gambling, the more unwanted trouble you may get yourself into.

Casino de Monte-Carlo is almost 160 years old. It was opened to help save the ruling family House of Grimaldi from bankruptcy after losing tax revenue from nearby towns. You could say that they made a fairly sure bet since the house always wins. It has, in this case, too. The idea turned out to be a success, and the casino served as the primary source of income for the Grimaldis and the Monaco economy until recently. Its name was even borrowed to label a class of computational algorithms – Monte Carlo methods.

We know well that many patrons of casinos have gone bankrupt looking for quick riches. We even know that there were casinos that have gone bankrupt. It had more to do with poor management combined with economic recessions rather than an unfavorable outcome of any game of chance. The casino is a business, though, and any business can’t be mismanaged and fail.

The stock market, or more precisely a stock exchange, used to be a physical place where buyers and sellers came to exchange ownership of shares of companies. Shares are pieces of businesses, not just tickers with prices. They represent participation in an actual operating company. The company can be offering services or goods to customers.  They do it to earn a profit and enrich their shareholders in the process. Today, we still have buildings that house or housed stock exchanges. The actual trading happens almost anywhere, and it’s virtual. How stocks change hands is really secondary. The nature of the stock exchange might have evolved from physical to virtual, but its role remains the same: a place to buy and sell stocks.

An investor buys shares of companies because they want to become an owner of the businesses that those shares represent. It’s no different than buying 20% of a local restaurant, laundromat, or gas station. Stock ownership allows us to build a collection of businesses. They could be local and operate in the same state or country where we live or be global and have operations worldwide. An investor’s success is correlated with the success of the business. An investor could be seen as a modern-day tycoon, just like Carnegie or Rockefeller. You don’t need billions or trillions to own pieces of great businesses out there; a smaller amount will do.

To me, the best test, whether one is an investor or a gambler, starts and ends with a simple question. Would you be comfortable holding what you own for at least a few years without being able to see a price quote or sell your shares? An investor carefully follows the fundamentals of the business. He or she wants to know if the company delivers profitable growth or is getting closer to that path. This means that each sale of a service or a good comes with a profit. If I own a growing, successful gas station in a promising neighborhood with healthy sustainable traffic, and I have a manager running the operations who finds new creative ways to monetize the location with other services, coffee, food, car wash, etc., I don’t need to know how much I would get for my 20% participation every minute of the day. As long as I know I haven’t overpaid for this business, I remain a happy holder, an investor.

We see our investment capital as money that our clients and we don’t need (at the moment) and money that our client and we can’t afford to lose. That sets a very particular framework for risks we are willing to tolerate and rewards that we choose to accept. Because the capital is not needed to cover any near-term expenses, it can be committed to a longer-term investment. At the same time, the capital may be hard, if not impossible, to replace; thus, we choose to avoid the risk of a permanent loss in any individual investment.

By eliminating large swaths of the stock universe, we lower the odds of coming across real lemons. We don’t buy companies with lots of debt, companies in fast decline, companies with questionable managements, and more. We often mention that what we buy matters as much as what we would never buy.

Some stock gamblers may chase those very lemons with hopes that they will turn less sour in a heartbeat, but they rarely do.

A stock gambler lives and breathes every stock price movement. They believe that the price is everything. It tells them whether they are wrong or right about their bet every minute of the day. This perspective turns the stock market into a casino, a ticker into numbers on a roulette table. With that mindset, it’s almost unnecessary to even know what they represent.

For stock gamblers, the money placed on bets is not only the money they do need but often money they don’t even have. It may feel new, but the phenomenon is as old as the stock market itself. There always those seeking quick riches with borrowed money-making quick bets on coin toss like gambles.   Today, we see a record level of margin debt. That’s borrowed money used to buy stocks. It jumped over 70% year-over-year alone, and it’s approaching a trillion dollars quickly.

Gambling has its appeal to some, and stock market gambling is no different than other gambling. Last year’s study showed that among those who traded for only one day, about 30% made a profit after fees. I imagine that very few leave the casino after a winning streak, and very few end their day trading gambles either. That’s enough success to invite more cohorts of gamblers. The study explained further that for those who traded daily for more than 300 days, 97% lost money.

Some argue that COVID-related restrictions led to a shortage of gambling opportunities and brought gamblers to the stock market. That might be the case. Unfortunately, it’s not just the new breed of stock market enthusiasts that are reshaping the investing vocabulary. I notice how the media is embracing it as well. I recently read how a very reputable, old investment research firm offers help identifying the next best bets on the new undiscovered meme stocks. These are stocks that have experienced an increase in trading not due to the company’s performance but social media hype. That’s a firm that made its name providing detailed business fundamentals for investors for decades now. Few can resist, and the gamble is on.

Investing takes both skills and luck, but with caution, experience, discipline, and patience, and most of all, with a long-term investment horizon, skills start to matter more than luck. I see our good fortune as a bonus rather than the reason for our success. A well-researched, well-chosen, well-bought stock can prove to go up much more than what we expected. We welcome those surprises, but we don’t leave our investment success to chance.

There is a method, there is a process, and the words we choose matter.

 

Happy Investing!

Bogumil Baranowski

Published: 7/1/2021

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.

It’s Always the Right Time

I remember getting introduced to a new client a while back. I was a novice portfolio manager. I was looking forward to our meeting, but I faced a bit of a challenge. I wanted to impress him with some new investment ideas that we could use right away. The stock market was reaching multi-year highs, everything looked pricey, and I had no immediate stocks I wanted to buy. The meeting went very well despite that, a nice lunch followed it, and I learned a lesson that day that I’ll never forget. It’s always the right time to start investing. Let me explain.

Whenever the stock market runs up as it has in the last twelve months, I get asked a similar question. Is this the right time to start investing, or should I wait? This question makes me think of the Chinese proverb: “The best time to plant a tree was 20 years ago. The second-best time is now.” Investing works the same way. We all wish we started a long time ago, but if we haven’t, today is the day!

Now and then, we get introduced by one of our existing clients to potential new clients. We always welcome the opportunity to help. It sometimes happens that they might be joining us when the stock market offers little in terms of immediately buyable new opportunities.

Today, the stock market levels might feel elevated, and the obvious investment opportunities might be scarce. There are always businesses out there that we respect and like, but the prices quoted by the market aren’t always compelling. The risks appear too high and the rewards too slim. In that case, we simply wait.

When I met our new client, I was in the early stages of transitioning from being an analyst to a portfolio manager. This growth path opens a world of opportunities but comes with great responsibility as well. The questions and challenges go far beyond whether this stock is a good buy or not. It encompasses a greater vision for the investment portfolio, its purpose, and how this particular stock can fit in the picture. The goal is to keep and grow wealth over the long run. We might be risk-averse and cautious, but we act quickly when compelling opportunities arise.

This new role of a portfolio manager requires a good amount of empathy and listening. It’s that moment when an investor learns that stock investment doesn’t exist in some financial void. It’s someone’s life savings or inheritance that are put at a calculated risk to harvest the rewards down the road. Since it’s someone’s capital, it’s essential to take into account the client’s preferences, and most of all, the risk tolerance.

I find that part very fulfilling. It closes the loop in my mind between picking an investment and seeing what role it can play in someone’s life, what difference it can make.

The new client that I was introduced to as a novice portfolio manager came with an existing portfolio. He had some legacy stock positions. When we spoke, he took the time to walk me through the history of the portfolio and shared the stories behind all holdings with me. He was willing to sell some of them, others he wanted to keep for the long run.

I remember our first meeting. We talked on the phone a few times, but it was that in-person meeting that I recall vividly. It was a winter day; I arrived early at a restaurant. When he joined me, we exchanged pleasantries and embarked on a long conversation about his career and investment preferences, and I started to see what kind of risk tolerance he had.

There was not a single stock I could say that we had to buy right away at that particular moment. Instead, I shared with him half a dozen companies that I was researching, but I mentioned that none were at the price I’m willing to pay.

I really liked that he respected it and said: “when the time is right, find room in the portfolio and start buying them.”

Over the coming few years, several things happened. We had a chance to get to know each other and share many long phone calls, dinners, and lunches. He allowed me to indulge in my investment curiosity. At times, on top of many more recognizable core positions, we’d buy some well-researched, very promising, but lesser-known stocks. He’d often say: “Tell me more about it; what do they do?”

I was always impressed how he remembered the stories, the businesses, the pivotal moments. I’d even get praise now and then when he’d notice that a particular investment finally got the attention of the general public. He’d reach out right away to tell me: “Look, look, you found it three years ago, and they are writing about it now.” He’d add: “I wasn’t sure about that one, but you were so convincing!”

I remember he called me “deliberate in my actions” more than once. It took me a minute to see that it was a compliment and what he meant by it. Everything I did with the portfolio had a good reason and specific goal. It was always clear to me why a certain stock comes or goes or how big of a position we feel comfortable holding. I think “deliberate” sums it up well.

These days, when the question if it’s the right time to start, comes up, I immediately think of this relationship, this client. When we met for the first time, I had no new ideas for him, the stock market was high, and opportunities were few. We took the time to get know each other, and soon enough, the portfolio filled up with many new ideas.

Similar stories repeated many times over the years, including early 2020 when the market offered limited immediate stock picks, followed by one of the best investment windows in years. We had new clients join us when there was almost nothing new to buy, but in a matter of weeks, we found more ideas than we had seen in years.

My mentor and partner, François Sicart, often reminds me that what we do is much more than investing. Our practice is all about building and nurturing relationships, and it’s always the right time for that!

Happy Investing!

Bogumil Baranowski

Published: 6/10/2021

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.

Long Stories and Three Lessons

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Catching up with friends and family recently, I noticed how there are no short and simple stories that cover the last 15 months. Any small question could be prefaced with “it’s a long story.” Some of us stayed put, some of us relocated. Some continued to travel to work; others turned our homes into offices. We’ve all seen many COVID peaks and a variety of responses to them. Though it’s been a long 15 months, with many long stories, there are at least three lessons that stood out.

The first big lesson — a surprise is just that, a surprise, and even the most informed people with a bird’s eye view of the world can miss it. Even if they see trouble ahead, it might be too difficult to acknowledge it and even more difficult to act on it. Only 2-3 weeks before the first series of lockdowns in the US, I was at a weeklong conference in Florida. I spent entire days with CEOs of the largest global consumer goods companies in the world. I heard no bells go off, no red flags; it was business as usual with an occasional mention of a virus in China.

Interestingly enough, I caught a glimpse of what’s to come after checking in with a few friends in Italy toward the end of my conference. I saw the news about COVID spread in Italy and towns under lockdowns, and I figured it was worth investigating further. Despite what I heard at the conference, I told Megan that maybe this is a bigger deal than what I believed it was. Looking back and appreciating the magnitude of the potential surprise was one of the most eye-opening life and professional experiences for me.

The second lesson, and it’s a lesson that I’ve been learning all my life – never underestimate the power of the government response. Looking at the stock market in March 2020 and watching the 30% or so decline, we knew that it’s not forever. Our team quickly assembled a list of stocks we wanted to buy, and we acted on it. We were getting quality businesses at bargain prices. I must confess this was one of the more exciting moments in my investment career. As I shared with many of you, I felt that the stocks were coming my way, and I didn’t have to chase them anymore.

That recovery could have taken a year or five years or more, but the monetary and fiscal response fired up the stock prices and shot them up 25% (S&P 500) above the pre-pandemic peak. History will judge if it was too much for too long and what the long-term consequences could be. As investors, we do our best to play with the cards we were dealt, and that’s what we have done and intend to do going forward. Nonetheless, it’s interesting to pause and reflect on how we got here.

The third lesson has been around how connected the world has become. Obviously, it started with a virus that’s not visible to the human eye going on a world tour to the most remote places where you’d think no one goes. I remember reading a story of this lone backpacker strolling into some Himalayan village bringing the one and only COVID case with him.

It’s followed by the global supply chain that’s both impressive, also somewhat invisible, but most of all immensely fragile. We have seen overcrowded ports and Suez Canal obstruction this year. I actually stood at the edge of the Canal in my teenage years, and I thought what the whole world thought this March – a global trade ocean route connecting continents couldn’t possibly be this narrow!

Finally, we have seen the incredible reach of the government policies creating waves in the economy, prices, and supply and demand. With stimulus checks, and more so, lower cost of borrowing, we see a spike in demand. On the other hand, with business restrictions, we might expect a supply constraint. Higher demand and lower supply usually lead to shortages and higher prices. Do they last? We are yet to see.

If you add to that pent-up demand, “you only live once” post-pandemic shoppers’ mindset, some anxious buying frenzy, we might see shortages of anything from ketchup, chicken wings, to swimming pool chlorine, lumber, and homes in desirable suburbs, and mountain destinations. Do too many people want to have a backyard barbeque all at the same time?

In the early days of June 2021, the world seems to be telling many stories. The US is celebrating vaccination milestones; at the other end of the spectrum, Australia is pushing for local lockdowns to eradicate a handful of COVID cases. There is a wide range of tunes in between.

The stock market collapsed and recovered, the economy and the corporate earnings went through a rollercoaster ride. BBQs are happening; masks are coming off, there is more optimism in the air in more places. I certainly hope we get to enjoy a bit more normalcy soon.

It feels as if we have lived a lifetime in those 15 months. We all have many long stories to tell, and there might be some lessons there, too.

Happy Investing!

Bogumil Baranowski

Published: 6/3/2021

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.

A Noisy Distraction

It’s been a long while since I watched any financial news channel. That changed last week, though. I was sitting on a plane (still a rare occurrence these days). The screen in front of me was split to accommodate half a dozen talking heads. Stock quotes were running in multiple lines at the bottom and headlines on the right with some charts. I didn’t have the right headphones with me, and I couldn’t listen to it, but I felt that this silent screen was screaming at me, desperate for my attention.

From what I can tell, very few investment advisors don’t watch financial news, and even fewer will admit that they don’t. After today, you’ll know at least one. This experience reminded me of the importance of a self-imposed information diet, not just in investing but in life in general.

I have nothing against financial news channels. They can be good entertainment and an example of very creative use of the TV screen real estate.

In the midst of last year’s market crash in March, I got many calls and messages from friends and colleagues. They wanted to know if I’m watching the financial news and if I heard what this or the other talking head had to share with the public. It was a very uncertain time; the US stock market lost three years of gains in three weeks. Travel stopped. Toilet paper became a hot commodity. We couldn’t leave our homes, and the economy stood still for a moment.

I gave them all the same short but polite answer: “No, I’m not watching any news. My partners and I are going through a wish list of ideas and buying stocks every day. We see shares at 5-10 or even 20-year low prices. We are as busy as it gets.”

As disciplined contrarian investors, we live for moments like that. I didn’t want to lose a single minute watching any news; it was the time to stay focused, calm, collected, and act. There was nothing that any TV expert would say that would sway us in any other direction. I only wondered how those experts had the time to get on TV instead of doing what we were doing. We knew exactly what we wanted to buy, how much we were willing to pay, and we were on the phone with our brokers doing the work, not missing a single beat. This was the most opportune investment moment in a decade.

I couldn’t even hear the six talking heads on my small screen on my flight, but the headlines were loud and clear. Apparently, we were all bracing for earnings of some particular company reporting after the market close. I just settled in my chair, and I wasn’t planning to brace for anything until the pilot advised otherwise. The terminology used reminded me of a horse race, boxing match, football game, or a space rocket launch gone wrong. It alternated between allegedly unbelievably good news and unexpectedly terrible news all in no time.

Buy, sell, panic, cheer — all mixed together. I learned that there are some actionable trades to do in the morning and others in the afternoon, and there is halftime to regroup. I change my mind too, but I never have six opinions about the same thing in a single day. I had to buckle up and brace myself for an emotional rollercoaster that lasted only a few minutes until I turned off the screen, picked up my book, and enjoyed a quiet flight.

I was reading Bill Bryson’s – “The Body, A Guide for the Occupants.” I enjoyed his “Walk in the Woods,” where he shares his adventures on the Appalachian Trail. Megan and I hiked sections of the Trail last spring and summer.

This loud news experience was no surprise to me. It was more of a reminder of the importance of a self-imposed information diet. I mention it in many posts; I even gave talks about it to groups of investors over the years. In investing, the environment that one creates for oneself matters as much or more than skills, knowledge, and experience. It’s not enough to know what to do; it’s as important to be able to think for yourself and act on it.

For many years, running around New York City from the office to lunches, events, and back, I’d see those silent, loud, tiny screens everywhere from the elevators to conference rooms and even kitchens. One office building, I remember, had Disney cartoons for a change. That was refreshing.

When a friend asked me recently if I watched the financial news channel this morning, I said no. He asked if I am living under a rock. I guess you could say that I have lived under a rock for over a year now. Megan and I spent half of that time in the deep woods with great Wi-Fi but no opportunity to see an elevator TV screen and the second half wasn’t that much different with a quaint seaside town as a backdrop. I’ve had an incredible amount of time to read, write, and think, though, more than at any other point in my life.

William Deresiewicz, a former Yale professor and author of a thought-provoking manifesto “Excellent Sheep: The Miseducation of the American Elite and the Way to a Meaningful Life,” shared in a speech at West Point in October 2009: “Thinking means concentrating on one thing long enough to develop an idea about it. Not learning other people’s ideas, or memorizing a body of information, however much those may sometimes be useful.” “If you want others to follow, learn to be alone with your thoughts.” – he concluded.

I treasure my quiet thinking time with no news, noise, or distractions. I’m immediately reminded of Sir John Templeton, the legendary investor who moved from Manhattan to the Bahamas in the 1960s. He did just fine reading the Wall Street Journal that arrived a few days late on the island. He shared how being away from the noise helped his thinking and investment results.

I have a laptop; I get the news. I read a lot. I take a good number of calls each week, but I value my information diet, otherwise. In investing, patience and discipline can be developed and nurtured, but neither is infallible. I make my life easier, and tune out of big swaths of noise out there, so I can hear myself think. Never watching the financial news is just a small part of it. It makes for more enjoyable flights, helps my quality of sleep and (hopefully) improves my investment choices as well!

 

Happy Investing!

Bogumil Baranowski

Published: 5/6/2021

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.

Phantom Losses & Neighbors Getting Rich

What are “phantom losses?” — In investing, we have gains and losses, but how many types of both are there? Last summer, I wrote a short article about two types of gains. Some recent conversations with clients, colleagues, and fellow investors made me realize that there are more than two types of losses. There are realized losses, unrealized losses, and apparently also “phantom losses.” I like to learn new things, and this was definitely a bit of a discovery. I felt compelled to share it with you, so here it is!

I don’t think you’ll find the term phantom losses in any investment manual, not in this context at least. It’s the best label I could find for this third category. Let’s start from the beginning, though, and examine the two more obvious, yet still at times, confusing types of losses: realized and unrealized losses.

Every stock we buy, we buy with an intention to make money. If we ever sell it, we’d like it to happen at a higher price than we paid. The world is too complex, the future too uncertain, and the information we can gather too imperfect to make every single investment a success. We know it, we accept it, and we prepare for it. The best we can do is minimize our losses, which helps us maximize our net gains. At all cost, we attempt to avoid a permanent loss when a particular holding turns out to be worth nothing. We call it avoiding zeros. In recent history, we have managed to avoid this unpleasant experience. We want to keep it that way.

What happens, though, when we make an investment, and the investment case doesn’t hold anymore. Enough might have changed in the meantime that we see low odds of the business regaining its footing and our purchase turning out to be profitable. In this situation, we decide to sell the position and realize a loss. It’s usually better to act quickly before too many fellow investors embrace the new, less attractive reality.

This is the kind of loss that we call a realized loss. The stock gets sold, and we move on. There might be some tax benefit of such a loss for the client, but that’s as much we can gain from it at this point, apart from a potential lesson for the future.

After we buy a stock, it may happen that the price drifts lower, and we are looking at unrealized or paper losses. We are waiting for a recovery, and the investment case is still valid. We don’t worry about a paper loss. We tend to look for companies whose stocks are down, cheap, and out of favor. Their prices might still be dropping for a while before we see any improvement. If anything, this offers an additional buying opportunity. That’s the very reason why we buy slowly and build the position over time. An exception to this approach would be last year’s March sell-off when we had a brief but very attractive buying window, and we had to act fast.

The first two types of losses are a part of our investment process, not all stocks will perform as expected, and we may have to sell them, or it could take our holdings a while to perform, and we may need to tolerate those paper losses for a bit.

Phantom losses are a category of their own. I think I was always aware of their existence, but I never paid too much attention to them, and I don’t expect it to change in the future. Either way, I believe it might be a good time to discuss them in more detail. With the stock market hovering close to all-time highs, there are possibly very few unrealized losses in the portfolios. The focus moves to everything that’s not in the portfolio. In times like this, market enthusiasts can be full of regrets. That’s the fear of missing out (FOMO) territory: “If only I bought this stock five years ago or even a month ago, then I would have had this much more today.”

There are many stocks and other investments that we never bought and never considered buying, but their prices rose. They might feel like a missed opportunity to some. These could also be stocks we considered and chose not to buy, but their prices rose, and finally stocks we decided to sell, but their prices rose even more.

The world of FOMO is big and has no limits. There is no better fuel for it than watching others get rich. J.P. Morgan, the legendary 19th Century Gilded Age banker, once said: “Nothing so undermines your financial judgment as the sight of your neighbor getting rich.”

As much as we are aware of phantom losses, they are outside of our immediate attention. There are thousands of stocks out there, there will always be many that go up for various reasons, but we would never feel comfortable holding them.

We continuously review our investment cases for stocks we bought, we hold, we sold, and we passed on, it helps us sharpen our approach, but we don’t waste much attention or energy on the opportunities we “missed out” on.

We keep it simple. We are happy as long as we can accomplish our investment goal within our chosen investable universe. Our goal is to keep and grow over the long run the family fortunes we manage. There is a lot we can do though to minimize even the phantom losses though. Our investable universe is not set in stone, and we have owned many companies that initially were outside of our original stock universe.

What’s more, we prefer to act gradually, both buying and selling stocks, but especially selling. This particular policy allows us to avoid leaving too much money on the table if a stock we own continues to rise beyond our expectations. We call this approach being a value buyer but a growth holder. We do our best to buy them right, but then we let the winners run.

Bottom-line: we focus on two types of gains, and losses, realized and unrealized. As much as we’d like to have all gains and no losses, that’s not the investment reality. We do our best to maximize the gains and minimize the losses. We know that regrets and the fear of missing out are a dangerous combination in investing and can make us blindly accept much higher risks for elusive rewards. Let’s remember, though, that phantom losses are just that — phantom, and watching our neighbors get rich might get in the way of our financial judgment.

Happy Investing!

Bogumil Baranowski

Published: 4/22/2021

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.

What’s Essential?

Last week, my wife Megan and I enjoyed the company of a German-Brazilian couple who also found refuge in our quaint seaside town. They sail and surf and have navigated the COVID travel realities getting stuck places and changing plans quickly. We compared notes and shared our experiences. We thought we pack light, but they pack even lighter. Megan brought up the topic of searching for what’s essential in the last 12 months. Beyond health, family, friends – what else is truly essential?

It made me think of a book I was reading in the early days of our work from home experiment with the stock market experiencing 4%-plus swings up and down daily, the pandemic anxiety peaking in our household – “The Power of Less: The Fine Art of Limiting Yourself to the Essential…in Business and in Life” by Leo Babauta – a blogger, and author focused on productivity. It offered a very helpful framework for the year ahead.

Before 2020, I never had to wonder what I would take with me if I had to pack for one year or two? What is that essential? Last year, I had to do it twice, first in my office of four years and then in my city apartment. This experience set the tone for the following months, and it had an immense impact on how we live, work, and invest.

In early March of last year, I called off my business trip. I took a cab to the office; I packed all I needed. I scanned some checklists, to-do lists; I uploaded some files to our cloud storage, and I left. It’s been over a year! That’s the longest time in my adult life that I haven’t worn a suit, by the way.

A month later, Megan and I went through a similar experience leaving our apartment. We had a tight schedule. Our move to a remote cabin in the woods was a very last-minute decision. We could only take what would fit in the trunk of our car. Eventually, we ended up with even less catching a flight to our current destination.

It wasn’t just the office or our home that required a refocus on the essential. Our investment approach also experienced a similar minimalist moment. From going into the market correction in March 2020 to riding out the quick recovery and rally in stocks, we had to double down on the highest conviction holdings, promptly sell what proved to be “dead weight,” and leave room for further buying opportunities, which followed later in the year.

It’s been a time for bold, decisive moves, and the path ahead was far from clear. As you may remember, we had been cautious about the markets for a while. We were fortunate enough to go into the 2020 correction with what we considered to be ample cash, market protection (a volatility ETF (exchange-traded fund), and a gold ETF), and already well-selected core holdings. When the stock market lost about 1/3 of its value in March, we knew that the timer is counting down quickly, and we must act fast. We bought many holdings at their lowest prices in many years. This massive reshuffle in the portfolios allowed us to benefit from the recovery that followed.

When it comes to our investment and research process, I noticed how the last 12 months made us focus on what’s essential. In March, April, and May, we had lots of work to do in a short period of time, and it set the tone for the rest of the year as well. I cleaned up my email inbox, unsubscribed from a lot of non-essential newsletters. I turned off the news alerts on my phone. I narrowed my information consumption only to what really helps me keep up with what’s going on and allows me to do a better job, but nothing more. I built a more efficient daily routine with ample time to read, write, take calls, listen to a podcast or two. I cherish my big blocks of uninterrupted deep work.

Without the daily commute, I even found time for some more regular physical activity, reading for pleasure, or even learning another language. If you can keep a secret, I’ll tell you that I also nap now, and then, that’s something I craved for years but couldn’t really do in the office. Since I often start the day with a sunrise surfing session, a quick power nap midday helps me recoup my energy. It does magic to my productivity and focus, too.

Our experience tells us that there is never a dull moment in investing, and we always have to be prepared to be surprised. When that happens, though, we like to think that we are positioned to be the least wrong no matter what cards we are dealt. That’s been the goal going into 2020, that’s the goal in 2021, and that will remain the goal when the pandemic is far in the rear-view mirror.

Today though, might be a good time to pause and wonder what’s essential – in life, work, and investing.

 

Happy Investing!

Bogumil Baranowski

Published: 4/1/2021

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.

Kicking the Tires: The Future of Due Diligence

Kicking the Tires: The Future of Due Diligence

I remember sitting in a pilot seat of a massive Boeing 777 cargo plane. It was just me with no co-pilot by my side. I wrapped my fingers around the control yoke; I reached for the throttle with my right hand. In my mind, I was ready for takeoff. It wasn’t a dream! It happened almost a decade ago. As a small perk of my research work investigating companies, I got to visit the FedEx facilities in Memphis, Tennessee. I shook hands and exchanged pleasantries with the founder and CEO, Fred Smith. Then I joined a group of portfolio managers on a small bus to the airport. I love planes and airports; they didn’t have to ask me twice. We got to see a new Boeing 777. We were kicking the proverbial tires and doing our due diligence, and those were some big tires to kick! If you know the smell of a brand new car, I’ll tell you that a brand new Boeing 777 has a distinct smell, too.

This was also the very airport where Tom Hanks’ Cast Away character Chuck Nolan was welcomed back by the very same Fred Smith, who at first had some doubts about having FedEx featured in a plane crash movie.

Funny enough, I was in the process of getting my private pilot license at the time, which allows me to fly single-engine propeller planes, no big jets (maybe one day). To raise my instructor’s blood pressure, I had someone snap a photo of me in the cockpit of this big cargo plane, and I sent it to him saying I’m on my way and asking if he has room in the flight school’s hangar. Flight instructors don’t joke much, neither does Tom, but I think he appreciates my sense of humor now and then.

In my recent conversation with a dear friend and mentor – James (Jay) Hughes (who has spent a wonderful career working with prominent families around the world in his role of a true homme de confiance), we discussed the future of due diligence in the investment process. We talked about due diligence in the COVID and post-COVID era. What will the world look like, we wondered.

I might have researched thousands of companies in my career, I met countless CEOs, and I kicked a good number of tires, big and small. In flying and investing, I live by checklists. Before each takeoff, a pilot walks around the plane and actually touches and checks vital parts. Tom would jokingly ask: “Will it fly?” I never said it, but I always thought that a better question would be whether it will crash!

As investors, we have incredible access to disclosure that the listed companies are required to share with the public. It wasn’t always this way, but over decades, the amount of information and reporting frequency have improved. I still think that US-listed companies are among the best in the world on that front. This gives investors in US equities a great advantage and more comfort.

Outside of the US, it can be a bit of an adventure trying to get a complete picture of the business and knowledge of the local market, and access to local research might be very helpful. Otherwise, a US-based investor might be at a disadvantage. We often lean on outside resources to fill in the gaps in our due diligence.

We have a rich network of connections built over decades of experience. We are a Zoom call away from someone on the ground, almost in any significant economic hub in the country and the world. These are our proverbial boots on the ground; somebody can do the kicking for us. It has proven especially important when travel is almost impossible these days.

Speaking of international travel, early in my career, I hopped on the plane and took a red-eye flight to Brazil. It was a big adventure for a junior analyst. I spent a week with a few fellow investors visiting companies in Sao Paolo and Rio. I also met with local research firms that help outside investors navigate the markets there. I was a bit envious of their office views in Rio with vast beaches as far as the eye could see. I’m still in touch with some of them.

The last time I met with CEOs of some of our holdings was a little over a year ago, two short weeks before lockdowns in New York City. We talked, we mingled, we had coffees and lunches. This year, the same event was hosted exclusively online. The amount of disclosure and information was the same. We missed out on some of the in-person experiences.

When I think of due diligence, I think of the many investors I met in my career. Their takes on due diligence couldn’t be more varied. Some go almost as far as counting the bags of frozen peas in the freezers or measuring foot traffic camping out by the store entrance. Others insist on never meeting the management or visiting the company; they believe that’s the only way to preserve their independent think and avoid being influenced by a charismatic CEO.

I believe we belong somewhere between the two. I like to think it’s challenging to invest in a business without firsthand experience with the product or service or access to someone who has had such an experience. I do believe that some CEOs have a true gift for inspiring their troops and “seducing” shareholders, bringing everyone on board their grand vision.

I personally prefer those executives who underpromise and overdeliver and tell me how things really are. I like to have enough mental space and emotional distance to make up my own mind about the business without too much embellishing. After all, I always would rather have our CEOs grow and expand their businesses than spend too much time at too many investor events.

The more confidence I have in the disclosure I receive, the less tire kicking is necessary, in my opinion. As a rule of thumb, if any investment calls for excessive due diligence, I immediately think that we might be better off moving on to the next one. If it takes so much to convince us to buy it, how much more will it take to make us keep holding it.

Between my trip to Brazil and shaking hands with FedEx’s Fred Smith, I had many opportunities to meet talented executives running incredible businesses. At times, I’d meet the same CEOs who ended up managing more than one company we held. In a way, we followed them on to the next business. I only had a handful of encounters that convinced me not to invest in a company. I can’t say it was a surprise. The meeting confirmed what I already thought after a careful study of all the available information. There were maybe three that stand out. In a few short years, all three ended up with fraud, investigation, and a collapse of the stock price. I didn’t need to shake anyone’s hand or kick any tires to see it coming. If the story is too good to be true, it never is.

When it comes to due diligence, if I don’t feel comfortable with the investment after all my reading, the meeting won’t make me change my heart; it never has. On the other hand, if I like what I’m learning, studying all the materials, kicking the tires, and shaking hands or speaking on a call with someone close to the story can give me a bigger conviction. It is the latter, though, that can make more of a difference. A potentially small position in our portfolios can become bigger because of the extra mile we go with our due diligence.

Due diligence has been helpful not necessarily in eliminating bad investments or investment “crashes,” but rather in helping to make sure we own the stocks that have the ability to “fly”!

I can’t tell if handshakes will be around in the post-COVID era, maybe there will be elbow or fist bumps, but the due diligence will be around. I think some of it might be done over Zooms instead of in-person; maybe we’ll rely more on our network or resources with boots on the ground. One way or the other, we’ll still want to get to know our holdings and the people who run them. I believe that in-person occasions won’t completely go away, but they might be more rare and special, and they will be valued even more highly.

I don’t know if I will get to sit in the cockpit of a 777 anytime soon, but I’m looking forward to seeing the future of due diligence. It might be a less-discussed aspect of the investment process, but it’s crucial, and it may have to be redefined and adapted to this new, much more remote, and dispersed world we live in. Lastly, I had my own 2020 wedding with an all virtual audience (except for my in-laws and my bride); I think I’m ready to have my imagination stretched when it comes to many aspects of investing, including the post-COVID due diligence!

 

Happy Investing!

Bogumil Baranowski

Published: 3/18/2021

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.

Two More Cents

Last month, the New York Stock Exchange president penned a historic opinion piece in the Wall Street Journal with an attention-grabbing title: “The NYSE Isn’t Moving—Yet.” The author shared how the new local tax ideas could force this over 200-year-old New York institution to find a new home. NYSE wouldn’t have had this kind of freedom of location independence had the last 12 months of remote work never happened. He writes: “We’ve proved, by pandemic-driven necessity, that we can close the physical trading floor on a moment’s notice and maintain service without missing a beat. Similarly, the broader financial services industry shuttered offices and shifted workforces, without hiccups to remote locations.” – we can’t help but notice that something immensely important has changed.

With the first anniversary of the biggest ever experiment in remote work upon us, I recently took on the topic of this possibly most significant disruption of our lifetimes. As a contrarian at heart, I would have been slightly disappointed if it hadn’t stirred a mild controversy. I have received a wide range of reactions, and I felt compelled to add at least two more cents to the discussion.

***

The Remote Work Revolution is a bottomless topic. We are just learning what it could mean for us as business owners, investors, employers, employees, consumers, or just people, human beings. I think there are some already obvious and even more yet unforeseen consequences of this new phenomenon.

There are at least three big themes here that I’d like to follow-up on 1) The Talent, the People, 2) The Office Space Conundrum 3) Inter-Company Dilemmas.

The Talent, the People

I have no doubt that the companies that will win in this new work/life revolution are those that will be the most agile, open-minded and that put people first. I remember a CEO tell me once that his biggest assets leave the office at 5 pm. Today those assets are dispersed and free to roam.

We already see many new and old businesses that emphasize freedom and flexibility and meet the talent where the talent wants to be, live, and prosper. I see some faint voices from a smaller group of executives whose tone is the polar opposite. They call work from anywhere an “aberration to be corrected  as soon as possible.” I got chills hearing it because it sounded more like something I would have heard on TV growing up in 1980s Cold War Poland rather than in the 21st century United States of America – “The land of the free and the home of the brave.”

Some executives say they will apply “a carrot and stick” method to round up employees back to the desks. In the 19th century English-language literature that’s a reference used to describe donkey races with a jockey using sharp and painful blackthorn twigs to motivate his steed (archaic: a horse being ridden). I have one word for them: yikes!

You don’t have to ask me twice who I’d rather work with or invest in.

I immediately think of what a Georgetown University professor told me almost twenty years ago: “people will vote with their feet.” If you have one company that insists on hiring only those in the commuter radius of their office, while the other company spreads its arms wide-open to all talent no matter where they choose to live — it won’t take long to see whose employees will be happier, healthier, and more productive, and who will get a competitive edge here in no time.  It’s the 21st century, and the best talent is independent, free, brave, and has the ability to dictate the terms of employment.

The Office Space Conundrum

It’s fairly obvious that office space needs are about to shrink, and if not for the multi-year leases, we’d see a lot more of it already. Most recently, Conde Nast the publisher of The New Yorker and Vanity Fair refused to pay rent at One World Trade. Last year, Pinterest chose to pay to get out of their leases. NYSE might think it doesn’t have to be in New York City, but there are companies that go a step further and believe that they don’t need an address to do business and even get listed on the stock exchange.

On the other hand, if you are fortunate enough to have a profitable business with a multi-year lease, you’ll likely wait until the lease is up to rethink your needs, and my guess is that they will be even smaller in 5 years than in 1 year. The last 12 months showed that we definitely need a reliable laptop and strong Wi-Fi, but we can surprisingly easily get by without an office with no apparent loss, quite the opposite.

I think the landlords will see delayed consequences of remote work. The best they think they can do right now is demand the profitable tenants to honor their leases until they expire. It doesn’t sound like a sustainable business practice to keep any customer, including a tenant, and expect him or her to pay above-market rates for something he or she doesn’t need or use. Those customers remain captive for as long as they have to, and once free, they’ll act, too.

If rent is often (outside of earlier mentioned talent) the single biggest line expense for many businesses, I can only imagine what it means to reduce it. The cost of starting and running a business drops significantly, and the profits end up in business owners’ pockets (where they belong) rather than the landlords’ who happen to own a formerly prime location.

In investing, it pays to see where the proverbial ball will be, not where it is now. When it comes to commercial real estate, office spaces, in particular, it’s not that hard to see where the ball is headed.

The Inter-Company Dilemmas

I heard opinions shared by experts about the possible demise of the informal side of work in this new remote work world. One of the pundits remarked how much used to get done within companies outside of the formal channels relying on favors.

I have researched many businesses in my investor lifetime. I would be hugely worried if any serious business operated exclusively or predominantly relying on informal favors, lucky run-ins. If anything, I witnessed how the last 12 months have formalized processes to make sure that nothing falls between the cracks. Communication channels have been established and improved. Paper-shuffling has been effectively reduced to zero.

As a firm, we have had several big advantages; we have operated remotely at times before. We have a small but mighty tightly-knit team. We also had a chance to build a business structure from scratch, and select software, tools, platforms, and service providers that could potentially allow us to work remotely. We knew we are building a 21st-century investment firm. I was invited to speak on the topic over two years ago at a remote work conference.

Becoming independent and starting a new company in 2016, we made a deliberate decision to focus on what we do best: investing and serving our clients to meet their needs, while we outsourced everything else from IT, accounting, compliance to trading, and reporting.

Things get done at Sicart Associates, not because of a lucky run-in with a colleague from another department; there is a process, it’s followed and completed.

We might be a mighty team of seven, but we have strong, dedicated teams work for us at half a dozen service providers who value our business and who stay on top of their game in their respective fields. All seven of us are working remotely, and all those outside teams have effectively worked remotely for us for years, and only now they are remote from their own offices and often dispersed around the country and at times the globe. One late night I had to address a software glitch, and the service provider’s Tokyo team stepped in to handle it and walked me through. I couldn’t help but be amazed and impressed. That’s how problems are solved by serious businesses.

I think the remote work revolution showed which companies have their act together, systems, and processes in place, and which are bursting at the seams holding the show together with the informal arrangement and favors.

To conclude, Warren Buffett famously said: “I am a better investor because I am a businessman, and a better businessman because I am an investor.” I’d count my last four and a half years as a partner of an investment firm, a business owner as very formative, and greatly helpful in my investment career.

I’m convinced that the remote work revolution is shaking up structures, assumptions, and routines that have been stagnant way too long. In the spirit of Nassim Taleb’s book “Anti-Fragile,” some prosper in moments like this; others call it “an aberration to be corrected” with “a carrot and stick.”  The biggest asset for all forward-looking companies is talent. The talent craves freedom and flexibility. Before investing in a company, soon enough, I’d expect that I won’t even need to ask about their remote work policy anymore. Everyone only with “a carrot and stick” in their hands will have either caught up or gone out of business, losing to a much more agile and open-minded competition.

The NYSE president’s WSJ opinion piece is one for the books. It made us think that something important has indeed changed. As investors, business owners, and human beings, we notice it and pay attention.

Happy Investing!

Bogumil Baranowski

Published: 3/11/2021

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.

Deep Dive: The Biggest Disruption — The Remote Work Revolution

The first anniversary of the biggest ever experiment in remote work is around the corner. It might be the right time to see what we have learned about this possibly most significant disruption of our lifetimes.

***

Megan and I are staying now in a quaint Caribbean fishing town a few hour flight away from our New York office. When it comes to time zones, I’m equidistant from the West Coast and London, which has been very convenient taking calls, and Zooms. In the morning, I’m more likely to see returning happy fishermen than running frantic commuters. I’m definitely outside of the traditional daily commuter radius. I’m working remotely, and our whole team is working remotely. All we need is reliable high-speed internet.  Maybe it would have been feasible years ago, but today, it’s not only feasible; it has become second nature and increasingly common practice. What happened?

***

In our role as investment advisors managing family fortunes over generations, we pay careful attention to the world around us. We know well that change is the only constant. We are especially curious about the sudden unexpected disruptions that may have far-reaching consequences creating challenges, and offering opportunities. The remote work revolution of the last 12 months has made it to the top of the list of the new phenomena we are watching.

***

Work is what you do, not where you go – that’s what I heard at a remote work conference over two years ago. I met hundreds of remote workers and digital nomads who relied on technology to live wherever they choose and however they choose. They were living the post-daily commuter life. It looked like the ultimate freedom to me. I wondered why aren’t more people following their path? And if they did, wouldn’t it be the biggest disruption of life and work in recent history? Maybe even the biggest lifestyle upgrade? What would it do to how we live, work, invest, how companies do business, where consumers shop, and more? Almost nothing seems to remain the same when the office worker is freed from the desk and chooses never to commute again.

Rory Sutherland, the UK-based Ogilvy executive, commented on remote work in the Spectator last month, saying: “Given that this technology might help solve the housing shortage, geographical inequality, intergenerational wealth inequality, the transport crisis, the pensions crisis, the environmental crisis and almost everything else people worry about, it seems odd that it attracted so little consideration until a pandemic forced our hand.”

We don’t have any control over when we are born, but I happen to have been born in what felt like the last five minutes of a failed ideology, outdated way of storing and transmitting information, and an archaic way of working. The fall of each led to more freedom in the lives of individuals and solved many more problems than we could have imagined. Let me explain.

I got to witness the last decade of a failed experiment of a communist regime in Poland, which deprived people of most of their freedoms from owning a business to sharing their views. So many people spent so much time making sure that nobody does or has anything. The fall of communism was a massive disruption. It unleashed an incredible potential in the former Soviet Bloc in Central and Eastern Europe.

Later as a college student, I felt that I was the last to print, scan, mail, and receive paper. Was I studying or shuffling paper — I wondered at times. My school materials, applications, dossiers were all paper. The fall of paper has changed a lot. I remember taking only a thumb drive with me when I was moving to New York City. Today, it’s all in the cloud, available where I happen to be. From millions of trees saved to a lighter, easier living, the paperless world has been a blessing.

Finally, the fall of the daily commuter culture can prove to be possibly the biggest, the most universal, and the most far-reaching disruption of our lifetimes. Office worker commute is such a bizarre concept. We took the 19th century Industrial Revolution era mindset and kept it with us all the way to the 21st century. Offices are not manufacturing plants; they have no physical assembly lines. It’s just rows of computers with hopefully decent Wi-Fi.

The belief that work is where you go, and our source of income and living is physically attached to a particular location could be much older than two hundred years. What if it all started during the First Agricultural Revolution around 10,000 BC. In a fascinating book, “Sapiens: A Brief History of Humankind,” Noah Yuval Harari writes: “The new agricultural tasks demanded so much time that people were forced to settle permanently next to their wheat fields.” If it’s really been that long, no wonder we have such a hard time shaking it off and dropping outdated assumptions about office work.

With no assembly line to attend or wheat fields to weed, for the first time in history on such a massive scale, we are finally free to decouple work permanently from the physical location.

Over 15 years ago, the renowned psychologist Daniel Kahneman “discovered” that commuting is the number one least enjoyed daily activity. That’s a polite way to put it. Annie Lowrey was much more direct, and on May 26, 2011, in the Slate article called commuting: “a migraine-inducing-life suck.” She quoted various studies and explained how long commutes cause obesity, neck pain, loneliness, divorce, stress, and insomnia. Wow! And why are we doing it?

If we accept that work is what you do and not where you go, everything changes. We save an incredible amount of time, energy, and resources. Statistically, an average commuter spends twice as much time commuting as vacationing.

Rory Sutherland adds in his article in the Spectator: “Digital networks, unlike hub-and-spoke road, rail and airline networks, deliver their benefits equally to everyone connected to them, regardless of their location.”

With remote work, we can live almost anywhere we want, however we want. We can hire talent from almost anywhere. We can find new business almost anywhere. I say almost because there is still a lot of red tape in the way of what Derek Thompson from The Atlantic called “the nowhere-everywhere future of work.”

That’s not all; the end of commute means a healthier, cleaner planet. Quartz wrote in late 2020: “No single activity contributes more greenhouse gas emissions than driving to and from work.” In 2020 we also saw the most reports of smog-free days in major cities and a comeback of wildlife to urban areas, including New York City’s Central Park. That’s where the rare snowy owl decided to return for the first time in 130 years. As a species and civilization, we might have done more for the planet in a single year than ever before, all by doing one thing: ending the office worker’s daily commute.

I’m reading how there are 18 countries in the world that already offer remote work visas. That number doubled in the last 12 months alone. I’d imagine it will keep doubling until everyone is on board. Most of those countries happen to be in pleasant climates, although somehow the island nation of Iceland made the list, too! There is something for every taste: from warm to cold. You bring the job with you; they let you live there. It’s not only countries that are jumping on board; some US states are even willing to pay remote workers to move there.

The way we think of taxation is evolving, too. Several states, including New York’s neighbors, are looking into ways to tax remote workers who no longer commute but rather live in the state and work from home. New York City was worried about the three hundred thousand taxpayers who permanently skipped town, but maybe another worry is the neighboring states’ appetite for a piece of the tax revenue pie. New York is not alone; other major hubs are going through a similar challenge. If employees no longer have to report to a particular zip code and can live wherever their heart desires, the cities face a real challenge.

I’d hope the tax authorities will be smart working with remote workers and attracting them rather than scaring them away. The one thing this newly freed from office crowd can do is vote with their feet and walk.

More companies are switching to all-remote work already without waiting for the pandemic to pass. Some even offer a stipend to set up a home office. The office-free, office-optional world makes doing business much easier. Many startups used to spend a fortune securing prime office space to impress investors; now, they can use this money in more productive ways. For many businesses, office rent is the biggest single-line expense. With smaller needs and footprint, it could lead to significant savings and lower the cost of launching and running a business. I agree with the opinion that a hybrid model could prove to be a complete failure. If employees are expected to be in the office a day or two a week, they are still tied to the office location and cannot enjoy the freedom of working from anywhere. Sid Sijbrandij, CEO of code-collaboration firm GitLab, explains how the old work model rewards attendance rather than output, but it’s the latter that really matters.

It’s fascinating that the same companies that enable remote work with cloud services, communication tools, and computing devices are also the ones that seem to have completely missed the memo! Some of the big tech companies only recently completed or started building colossal campuses; many of them are the size of multiple Vatican Cities. Who will be commuting to them to get free potato chips, use sleeping pods or play some ping pong? It’s as if someone was trying to lure new employees with fancy staplers in a paperless world. Some Silicon Valley executives notice the change themselves. Salesforce president and chief operating officer recently said: “An immersive workspace is no longer limited to a desk in our Towers; the 9-to-5 workday is dead, and the employee experience is about more than ping-pong tables and snacks.”

I also don’t think that the gray rows of dark cubicles with fluorescent lights high above them will be of much use in this post-daily commuter world. I’m somehow still not convinced that this is the place where creativity and productivity blossom. As a matter of fact, Inc. magazine’s article “Is the Office Dead Forever” explains how 80% of US workers said they’re just as productive or more productive working from home.”

In the book “Remote: Office Not Required” by Jason Fried and David Heinemeier Hansson, they write how remote work used to be rebuffed in the name of no special privileges for anyone. They jokingly write: “It simply wouldn’t be fair! We all need to be equally, miserably unproductive at the office and suffer in unity.” That’s the kind of tone I’m hearing from the faint return to office (RTO) voices these days. These voices come mostly from landlords whose empty office buildings might need to find a new purpose in the future instead of hoping for armies of suit-clad commuters (like me) to report back. The reality is very different. Only 1 in 10 companies expect all their employees to be back in the office once it’s safe.

I know, I know — not all jobs can be done remotely, but let’s look around and appreciate how many jobs can and have been done remotely in the last twelve months. The University of Chicago reports that “37 percent of all jobs in America can be done entirely remotely,” and they account for almost half of all income earned! If it’s not a game-changer, I don’t know what is. That’s a staggering number on the move, free to roam, decoupled from the office location. For tax collectors, it’s a fleeing tax base; for businesses, it’s an office-free or office-light cost structure, and more mobile consumers that still need services and goods but might want them somewhere else; for employees, it’s a whole new world of opportunities.

I do not doubt that we will have in-person social interactions in the future beyond COVID and apart from video calls. I think we’ll value them more highly than ever before. Humanity has been worried about missing out on in-person experiences for at least 2,500 years. It predates the water cooler talk and goes as far back as the village water well tête-à-tête. It was then when Socrates discussed the challenges of the written word, which he believed can’t possibly be as good as the spoken word. Lane Wilkinson explains that according to Socrates, the “written word stands as a mute testament, incapable of explaining itself beyond the text presented.” I don’t disagree, but it’s so much better than nothing! I have never had a chance to attend any of Socrates’ live lectures, but I’m grateful someone wrote them down since he didn’t author any texts at all.

Fortunately, the written word has traveled through time, and now it travels in no time across the globe. I think even Socrates would have been impressed with what Zoom calls have meant and done for us on the family, friends, and business fronts the last 12 months. The same as writing hasn’t completely replaced the spoken word, Zoom won’t replace all in-person social interactions, but something tells me that both the written word and video calls are here to stay.

Long before the pandemic, I read a few books about remote work. One of them was the earlier mentioned “Remote: Office Not Required”, the other “Remote Revolution: How the Location-Independent Workforce Changes the Way We Hire, Connect, and Succeed” by John Elston.  I read them both when I was writing “Money, Life, Family: My Handbook: My complete collection of principles on investing, finding work & life balance, and preserving family wealth.” Both made a very convincing case in favor of remote work not long before the 2020 work from home days. In the former, the authors write: “The next luxury is the luxury of freedom and time. Once you’ve had a taste of that life, no corner office or fancy chef will be able to drag you back.” In the latter, I read: “The Remote Revolution allows employees to choose both their best life experience and their best work experience, not one or the other. It’s a game-changer.” When I read it, I couldn’t argue with either, and I definitely can’t today.

The biggest difference between now and the pre-COVID world is the adoption rate. There were remote workers before, and there were tools to work remotely available. Still, it was hard to convince others when 20 people are ready to start a meeting in a stuffy conference room, and you ask if you can call or video in from where you happen to be living these days. Now, in many case, everyone is calling in, and that’s the only way to join the meeting, and the best part is – no one cares anymore that you are not at your desk or where you really are.

Our 2020/2021 work from anywhere experience was probably the most rushed way to get acquainted with this new world of possibilities. Rushed or not, it is what it is. Many have tried it; some loved it, some needed time to warm up to it, some will likely fight it and try to reject it.

Once we leave the pandemic inconveniences behind and embrace what remote work means beyond it, we might wake up to a very different world. Someone told me that if you liked the COVID era remote work, you’ll love it in the post-COVID times. I agree.

We have yet to rethink the legal, tax, immigration, business, social, and other frameworks for this new remote work revolution. We learned how to hunt animals many times our size; we discovered flight, we put men on the moon, I have no doubt, we’ll figure this out, too. Some already call it potentially the biggest lifestyle upgrade in a century. Many tell me they can finally see their kids grow up. Others have “Sunday scaries” at the thought of being called back to the office. I think we are witnessing possibly the biggest, the most universal, and the most far-reaching disruption of our lifetimes. We can fear it and resist it or embrace it and benefit from it.

I think the proverbial cat is out of the bag. We can’t pretend that 2020/2021 remote work revolution has never happened.

The ideology I grew up with is almost gone, the paper culture is disappearing, and finally, the commuter life is fading, too. I’m very curious to see how many new investment opportunities this remote work revolution will create. It’s already shaking up structures, assumptions, and routines that have been stagnant way too long.

 

Happy Investing!

Bogumil Baranowski

Published: 2/24/2021

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.

Not for profit

The last twelve months brought many new exciting IPOs; new companies got listed on the stock exchange and made their shares available to stock investors. Not all of them seem as promising as their prices would imply. They got me thinking of a conversation I had a few years ago when I met an enthusiastic entrepreneur. He started a venture, which provided a service that the local community enjoyed. The economics didn’t work, though. There was no profit. His solution to the problem was getting more investors. He openly admitted that profit is not the goal of this particular entity. Hearing that, I suggested he turns it into a non-profit and accepts donations. He laughed and said – “No, no, I want to grow it and sell it.” Interestingly enough, I believe that’s the mindset of too many entrepreneurs these days. Why earn a profit if you can grow it and sell it?

Whether it is a cupcake shop with whimsical frostings or a cloud computing service provider with a cheeky name, a venture becomes a business if it currently makes a profit or has a clear path to profitability in the not-so-distant future. If profit is not the goal, it’s either a hobby or a non-profit. There is nothing wrong with that. The former gets funded from the hobbyist’s pocket, and the latter – the non-profit lives off donations, often tax-deductible donations. There is a whole variety of non-profits providing services to communities around the world, from organizations buying books and pencils for students in need to major museums and more.

In this new brave tech world, though, we have a whole new breed of ventures that disguise as businesses, but when you look closer, they resemble more non-profits. In the very competitive, very innovative world we live in, all entrepreneurs have a significant challenge in front of them. They need to identify a new or an existing profit pool. If it’s new, it may be potentially easier to capture it; if it’s an existing one, a battle with an incumbent is inevitable.

There are non-profits in the online tech world, too. Among the most well-known is Wikipedia. An incredible service that took encyclopedias online and made them permanently editable and current. I must admit that I spend a disproportionate amount of time on Wikipedia researching bottomless topics for both work and pleasure. It’s 20 years old and available in 317 languages. Its founders are Jimmy Wales and Larry Sanger. They are no tech billionaires, yet they had done a lot democratizing access to knowledge. Wikipedia relies on donations. Wikimedia Foundation, the non-profit that owns Wikipedia, collected little over $100 million in donations last year.

Wikipedia is more of an exception than a rule in the online world. Judging from a swath of new tech IPOs, there is a theme that repeats a bit too often. Companies are growing rapidly yet not making money. It’s not just that. The faster they grow, the deeper the losses get. Traditionally, companies would go public, offer shares to investors, and raise money to grow. They would add store locations, manufacturing facilities, hire talent. Many of today’s tech IPOs raise money to cover growing losses. If the mindset is that they could grow their losses even faster if only they could go public, then it seems to me that the public shareholder is becoming more of a donor, making a donation, not an investment. The only difference is that there is hope that one can sell his or her participation in the venture (shares) to someone else for a higher price. As long as the stock price is going up and the public is willing to buy into these growing losses, no one cares about profitability, and everything appears to be fine.

If covering losses with newly raised capital wasn’t enough, recent IPOs have another peculiar quality. Their founders can cash out before the company even goes public. They can walk away with over a half-billion dollars before the company developed a business model, turned a profit, or got listed on the stock exchange. If creating a profitable lasting business is the goal of starting a company, then cashing out so early in the race feels greatly premature.

The challenge of the entrepreneur of the venture I mentioned at the beginning, and the many recent tech IPOs, is unit economics. It seems to be a forgotten concept these days, so let’s go back to cupcakes for a minute. If a pistachio cupcake with strawberry frosting costs $1 to make, including all – rent, labor, ingredients, marketing, etc., and it sells for $2.50, we have a $1.50 profit per unit. If we were selling it $0.50 and losing $0.50 on each cupcake, instinctively, we’d know something is not right.

In a phenomenal book “The Undercover Economist: Exposing Why the Rich are Rich, the Poor are Poor – and Why You Can Never Buy a Decent Used Car,” Tim Harford explains: “In a free market, people don’t buy things that are worth less to them than the asking price. And people don’t sell things that are worth more to them than the asking price (or if they do, it’s never for long; firms that routinely sell cups of coffee for half of what they cost to produce will go out of business pretty quickly).”

If it’s an exciting tech company, though, and it’s harder to tell what the cupcake really is, how much it costs to make, and how much we should charge for it, the story appears to get conveniently lost. We are told that losses are an investment in growth. How many cupcakes could you give away, and how fast, if you were “selling them” (translation: giving them away) at half the cost?

Let me be clear: a new business typically goes through a money-losing phase. It reaches a certain scale, figures out its cost structure, tests its pricing power, and eventually turns a profit. Otherwise, it’s a harsh reality check, and the cupcake store shuts down. Many new tech IPOs may prove to have a healthy business model, but others might be permanently not for profit. The latter won’t be worth billions as the market implies today. Maybe they will scale down and reach profitability as much smaller businesses. BlueApron, Groupon, RenRen, and many others among them, couldn’t defy gravity. Groupon was the craze of the day almost ten years ago, the fundamentals massively fell short of rosy expectations, and its stock price eventually reflected that with a 95% decrease since IPO (Source: Bloomberg).

We are always curious to learn about new companies getting listed. We keep reading about new travel sites, online dating apps, big data government contractors, online mortgage companies, food delivery apps, and more. It makes our job more interesting. We get to pick investments not just from the currently available few thousand publicly traded companies but also from all the new ones.

With the abundance of capital and the shortage of yield in the near zero-rate world, stock appreciation appears to have become the main source of returns. If it’s earned and deserved, it will likely last; if it’s only hyped up and inflated with no fundamentals to back it, it’s bound to vanish.

I think the lines between a business and a non-profit have gotten blurred. As long-term investors, we have to pay extra attention and don’t get tempted with any delicious frostings, especially when the cupcakes are given away at half the cost. It pays to know if we are making an investment or a donation, and they are not the same.

 

Happy Investing!

Bogumil Baranowski

Published: 2/17/2021

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.

Can we learn anything from GameStop?

In the last few weeks, everyone’s attention has been captured by unusual price action in a particular stock – GameStop. It rose many times over, and a few more times on top of it. It’s gone up about 20x in a matter of weeks, and most of it in days. The media gave small retail investors credit for this eye-popping price move, and it came at the expense of a small group of prominent hedge fund investors who were on the other side of that trade. At first, it may seem that we are looking at a biblical moment of David’s victory over Goliath – but is it really so?

What happened with GameStop? We don’t usually comment on individual investments unless they are curious case studies that we feel compelled to share, and we think we can all learn from them. Let me try to cut through all the noise and fuss, and explain GameStop’s debacle.

GameStop is a video game retailer that was flirting with bankruptcy. They sell games through over 5,000 store locations. With consumers shifting away from physical towards downloaded video games, GameStop sales have been declining for years now. Bankruptcy is a legal process through which a company seeks relief of some or all of its debt to the creditors at a time when it can’t repay it. GameStop has struggled for a while, not being able to earn a profit, while the debt burden left them with few options. It wasn’t the first, and it won’t be the last company to find itself in this predicament. Usually, it’s a combination of a shrinking business with fixed costs, which leads to falling profits that turn into growing losses. The cash gets depleted, and often enough, a company on this path has substantial debt accumulated earlier, which eventually leads them into bankruptcy. In the last few years, and especially in 2020, we have seen many retailers go bankrupt, and GameStop was on a similar trajectory. In a bankruptcy, the shareholders, the equity investors lose it all and get completely wiped out in the process.

This creates a peculiar opportunity, though. As a shareholder, you own a small piece of business, and you potentially participate in its success. As a short-seller, you can benefit from the stock’s demise. Any investor aims to buy low and sell high. The shareholder does it in this particular order. The short-seller does the latter — first, and the former — second – he or she sells high and buys back low. A short-seller borrows shares, sells them with the hope of buying them at a much lower price later, and returning them to the lender.

I personally, and we as a firm have never done short-selling. We don’t like the risk/reward offered by this kind of trade. In simple terms, when you sell a stock short, your hypothetical upside maxes out at 100%, while your potential loss is unlimited. Imagine anyone shorting GameStop at $20 and covering his or her short position at $400; that’s a loss that amounts to 20x the initial invested capital. If it was a coin toss with a $1 bet that pays you a double or you lose $20, would you play? Usually, short-sellers do their work and research a company inside out, finding out every detail that could lower the odds of a 20x loss.

If the risk/reward wasn’t enough, from experience, we know that it’s intellectually and emotionally difficult to argue that there will be absolutely no good news ahead that could turn the fate around for an almost bankrupt company. We enjoy owning companies because they continue to surprise on the upside with new products, new markets, new ways of growing the business or doing business. The repertoire of good things that can happen is usually broader than a list of bad things that can truly tank the stock and bring it down to zero. We try to be rational optimists. There is no one size fit all, but for our clients and us, we don’t like the odds of short-selling; it’s one of many things we choose not to do.

What happened to GameStop is not unprecedented. It was a heavily shorted stock, which means many shares were borrowed and sold in anticipation of a price drop. Short-sellers don’t make a company go bankrupt; it’s lack of customers, the lack of demand for its products or service, or in other words — the shrinking, failing business that makes companies go bankrupt.

What followed wasn’t that unusual either. It’s referred to as short-squeeze. When something suddenly moves the stock up, the short-sellers quickly face an ever-growing loss. They sold the stock at $20, but now they have to buy it back at $40, $100, $200, $400, etc. To cut their losses, they tend to buy back the stock and return it to the lender. They close out the position. What happens, though, is that they create additional demand for the stock. The more shares were sold short earlier; the more has to be bought back to limit the losses. This will make the price go higher and move faster. It doesn’t mean it will stay high forever or even for long. It is no reflection on the failing business either. If the business was bad before, it remains bad no matter what happened to the price.

GameStop was doubling in price every few days recently, forcing short-sellers to act quickly. Who was on the two opposite sides of this intriguing price action? We had the buyers and the short-sellers. The buyers were apparently small retail investors who decided to jump in. The short-sellers were big hedge funds with billions on the line. There was probably more than one reason why buyers chased shares of an almost bankrupt company. Maybe some of them even genuinely hoped for a miraculous turnaround. Part of it was attributed to a coordinated effort from Reddit forum users. This was followed by Elon Musk’s tweet, and the stock was soon on fire. The more it rose, the more demand there was for the shares. Speculators were no longer interested in just the stock. They also bought derivatives, call options, which can potentially offer an even bigger upside if the stock price continues to go up.

Eventually, the trading in the stock was briefly halted on the stock exchange, and some retail brokers restricted trading in it. The whole debacle invited a big reaction from all directions, including the world of politics, with some congress members chiming in.

All noise and fuss aside — I still believe in the distinction between price and value. Without it the stock market becomes just a casino where pieces of paper trade with no regard for the businesses behind them. The value is what you get, and the price is what you pay. If a business is failing and short of a miracle it’s worth zero, the price will eventually be also zero. It doesn’t really matter if the price runs up 2x or 20x in between, and it doesn’t matter if it happens due to a sudden and potentially short-lived optimism around the businesses or frenzied share buying. It also doesn’t matter if the buyer is a handful of multi-billion dollar funds or tens of thousands or even millions of small investors. Again, short of a miracle, they are defying gravity here and making the price rise, while the value is what it was — likely still not far from zero.

Whether it’s a handful of big investors or millions of small ones, a coordinated effort to move a stock price (if that’s what indeed happened here) has a name, a reputation, and a long history. It’s commonly known as stock market manipulation, defined as a deliberate interference in the operation of the market. The way it happens has evolved. Participants don’t do it in person with paper receipts screaming on a floor of a stock exchange anymore; they do it with their smartphones from their couches. They don’t meet behind closed doors; they communicate in online forums. This doesn’t make it any easier to prove. WSJ recently wrote how the GameStop stock surges test the scope of the SEC’s (U.S. Securities and Exchange Commission) manipulation rules. WSJ further added that what happened resembles an all-too-familiar pump-and-dump scheme, when the stock is bought up at first to inflate the price and sold soon after to book a gain before it drops.

GameStop’s price rally suddenly became everyone’s business. The media painted a picture of David and Goliath, a small retail investor with hundreds of dollars, took on a big hedge fund honcho with deep pockets, and billions on the line. We weren’t there when David struck Goliath, but we were all here to watch this show live. I got messages and calls, and I have to confess that I almost missed the first leg of this performance until someone asked me what’s going on with GameStop? It’s not the first or the last market’s unusual behavior that might escape my attention.

With stocks, you can make money, and you can lose it. As long as you can afford what you are losing, I’d count it as tuition, the cost of an investor’s education (it’s cheaper to learn from other people’s mistakes, though). It’s a chance to learn from it and never do it again. If you are losing what you can’t afford or, worse, what you borrowed, and don’t even have, I think it’s a risk not worth taking. When the dust settles, GameStop will still be what it was earlier, an almost bankrupt company with failing fundamentals, too much debt, and growing losses. I know that miracles happen in life and business, and the management might have just earned a second chance to save the business. If some recent stock buyers truly wanted to save GameStop, their money would have been better spent actually shopping at GameStop, not bidding up its stock.

Will the stock hold the $200, $300, $400 price? We are yet to see – but there is the price, and there is the value, and the two don’t stay far apart for too long. Small investors might have taught the big hedge funds a lesson in the process, but I worry that the last bill is still due, and unfortunately, too many might be left with losses they can’t stomach.

I never owned it, I never shorted it, and I never will. I have no bone in the fight. I’m just a curious observer. It’s another case study for the books. The stock market can be a casino or a wealth-building machine. You can be a day trader or a lifelong investor. I don’t know of any lifelong day traders. They all eventually run out of money to lose. The beauty of investing is that you can have a lifetime of successful investing without ever participating in the noise of the day, and that’s what I’d recommend — if you asked.

 

Happy Investing!

Bogumil Baranowski

Published:  2/1/2021

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 clientspecific 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.

 

PERMA-BEAR, NO. BUT PERMA-SKEPTIC?

In a 2016 article entitled “Why Does Pessimism Sound So Smart?” Morgan Housel mentioned the English philosopher John Stuart Mill. It was Mill’s observation,150 years ago, that the individual  most admired as a sage is “not the man who hopes when others despair, but the man who despairs when others hope.” At Sicart Associates, as convinced investment contrarians, we agree with Mill’s perception. Pessimists do often appear smarter than optimists because they acknowledge the complexity of situations and thus appear profound. Optimists, in contrast, tend to be perceived as superficial or naïve.

In the last ten years, I may sometimes have come across as a pessimist regarding the stock market. I don’t think this has made me look particularly discerning as stock prices kept rising, but I definitely am not a perma-bear. On the contrary, I consider myself an optimist since I am constantly looking for opportunities to invest, as I have during my whole career through bull and bear markets alike.

 “Being Right or Making MoneyThis is the title of a book by renowned market strategist Ned Davis, and the question it implies is utterly legitimate. The answer depends on what you desire in life: to make guesses or predictions that will flatter your ego when you are right? Or to build a quiet fortune over time simply by being right a bit more often than you are wrong?

I was reminded of this when looking at the short history of our very small private fund, which we started on April 1, 2020. As a rule, we have eschewed in-house funds to avoid the many potential conflicts of interest between the firm and our clients. But we needed some kind of published indicator of Sicart Associates’ performance. Most of our accounts are custom-managed individually to take into consideration the goals and family circumstances of each client, as well as the tax considerations in their countries of residence. So, we decided to create this fund, which generally mirrors the main investment positions of the firm. Its performance track record is available upon request. At this time, the partners of the firm are its only investors.

The point of this long explanation is that since the fund’s inception, in spite of generally successful stock picking as reflected in the equity portion of the portfolio, we have basically been wrong on the trend of the stock market. Our economic and market views have been cautious and defensive, as reflected in the high portfolio levels of near-zero-yielding cash and presumably-protective positions such as gold. Still, the market has continued to rise to new highs.

The brief existence of this fund makes performance figures irrelevant; nevertheless, here is an overview versus the indices.

Since the fund’s inception, the S&P 500 is up 44.9% and the Nasdaq up 66.8%. While we have beaten these indices with the equity portion of the account as a whole account (which includes cash equivalents as well as gold and small protection derivative ETFs), we were slightly below the indices, net of fees.

However, I believe that being “wrong” in the short term has not penalized us in a long-term perspective. We obviously could have made more money by being “right,” but what I view as our long-term goal of letting compounding work to build our wealth has not been interrupted, as it would have been by a severe loss. And we still have ample “dry powder” to seize future opportunities when they arise.

 

The “FANGs Are Not the Market, and the Stock Market Is Not the Economy CMG Wealth’s January 15 issue of Steve Blumenthal’s “On My Radar” lists the following statistics of 2020 stock market performance:

S&P 500 Index:                                  18.40%

S&P “6” equal-weighted:                   49.32% (Facebook, Apple, Amazon, Alphabet, Microsoft, Netflix)

S&P “494” * equal-weighted :           4.05%

It is clear, therefore, that if 6 of the heaviest tech stocks are excluded, the remaining 494 stocks in the S&P 500 index do not come close to the “official” performance of the leading US stock market index.

Similarly, the last ten years have amply demonstrated that the economy and the stock market are very different animals. The economy has recovered from the Great Recession of 2007-2009 through fits and starts, further aggravated by the COVID-19 crisis, while the market has experienced a seemingly irrepressible rise, only interrupted by a couple of brief corrections.

The dichotomy between the market and the real economy, especially over short and medium-length periods, is not news. It has been amplified since the invention of the “Greenspan put” in response to the 1987 crash, and that evolved into the “Fed put” after subsequent Federal Reserve Bank chairs adopted similar policies. The principle of these policies is to pump liquidity into the economy at the first sign of weakness. Since the stock market is widely viewed as a leading indicator of the economy, the policy has increasingly meant to pump liquidity into the economy at the first sign of stock market weakness.

But monetary policy is a macro-economic tool, not particularly adapted to stimulating specific sectors of the economy – a dilemma which I once likened to trying to fix a carburetor while wearing boxing gloves. This is a disadvantage in normal times, and it was already felt in the uneven recovery from the 2007-2009 Great Recession. But it really began to create severe imbalances during the COVID-19 crisis, when whole segments of the economy were decimated, such as travel, hotels and restaurants, retail stores, etc., while others prospered, such as internet shopping and do-it-yourself home improvement.

Among consumers, a large proportion of the population had little or no accumulated savings and minimal access to credit when COVID hit. They required basic government help just to survive layoffs or furloughs. For those consumers, the pandemic period was, at best, one of suppressed spending. For the more fortunate ones, who kept their jobs or their small businesses, the inability to travel, visit restaurants, or enjoy weddings and other gatherings resulted in forced additional savings.

For businesses, most of which had access to cheap borrowing, the high level of economic uncertainty dissuaded many from investing that money in long-term opportunities. They often preferred to buy back their own shares in the stock market, buoying both their reported earnings and the major market indices in the process.

The net result of these trends was that much of the liquidity created by the central bank (through either money creation or lower interest rates and easier credit) was either not received or not used by large segments of the economy.

“Liquidity” is a somewhat elusive notion that may describe either ownership of liquid assets (cash and other very short-term, saleable investments) or easy access to cash through borrowing. My observation, over the years, is that liquidity created by central banks tends to flow as in communicating vessels: it enters the financial markets first, boosting the price of financial assets, but eventually finds its way into the “real” economy. When the real economy accelerates and requires more liquidity to function, the financial markets’ “vessel” empties, depressing the price of assets such as stocks and bonds. Hence the paradox, and the explanation of the dichotomy between the economic and the stock market performances.

The net result of easy-money policies, from the “Greenspan Put” to QE (Quantitative Easing) and now ZIRP (Zero Interest Rate Policy), has been to constantly prop up stock valuations without allowing the market to “purge” itself of excesses during more propitious economic times. This failure has been aggravated by the shape of the economic recovery.

While it was initially debated whether the recovery would look like a V, a W, or even a square-root sign, the consensus of economists seems to have settled on a K-shaped recovery. I am not sure how economists write their Ks, but this appellation is meant to describe an economy in which two different parts behave at very different paces. There is little doubt that investors whose assets have appreciated significantly in the last ten years have done much better than workers who depend on a salary or savers who must live on a fixed income.

 

 

Risk Rising

With interest rates at zero percent or lower, there develops a frantic hunt for alternatives, marked by diminishing regard for safety considerations. Traditional income investors first crowded the High Yield (formerly known as “Junk”) space. Then they moved to “credit” and distressed vehicles with higher risk and fewer covenant protections. That is without counting many derivatives-filled products invented by mathematicians at the service of bank marketing departments.

On December 14, 2020, Financial Times editorial, Mohamed El-Erian argued:

“Nothing is more reassuring to an investor than the knowledge that central banks, with much deeper pockets, will buy the securities they own — particularly when these buyers are willing to do so at any price and have unlimited patient capital… The result is …seemingly endless liquidity-driven rallies regardless of fundamentals.” El-Erian concludes that while investors will continue to surf a highly profitable liquidity wave, for now, things are likely to get trickier as we get further into 2021.

Steve Blumenthal of CMG Management Group Inc. recently had a conversation with William White, the highly respected former Chief Economist of the Bank for International Settlements (a.k.a. the central banks’ bank).

Mr. White, who warned of the Great Financial Crisis of 2007-2009, famously believes that debt creation facilitated by central banks in recent years has materially weakened the world’s financial system and made it unstable. He argues that traditional remedies like saving more or engineering faster growth to facilitate repayment are not practical today because one might throw the economy back into recession and that already-high debt levels are likely to hamper growth anyway. This leaves two options: inflation, which raises nominal rather than real growth and thus makes repayment less painful as the value of money shrinks, or debt restructuring and write-offs. White advises a combination of these two, and they may also shape the eventual outcome.

Shades of the 1970s

As I was finishing this paper, I came across an editorial by John Authers, formerly head of the “Lex” column and chief markets commentator for the Financial Times, and now a senior editor at Bloomberg. He mentioned a name almost forgotten today except by economic historians: Nikolai Kondratieff.  In the 1920s, this Soviet economist documented the existence of a cycle of about fifty years (47-60) in commodities prices, which he eventually labeled “the Long Wave.”

Like many of my Wall Street contemporaries, I spent quite some time in the mid-1970s studying the Long Wave as inflation was accelerating. Now I vividly remember the 1974-75 global recession and bear market in stocks (which, for a while, was attenuated for our clients by the foresight of my then-mentor and later partner Christian Humann, who had invested heavily in commodities and gold a few years earlier).

The more I think about the current situation, the more it reminds me of the early 1970s, coincidentally about fifty years ago. Of course, there are many differences between the two periods, but (as Mark Twain may never have really said) history may not repeat itself, but it often rhymes.

So when clients ask me about the future — which, as a rule, I don’t predict — I answer that with effective vaccines and massive infrastructure projects, it makes sense to anticipate a strong economic recovery within a couple of years, but that this may result in a drying-up of liquidity for financial markets, and ultimately, lower stock market valuations.

 

François Sicart

January 27, 2021

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 clientspecific 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 Three Disconnects

I often ask my partner and mentor, François Sicart, to share more about investing in the 1970s and the 1980s. We both like to find themes, parallels, lessons in the past that may help us understand today and the future. I can picture a younger client, or portfolio manager asking me in 2050 to tell him or her more about 2020. I will be a young 70-year-old at that point. I will refresh my memory and look for a theme or maybe even just one word. That word will likely be – the disconnect. There are at least three major disconnects occurring this year. First, the stock market has decoupled from the real economy. Second, a handful of mega-cap tech stocks took off and left the rest of the market behind. Third, those who were able to work from home have experienced a very different year than those whose jobs were lost because their work depends on the face to face interactions.

If we were to look at the economy and the stock market, we’d see two very different stories. The economy is still struggling to recover, while the stock market is reaching new highs. We often remind our readers that the stock market is not the economy, and the economy is not the stock market. The economy represents all the economic activity in a specific year in a particular part of the world. It’s all the goods and services that have been made available and found buyers. The stock market is a place where the ownership of many businesses can be exchanged in the form of shares. When we talk about the stock market, we often have an index in mind, the S&P 500, for example, representing the 500 largest U.S. corporations. We also have a tech index — Nasdaq, and broader indices like Russell or Wilshire 5000. The last one is often called the total stock market index since it attempts to capture all publicly traded companies in the US. We also have countless indices abroad around the world. The list goes on.

If the economy represents the activity and the stock market the ownership, they can sometimes tell the same story, but other times, they might be disconnected. Suppose the economy is doing well and continues to improve. In that case, it’s not unusual to see the stock market move up higher to account for more activity and likely higher corporate profits. The stock market tends to react quickly, and it usually leads rather than follows the economy. It’s far from a perfect leading indicator, though. If there is any doubt about the future growth in profits and economic growth, the market may promptly turn lower. The opposite happens when the market rises when investors find any reason for more optimism ahead.

This year between February 20th and March 23rd, the S&P 500 dropped 33%.  The market lost three years of gains in a matter of three weeks. We like to compare it to an escalator ride up and an elevator ride down. We had a number of days with 5%+ drops, and the Dow Jones Industrial Average lost almost 13% on March 16th alone. The market decline started weeks before we saw any lockdowns in the U.S. Ten days after the U.S. declared the national emergency on March 23rd, the market bottomed though and began a quick rise. By August, the S&P 500 recouped March losses and reached pre-Covid February levels, and now in November, it’s hovering almost 10% above that earlier peak (Source: Bloomberg).

The March market correction was an exceptionally accurate estimate of what we were to see in terms of earnings drop and the business decline in the coming months.

When the S&P 500 bottomed in March, it was down 33% from its February high. In July, we learned the GDP; the economy contracted at an annual rate of 32.9% in the second quarter. The third quarter showed a 30%+ recovery from the previous quarter. The Brookings Institution reminds us that despite last quarter’s recovery, the economy is “still more than 4 percent below its level at the end of 2019, which is more than the farthest the economy ever was from its prior peak in the Great Recession.” We also witnessed a 33% decline in corporate profits in the second quarter, which was the largest quarterly decline since the first quarter of 2009. In the third quarter, S&P 500 profits were down 7% year over year. As much as we have seen improvement since the second quarter, the economy and the corporate profits still have a long way to go before full recovery.

We could say that the market went from discounting the potential economic downturn to ignoring it entirely and looking far past it. Ideally, we could see the economy and earnings converge with a rising market at some point. That quick path to recovery is far from certain, though. For now, we know that the number of companies issuing quarterly guidance dropped by 1/3, and more the 100 S&P 500 companies have either withdrawn or not provided annual guidance for 2020 and 2021. The forward visibility remains limited.

The second disconnect we see is between the performance of the mega-cap tech stocks and the rest of the market. We may think that the stock market experienced such an incredible recovery this year, but we’ll notice that there are two different stories to tell if we look closer. The entire S&P 500 year-to-day performance can be explained by the rise of the tech giants, the FAANGs; the rest of the market returned (after one of the wildest rides in the market history) 0% for the year as of mid-November.

According to Yardeni Research, the FANGs represent 12.7% of the market capitalization of the S&P 500, but only 4.9% of earnings and a mere 0.5% of revenue. An image of a tail wagging the dog comes to mind. If we broaden the FANG index from the four stocks: Facebook, Amazon, Netflix, and Google, and add Apple and Microsoft, the tech giants account for 25% of the S&P 500, up from 8% only in 2013.

Tech giants reported record earnings last quarter. Apple was the only major tech company with profits dipping. The nature of their business and their growth profile helped them grow and even benefit from the pandemic downturn. More shoppers spent money online, and that’s where advertising dollars headed, too. If we look back at the fourth quarter of last year (which was reported weeks before the March crash), we’d see a very similar picture, though. Outside of the five tech companies, the S&P 500 recorded no earnings growth in that quarter. Even without the pandemic, the whole earnings growth for all 500 largest US companies already relied almost exclusively on a few tech giants pulling all the weight.

There is no question that tech companies caught a significant tailwind this year, on top of favorable long-term trends helping their businesses. NYSE FANG+ index tracking the tech giants rose over 100% since March, while the entire S&P 500 went up by 57% (Source: Bloomberg). The question remains if their eye-popping rally this year is fully deserved. Will, the rest of the stock market, catch up, or the tech valuations will come down and converge with the rest of the market?

The third disconnect has appeared between the work from home employees vs. face to face the economy. In March, everyone that could do it transitioned overnight to a 100% work from home model. They picked up their laptops and went home. They turned their attics, spare rooms, bedroom, kitchen table, porches into their home offices. I know that Megan and I did, so did our entire team. We realized, though, that we were the more fortunate group. Our work can be done from almost anywhere. I know it’s not all of it, and many aspects could be done better in person, but if we have to, we can make a lot happen remotely. This year, it has been a blessing and allowed us to conduct our business as usual smoothly and without missing a beat.

At the same time, during spring lockdowns, we saw many local bars, restaurants, gyms, barbers, coffee shops, and stores shutdown. Some of them were able to adapt and do business online one way or the other. Some switched to curbside pick up, delivery, or drive through. All those attempts to do business despite restrictions gave only that much benefit and hasn’t entirely replaced the lost business. Summer months brought some relief, with more businesses reopening around the country and the world.  Here we are in November 2020, though, and we see more restrictions and lockdowns triggered by Covid cases spiking again. We might not be out of the woods yet. We also notice how major cities in the U.S., New York City, among them, have struggled to recover. It hasn’t been enough to just open doors again and let customers in. The new challenge has been the absence of traffic. The tourists aren’t back due to travel restrictions, and the daily commuter crowd is not there. The current office use in New York City has been under 10%.

The Covid pandemic made us realize how much of the economy and the employment relies on the daily commuter culture. I used to drop off my dry cleaning on the way to work, get coffee now and then, see clients for lunch, friends for dinner, catch a show or a movie in the theater. Our Manhattan life and daily routine kept a lot of businesses around. September’s article in the Medium pointed out a whole multi-trillion-dollar ecosystem built around a white-collar office worker in the U.S. alone. This might prove to be one of the biggest policy challenges for major cities and commuter areas. For now, though, we see the disconnect between those who were able to keep their jobs, do business remotely from home and those whose face to face interaction driven, location depended businesses have struggled. We are yet to see how we can reconcile the two over time.

The three disconnects are related. Would they have happened without Covid? My best guess is that work from home would have happened, but much more slowly. The U.S. stock market would have struggled to keep rising without such a massive pandemic booster shot in the arm from the Federal Reserve. Without lockdowns, the tech stocks would have still shined compared to the rest of the economy, but the difference wouldn’t have been a lot less striking.

Disconnects tend to close over time. Will the economy catch up with lofty market levels? Will the rest of the corporate world catch up with the high flying tech stocks? Will the face to face economy find a way to catch up with the work from home model? Maybe all three will meet halfway. I trust that when I get asked about 2020 in 2050, I’ll have all the answers. For now, we have to operate with what we know. The disconnects are there, and if the gaps were to close, we could see some interesting challenges and opportunities ahead.

 

Happy Investing!

Bogumil Baranowski

Published: 11/19/2020

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 Other Unicorns

A unicorn might be the famous mythical creature with a spiraling horn projecting from its forehead, but in the investing vocabulary, a unicorn is a privately held startup priced at over $1 billion. The unicorn as a term with its Latin and Ancient Greek roots signifies something desirable but hard to find. CB Insights lists 495 unicorn companies in the world. There are 500 companies in the S&P 500, the US stock index that includes the 500 largest companies. If there are almost 500 unicorn companies, are they still that rare and hard to find? This revelation made me think of the other unicorns. Not the highly-priced new exciting companies that have yet to prove their business models, but the older, more established companies that trade at low valuations (less than ten times their annual earnings, for example). There aren’t many of them to be found.

The terms value and price are often confused in the investing world. We agree with the legendary investor Warren Buffett’s definition: “Price is what you pay; value is what you get.” In that case, tech unicorns are priced at $1 billion or more, but we are yet to see what we are really buying and what the value might prove to be. Some of those companies will prosper; some of them will fail. That’s the nature of all early-stage companies. They are still in the process of developing their product or service, finding their customers, and finally establishing their business model – a path to profitability. Any company with no plan or intention to reach a profit has no business, in our opinion. It resembles more a non-profit with private shareholders providing financial support for the time being. When those shareholders realize that there are no profits, we expect/believe/have seen they wake up and run. If they are still holding on to their shares with hopes of gains, they possibly subscribe to the Greater Fool Theory. That’s the idea of selling shares at a higher price to someone else — the greater fool.

Most recently, WeWork has been a prime example of such a company, a tech unicorn who rose quickly, focusing on growth at any cost. We had our experience meeting with many WeWork reps as we were looking for our New York office space over four years ago. It seemed to be a very aggressive sales machine taking over buildings and floors from major companies as they were shrinking their Manhattan footprint. One of those locations was a prime Park Avenue location that I remember visiting a few years earlier. It held the offices of one of our portfolio holdings that’s been in the process of reviewing their office space needs. That was long before the 2020 work from the home shift caused by the Covid pandemic.

After years of eye-popping growth, WeWork attempted to go public and offer its shares to new investors. It was supposed to be priced at $47 billion. That would buy you one and a half of Walgreens, one of two major chains of pharmacies in the U.S., together with its international presence. WeWork reported a $1.3 billion operating loss in the first six months of 2019 alone (Source: company filings, S-1) while recording $1.5 billion in revenue. That’s not that much different than giving away $100 bills for $50. How quickly can you find takers for $100 bills if you charge $50 for them? There is no real limit to such growth, but it’s not growth that leads to profitability. As a comparison, Walgreens earns around $4 billion of profits on over $130 billion in revenue annually.

WeWork knew it well and didn’t hide it. They actually openly disclosed in their IPO filings: “We have a history of losses and, especially if we continue to grow at an accelerated rate, we may be unable to achieve profitability at a company level (as determined in accordance with GAAP) for the foreseeable future.”

A long-term investor (as opposed to a trader or speculator looking for a greater fool) would only buy a business for its current or expected profits (earnings). How would we value a company that doesn’t expect any profits in “the foreseeable future.”  That might be beyond the limits of any reasonable investment horizon.

It was quite refreshing to see the market reject the IPO, and WeWork is still trying to find its bearings a year later. The Covid pandemic and work from the home model have only made it more challenging to turn it around. WeWork might have been priced at $47 billion at some point, but we are yet to see what its actual value proves to be.

Looking for the other unicorns, I came across an article. This summer, Barron’s made a list of ten S&P 500 stocks with a market capitalization above $5 billion, and the lowest price to earnings, in other words, ten cheapest stocks. A shortlist of ten included some insurance, health care, old tech companies, among others—familiar brands and businesses, with mostly steady earnings but no excitement or growth. What caught my attention was the length of the list – 10! Not 495. What rare finds these stocks have become, especially compared to startup unicorns.

I remember recommending stocks as a junior analyst some 15 years ago now. We would sit around a big long conference room table and present investment ideas to fellow portfolio managers. Some of my more senior colleagues with vivid memories of the 1980s markets occasionally asked me if the stock was trading below ten times earnings (meaning, we pay less than ten dollars for each dollar of our annual earnings of the company). I would often say no, and explain why it deserves a higher multiple. It had a unique market position, growth potential, brand, etc. I was always curious about those mythical times when the markets were apparently full of companies trading at sub-10x earnings. In my early days, I still could find cheap stocks that met this stringent criterion. Some of them even qualified as decent investment ideas. More recently, though, I see that this group has dwindled to the point that I could almost count them on the fingers of my two hands. What happened?

As a student of history, I asked, investigated, and read to understand better where those other unicorns have gone. Those mythical creatures that used to roam the markets freely and could be bought at low multiples, and even offer generous dividends are nowhere to be seen. Today, the unicorn label has been claimed by the exciting startups, who have become anything but rare.

I believe the most significant phenomenon that occurred since 1980, which coincides with the year when I was born, has been a gradual decline in interest rates and a continuous increase in debt worldwide and in the US. The 10-year US treasury yield peaked at close to 16% in 1981 and has fallen to 0.8% as of November 2020.  Simultaneously, the price to earnings ratio for the S&P 500 rose from 7-8x in 1980 to 25x+ this year. No wonder most of the sub-10x earnings companies that many portfolio managers reminisced about vanished. When the entire S&P 500 was trading at 7x-8x, I’d imagine there were many sub-10x earnings stocks in this index of 500 companies. The term startup unicorn was not even around yet back then. We’d have to wait until 2013 when Aileen Lee, a venture capital investor, chose the word unicorn to represent a statistical rarity of a billion-dollar venture. It took only seven years to have all 495 of them!

As the debt got cheaper, we got more of it. The US public debt went from 32% of the GDP to over 100%. Household and corporate debt grew with it. Accommodating monetary policy with ever lower interest rates made it harder to earn interest on savings. I remember how only 15 years ago, I had a one year certificate of deposit with a major bank paying 5% annually. Today, it’s not only impossible to find such a rate but 10-year Treasury yields below 1% (Source: Bloomberg); finding any respectable yield has become more challenging.

On top of that, we witness a sea of negative interest rate bonds that reached $16 trillion recently. You have to pay the borrower to take your money. I remember defending my master thesis at the Warsaw School of Economics 17 years ago. One of the questions that came up was about credit risk. We discussed the need to compensate the lender for taking on the risk of lending the money to the borrower. Watching the growing number of bonds with negative yields, I wonder if the laws of economics have somehow been rewritten since I picked up my diploma? Today, we flipped the 5,000-year-old logic on its head. That didn’t happen without some unforeseen consequences and bizarre phenomena – tech unicorns among them.

In the name of maintaining economic growth, we embarked on a monetary and fiscal experiment that has numerous curious side effects. With the lack of yield in the bond markets and a shrinking number of dividend-paying stocks, price appreciation has become the primary goal for many investors. They felt forced to move toward riskier assets in search of returns. This phenomenon made substantial capital available to promising new ventures that can quickly reach very high prices, multi-billion dollar market capitalization still in the private market — the famous startup unicorns. Among them, you can find these days decacorns and hectocorns with over $10 billion, and $100 billion private market valuations, respectively. Deca and hecto are terms derived from Ancient Greek, similarly to a unicorn itself, which has been a wonder for humanity since Antiquity. It took the 21st-century financial creativity of zero interest rates combined with desperation for returns to breed not only unicorns but a whole new species — decacorns and hectocorns. We could only imagine what the Ancient Greeks would think of these inventions.

As students of history, and observers of nature, we see how both follow cycles, empires rise, empires fall, the ocean tides follow a similar pattern, so do the seasons of the year, and credit, business, and economic cycles are no different. We might be at a peculiar point in our financial history as it’s being written today. Tech unicorns are proving to be as common as US large-cap companies. Low multiple, good business, high dividend stocks seem to have become as rare as a fair-weather rufous hummingbird sighting in Alaska in January. We might have to wait a little longer than expected, but something tells us that tides will turn, as they have before. We believe investors will have abundant investment options again with yields and valuations closer to historical levels when the other unicorns make a comeback (my other unicorns might actually resemble more majestic rhinos, given their steady business and intimidating size). For now, I’d recommend two words (also borrowed from Latin and Greek): a healthy dose of caution and skepticism.

Happy Investing!

Bogumil Baranowski

Published: 11/12/2020

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.

HOLD THE CHAMPAGNE…

I was prompted to write this paper by a new book from Ben Carlson, author of the always-stimulating blog “A Wealth of Common Sense.”  Reading his book Don’t Fall for It: A Short History of Financial Scams (Wiley, 2020) reminded me what I really always knew: speculative bubbles do not need fraudsters to happen. The victims can both create and succumb to the schemes all by themselves — out of ignorance or greed, and sometimes both.

The timing of the paper was also influenced by younger colleagues, several of whom recently asked me how previous bubbles, which they had not experienced directly, had felt in real life.

Over an investment career encompassing many bull and bear markets, I have witnessed only four (and a half) genuine bubbles and their aftermaths: The Nifty Fifty episode of the early 70s, the Japanese asset bubble of the late 80s, the Dot-Com bubble of the late 90s. the sub-prime lending bubble and crisis of 2007-2009, and the current “fleeing forward” of the tech sector which has not burst yet but, in my opinion, looks like a bug in search of a windshield.

The Go-Go Years and the Nifty Fifty

Although the stock market and the economy do not necessarily move in sync, the1960s enjoyed both an economic boom and a buoyant stock market. So much so, in fact, that a leading economist proclaimed that we had now “conquered the economic cycle”, implying that we would no longer suffer recessions. Right on cue, of course, a recession and stock market downturn hit the United States in 1969 and 1970, with the stock market shedding 35% of its value.

Bankers and money managers, shaken by the surprise loss, nevertheless noticed that fifty or so companies had continued to be profitable and to grow throughout the recession. As a result, these recession-resistant, “one-decision” stocks (which should theoretically be bought and never sold), became known as The Nifty Fifty. Major institutional investors began to concentrate their portfolios into those shares, whose valuations, measured by their Price-to-Earnings ratios (P/Es), rose stratospherically as a result, further helped by synergy-creating acquisitions and earnings-inflating “pooling-of-interest” accounting.

Of the Nifty Fifty stocks documented by Morgan Guaranty, the top dozen sported P/Es between 50- and 90-times earnings before the stock market (as measured by the S&P 500 index) lost 45% of its value between December 1972 and December 1974.

Quite a few of the Nifty Fifty survived and prospered over time, although usually after a multi-year lull.  Among the institutional favorites, Avon Products dropped 86% from $140 to $19 between the end of 1972 and the end of 1974, while Coca-Cola lost 70% from $149 to $45. More generally, the majority of the Nifty Fifty underperformed the broader S&P 500 index for the next 29 years and even long-term survivors like Disney, Coca-Cola, Eli Lilly and Merck were still down after ten years.

On the other hand, such Nifty Fifty stars as Polaroid, Simplicity Pattern, Kresge (later Kmart), Burroughs and Eastman Kodak disappeared — or nearly so. (Sources: The Journal of Investing – Fall 2002 and a blog post by Jason Zweig with Malcolm Fitch  – 12/11/2016)

Personally, I have pleasant memories of the Nifty Fifty episode for two reasons: first, value-type stocks did not lose as much in the decline as the previously-favored, “one-decision” shares; second, my mentor and partner Christian Humann had anticipated very early the return of inflation and had invested heavily in producers of natural resources and commodities, from oil to copper, gold and even sugar. All I had to do was to hold on to them. Even after the bubble burst and former favorites started declining, inflation hedges continued to rise with the accelerating inflation and the declining dollar.

All in all, I was lucky that my investment record started at a time of depressed prices for the stock market, and benefited from the first couple of years of the rebound, augmented by the good returns of the natural resources sectors. This taught me that the way to make money over time is, first to avoid periods when a few names are responsible for the momentum of the broad stock market indexes; and second, to possess cash to invest at market bottoms, when most investors are forced to sell – rules that I still follow.

The Japanese Asset Price Bubble

In the late 1980s, Japan’s swift money-supply growth and credit expansion resulted in grossly inflated real estate and stock market prices. In only six years between 1985 and 1991, commercial land prices in six major cities rose 302% while residential land gained 180%, while the Nikkei 225 stock market index tripled to a record 39,000 between 1985 and 1989 — after being briefly interrupted by New York’s Black Monday crash in 1987.

The yen also appreciated strongly against a weakening dollar after the Plaza Accord of 1985. The value of the dollar in yen was almost cut in half, from 260 in early 1985 to 139 by mid-1989. This allowed Japanese companies to spend huge sums to acquire trophy properties abroad. In the United States, such acquisitions included Firestone Tire, Columbia Pictures and Rockefeller Center in New York — which pretty much marked the top of the Japanese bubble.

I must say that the Japanese bubble of the 1980s left me essentially unscathed, since I had no investment in Japan at the time. My worst memories of that episode are from TV interviews where I was exposed to the irony of temporary “experts”, who explained that Japanese assets were not expensive in view of Japan’s much lower interest rates and its corporations’ generally more conservative accounting and reporting practices.

Yet, when I saw the Japanese shares’ valuation statistics and the prices Japanese buyers were paying to acquire American companies and properties, my convictions were strengthened rather than shaken.

As usual, it took some patience but by 2004, for example, the price of Tokyo’s homes was less than a tenth of its peak, and the Nikkei 225 stock index fell almost 80% from 39,000 in December 1989 to 8,000 in March 2003.

 The Dot-Com Bubble

In a way, it is best to be contrarian when the “madness of crowds”, as Charles Mackay called it in 1841, becomes evident in the financial markets. Even so, ample patience is still required because, as John Maynard Keynes said, “the market can remain irrational longer than you can stay solvent”.

The late 1990s present a perfect example of this phenomenon. All reasonable valuation criteria were thrown to the wind for Internet-related companies. Companies could simply add “.com” to their name and watch their shares explode upward in the stock market. Even a hint of involvement in the Internet could create millions or billions of stock market wealth almost overnight. Between 1995 and its peak in March 2000, the NASDAQ Composite index, which included most of the Internet-related companies, rose 400%. The index’s price/earnings ratio reached 200x in 2000, more than twice that of the Nikkei 225 at the peak of the Japanese asset bubble in 1989.

In subsequent years, the dot-com stocks gave back all of their gains.  Ben Carlson’s book, mentioned earlier, contains a table depicting the carnage:

Tech Stock Losses During the Dot-Com Crash

Amazon           -95%

Apple               -80%

Cisco                -86%

Intel                 -78%

Oracle              -83%

Microsoft         -60%

Note that most of these companies have remained among the top technological leaders in the world to this day. Yet even the stock of Amazon.com, for example, did not reach its bubble high again until October 2009 – nine years later.

The memories of the bursting of the bubbles of the Nifty Fifty in the 1970s and the dotcoms in the 2000s remain vivid, even for those who were relatively unscathed.

My old friend and colleague Jean-Marie Eveillard, who was eventually inducted into the Morningstar Hall of Fame for his career achievements, lost many shareholders of his mutual fund during the bubble because, as a staunch value investor, he temporarily “underperformed” trendier managers. He famously stated in an interview: “I would rather lose some shareholders than lose my shareholders’ money”, a phrase of which I am envious. Not only did his fund continue to prosper, but it reached a record size in the few years after the dot.com craze.

The main teaching from the dot.com episode is that bubbles usually spring from valid observations and ideas. They only become bubbles when analysts and money managers with plentiful intelligence, knowledge and money (but no discernment or common sense) start justifying the prices fetched by trendy favorites, and promote them to investors without regard to valuation or potential limits to their success. As Warren Buffett famously stated: “Price is what you pay, value is what you get”.

There is a danger in buying at any price shares of companies that promise to change the world. I once wrote a paper comparing RCA in the 1920s to AOL in the 1990s. Radio did change the world and “disrupted” traditional and advertising media and RCA’s earnings and stock price exploded accordingly. The number of households with radio sets grew from 2.75 million in 1925 to 10.25 million in 1929 and, through the Great Depression, to 27.5 million in 1939.

But investors were wrong about RCA’s price. As we can see in the following chart, the fate of AOL’s stock was not different in the 1990s after its vogue during the early Internet boom.

 As Warren Buffett once said: “Price is what you pay, value is what you get”.

 The Great Recession and the Fed “Put”

In late 1987, Federal Reserve Chairman Alan Greenspan invented a policy orientation then labeled the Greenspan “put”. A put is a stock market instrument which gives the holder the option to sell a security at a given price in the future. Investors typically use that option to protect themselves against a decline in the price of the security, thus reducing the risk of their investments.

After subsequent Fed chairs adopted a similar policies, the “Greenspan put” simply became known as “the Fed Put”. This is important, because the new asymmetry of monetary policy explains the length and severity of subsequent bubbles.

Greenspan and his successors became convinced that financial market turmoil was a sign of looming economic recessions, and proceeded to implement aggressive monetary easing at the first sign of stock market weakness. This tended to cut short bear markets in stocks and often postponed economic recessions – for a while. But it also failed to fully correct speculative excesses, setting up the stage for future crises..

After the “Sub-Prime” financial crisis of 2007-2009 and its resulting “Great Recession” engulfed the United States, a relatively unknown professor of economics named Hyman Minsky was re-discovered. Minsky had hypothesized that financial crises and recessions did not require a trigger: they were inherent to the free market system and long periods of financial and economic stability were naturally destabilizing over time. Stability made people feel more adventurous, and prone to risk-taking (usually by undertaking more debt) until too much became too much and the speculative bubble burst.

I always felt that Minsky’s lack of renown (in spite of the intuitive logic of his “hypothesis”) resulted from his blaming the economic cycle on the very nature of free markets. In a way it reeked of Marxism, which was of course very unpopular on Wall Street. Personally, I never felt that Minsky was particularly left-wing, and his views have now become more mainstream, with the development of behavioral finance recognized by a few Nobel Prizes in recent years. The experience of recent bubbles has also tended to reinforce Minsky’s ideas.

In the years leading up to 2007, increasingly easy monetary policy led to historically-low mortgage interest rates and loosening bank-lending criteria: borrowers lied about their financial situations and bankers failed to verify their information or, sometimes, even encouraged them to lie.

The following paragraphs, extracted from Wikipedia, provide a brief but sufficient description of the domino effects of the crisis and recession:

“Excessive risk-taking by banks… combined with the bursting of the United States housing bubble caused the values of securities tied to U.S. real estate to plummet, damaging financial institutions globally, culminating with the bankruptcy of Lehman Brothers on September 15, 2008, and an international banking crisis. The crisis sparked the Great Recession, which, at the time, was the most severe global recession since the Great Depression. It was also followed by the European debt crisis…

“U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008… The increase in cash-out refinancing, as home values rose, fueled an increase in consumption that could no longer be sustained when home prices declined. Many financial institutions owned investments whose value was based on home mortgages such as mortgage-backed securities, or credit derivatives used to insure them against failure, which declined in value significantly. The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.”

From October 9, 2007 to March 9, 2009 the S&P 500 lost approximately 50% of its value. Severe setbacks were also experienced by other world stock markets and the economic recession spread to foreign countries as well. It could be argued that the recession lasted until 2016 and some of its effects even longer, but the duration of the bear stock market was shortened by aggressive monetary policy (“quantitative easing”) from the Federal Reserve board, all the way to near-zero or even negative interest rates.

Still, a fellow value manager later reflected that, in 2006-2007, rather than focusing only on stocks’ valuations, “we probably should have paid more attention to the macro economy”.

 The Era of TINA, FAANGS, NASDAQ and FOMO

More than 10 years after the Financial Crisis and Great Recession, and after the longest statistical recovery in recent history, unemployment remains stubborn and many businesses are weakened by heavy debt burdens. These trends have recently been aggravated by the Covid-19 pandemic, and the efforts of governments and central banks have mobilized unheard-of fiscal and monetary resources to prevent their economies from falling back into recession.

But it is hard to stimulate economies when many consumers are unemployed, general uncertainty prevents many businesses from investing, and governments realize that their current stimulative efforts will burden their budgets for years or maybe decades to come.

In recent times, the main responsibility for supporting weak economies has rested with central banks.  The usual reaction has been to lower interest rates, which fell toward zero or, in some countries, lower. With bond interest also hovering at the same level, savers and retirement or insurance funds could only invest in the stock market or real estate, both of which have been in a price uptrend for more than a decade.

This is why TINA (“There Is No Alternative”) and the old adage “don’t fight the Fed” have become popular themes in recent years. With many traditional, mature industries still reeling from the recession and lukewarm recoveries, a large proportion of investing money flowed to shares of companies expected to grow faster, in technology-related activities. Since many of these companies such as the FANMAG (Facebook, Amazon, Netflix, Microsoft, Apple, Google) are listed on the NASDAQ, this group outperformed older and more diversified indexes by a wide margin.

As had been the case with previous bubbles, investors and advisers who often have more smarts than common sense formulated and promoted the rationale for holding these stocks above all others. Under their influence and the “evidence” of the tech sector outperformance in the stock market, much of the investing crowd succumbed to FOMO (Fear Of Missing Out) and added to the demand for this relatively small sample of companies.

In this respect, the following chart, from Ned Davis Research (www.ndr.com) courtesy of Steve Blumenthal’s blog, is strikingly self-explanatory.

As can be seen, the FANMAG stocks have gained over 30% this year to-date, while the other 494 stocks in the S&P 500 index have lost almost 7%.

As I conclude this brief overview of my experience with investment bubbles, I wonder what some of the great entrepreneurs of history, who painstakingly built their iconic fortunes, would think of today’s wave of financial “unicorns”. In today’s stock market parlance, a unicorn is a privately held startup company valued at over $1 billion. Thanks to the huge overflow of central-bank-provided liquidity into the stock market, many of these startup or near-startup companies raise phantasmagoric amounts of capital through Initial Public Offerings (IPOs) before producing even a dime of profit.

TESLA, founded in 2003 by visionary Elon Musk, has yet to make a profit according to some of the best financial analysts, if one excludes revenues from selling to customers and competitors the carbon credits granted by the government to “green” companies. Yet, TESLA is valued by the stock market at $380 billion!

In the words of my early mentor Walter Mewing, “As long as a company makes no money, its shares can go up indefinitely, because they sell on hope. But when they start earning a measurable profit, BEWARE, because you will now have to deal with data.” A word to the wise…

François Sicart – September 30th, 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.

An Apple, A Plague, and A Bubble

This article was inspired by comments and thoughts I have been hearing from fellow investors concerned about the fear of missing out on this ever-rising market that has defied laws of gravity.

I imagine that almost everyone has heard the story of young Isaac Newton watching an apple fall from a tree, which inspired his theory of gravity. A story he shared himself in his memoirs. I will guess that a few would know that he was home at the time, away from school due to a plague going around. And I can bet that even fewer know that the same Newton made some money, but lost a fortune in a stock bubble of his time!

I remember how my physics teacher was able to bring his stories and discoveries to life (she didn’t mention he made and lost a fortune in the South Sea Company Bubble!). When I think of physics, laws of nature, I still see him. When I see a stock melt-up quintupling in a few months, for no reason, I also think of him! For a long time, physics was one of my favorite subjects at school, and I still have a weakness for it. I liked its logic and how it explains the universe. I think that in some way, I often hoped that economics, finance, and investing would have clear laws like physics, and explain the world around us. They don’t.

You might see some parallels between Newton’s life and our 2020 pandemic, stay-at-home, work-from-home policies, and a bubbly stock market.

The time spent at home between 1655 and 1657 Isaac Newton called in his memoirs the Year of Wonders, the time he embarked on a journey of understanding how the universe works. Woolsthorpe Manor, his birthplace and the family home, was the place where Newton found refuge during the plague, and it was the place where he retreated through his life to think and write.

The bubonic “Great Plague” (the worst plague to hit the UK since the black death of 1348) sent many home, away from schools, and cities. Town-dwellers retreated to the countryside, while London alone lost 15% of its population to the plague. Newton made the best of this time, writing later: “For in those days I was in the prime of my age for invention and minded mathematics and philosophy more than at any time since.” It was then when he developed his theories on calculus, optics, and the laws of motion and gravity.

It’s been a little over six months since this year’s pandemic sent our Team home. We left our Manhattan office behind and retreated to our homes, and in my case, two different cabins in the Appalachian Mountains. I can’t say that I had a chance to reinvent the laws of physics in my time away. I have been reading, writing, and thinking more than in a while, though. I can’t help but count this peculiar period among the most productive in my life. I also took up several online courses that I have always wanted to do. Megan and I even embarked on learning Spanish together. To a great surprise of other hikers, we have been practicing rolling our “Rs” lately on our regular waterfall walk. I also completed training for various software solutions we use for work. I saw significant leaps in virtualization, digitization, streamlining of many processes that make up the work we do. It saves time, limits errors, and leaves more time to talk to our clients and look for investment ideas. We owe a big thank you to all our service providers that make our business possible.

Newton might have spent his time at-home wisely explaining the laws of physics, but it was only later that he learned more about human behavior, finance, and stock investing! He is believed to have concluded: “I can calculate the motion of heavenly bodies but not the madness of people.” If not for human emotion, one could imagine the stock market and finance follow precise laws the same as those that govern the stars and planets in the sky. For better or worse, it’s not the case. It offers buying opportunities for calm, disciplined investors, and it may cost a fortune those who give in to greed and fear—the fear of missing out being at the very top of the dangers to any investor.

Sir Isaac Newton was not immune. Apart from physics, mathematics, astronomy Newton was no stranger to money, finance, and investing. He held a position of the Master of the Royal Mint and even worked as a detective chasing money counterfeiters. He was also a shrewd investor in years before the South Sea Company Bubble. It is believed that Newton made money in the initial rise of the South Sea Company stock, sold his holdings, only to buy in again as the stock continued to rise with no end in sight. The South Sea Company bubble eventually burst, fortunes were lost, and Newton himself lost some £20,000 (or about $20 million today), according to his biographer.

That’s a story I didn’t learn in my physics class. I read it first in the commentary to the introduction of  Benjamin Graham’s (father of value investing) classic – The Intelligent Investor:

“Back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he ‘could calculate the motions of the heavenly bodies, but not the madness of the people.’ Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price — and lost £20,000. For the rest of his life, he forbade anyone to speak the words’ South Sea’ in his presence.”

My Parisian grad school professor in the aftermath of the Internet Bubble burst (2000), and likely due to his own experience losing a fair amount of money, assigned to us a study of all the major past bubbles. I couldn’t be more grateful for that lesson. It definitely shaped my investment approach for the rest of my career. My professor’s quick advice was – don’t buy stocks because there are bubbles. What I heard, and what I chose to walk away with was – since there are bubbles, there might a good time to buy stocks and a good time to sell them.

Newton’s investment: the South Sea Company Bubble was at the top of our study list, as it is among the most famous bubbles in history. South Sea Company was founded in 1711 as a joint-stock company. This particular company was created to consolidate the national debt of Great Britain and reduce the cost of it. Needless to say, excess public debt seems to be a theme that repeats through history, including today, with looming record deficits all around. The company was given a monopoly on trade with South America to generate income. Since Great Britain was involved in the War of the Spanish Succession at the time, and Spain and Portugal controlled most of South America, the prospects for profits were meager. The company never realized any significant profit from its monopoly.

South Sea Company leadership wasn’t worried too much by likely business challenges. They got inspired by the financial wizardry of a Scottish financier, John Law. France, as much as Great Britain, wanted to get rid of its debt. Louis XIV’s reign almost bankrupted the French monarchy, leaving the country with a big problem. Instead of tightening the belt and paying off what’s owed, France endorsed John Law’s monetary shenanigans. He consolidated the debt and offered shares in a promising business venture in exchange. His Mississippi Company was given a monopoly on trade and mineral wealth in French colonies in North America and the West Indies. Law exaggerated the business opportunity creating excitement around the stock, which kept rising higher and higher. He also controlled the money issuing bank in France, Banque Royale. Eventually, the company and the bank merged. Money was printed to allow investors to buy more shares in the company, further inflating its price. Ultimately, the sentiment shifted; investors wanted their money back; the price collapsed. Law tried all kinds of restrictions to keep the madness going. Payment in gold and silver for paper money was suspended. Holding precious metals was made illegal.

The bubble burst, John Law, escaped, and one would hope an invaluable lesson for investors, financiers, and central bankers was carved in stone never to repeat. I highly recommend Virginia Cowles’s book – The Great Swindle: A History of the South Sea Bubble, if you want to learn more about both companies, both bubbles and their aftermath.

***

Yet here we are, in the second half of 2020, public debts are at record highs. US numbers are staggering. This year’s fiscal deficit is expected to reach almost 20% of the GDP (the 50-year average is closer to 3%, and the last recession recorded about a 10% deficit). Total Federal government debt is about to reach 100% of the GDP, which is as high as during the last debt peak after WW2.

Our money is not convertible to gold or silver; we can still, though, buy and hold precious metals. The Federal Reserve (the US central bank) has been busy printing more money, lowering the cost of debt to almost zero. This new money might be digital, and it might be sitting on the balance sheets of banks, but no matter how you look at it, these are fresh new dollars created at no cost, and there are a lot of them. Pre-pandemic, the Fed already held $4 trillion in assets on the balance sheet, and now leaped to $7 trillion in a matter of months. What does it mean, though? The Fed issued new money to buy the debt of various kinds: public debt, mortgages, and, more recently, corporate debt. Now, if the Fed is buying, someone is selling and ends up with cash. That freed up cash can buy whatever is left to buy – how about stocks? I can’t help but see another parallel with John Law’s attempt to print money to help investors buy more shares in the Mississippi Company.

Where does the Federal Reserve end, where does the market begin, we can start to wonder? That’s been a moving target, but it starts to bear the resemblances of John Law’s merger of Banque Royale and his Mississippi company. Actually, the minute the Federal Reserve starts buying US equities, there won’t be much of a line left between the Fed and the market. The Fed will effectively become the market. We certainly hope we never go that far, but other central banks, including the Swiss National Bank and the Bank of Japan, have crossed that line already. Our portfolio gold holdings give us some peace of mind if that were to happen.

Lots of debt, unlimited paper money, and a bubble in a stock or many stocks… that summed it all up in 1720 Great Britain and France, and it sums it up in our 2020. If you overlay it with an economic recession – GDP dropping by 1/3, corporate profits down by 1/3 in the second quarter, with record unemployment, the disconnect between the market and the reality is even more glaring.

You would think that investors today have a wider choice than two trading companies with promised trade monopolies oceans away. Nasdaq 100, the technology index of the largest 100 tech companies, rose over 70% since March lows through the summer peak (Source: Bloomberg). At the same time, the NYSE FANG+ index doubled during the same period. The latter covers only a handful (ten) of the largest, best performing technology stocks. Investors have conveniently ignored the other few thousand publicly traded stocks and chose to chase a tiny group of ever-rising, seemingly invincible stocks. The index mentioned above generously includes ten companies, but investors’ attention has been mostly focused on 4-5 stocks, namely Facebook, Amazon, Apple, Netflix, and Google, with frequent mention of Tesla, Inc.

In a single year, the South Sea Company price went up from £100 to £1000; in our today’s tech world, we witnessed Tesla, Inc. rise seven times since March alone before early September correction. One rose on expectations of the great riches brought by a trade monopoly from distant lands, the latter on the great success of electric cars in the distant future.

Both Americas prospered over the following centuries, but it wasn’t either of the two trade companies that benefited much from it, and it was definitely not their shareholders that saw much gain from it either. During the Internet bubble (which still haunted my grad school professor), we witnessed a new technological revolution, but again very few companies lasted long enough to capture its benefits. Today is not different; we do not doubt that some of the top tech companies inflating the market might have some remarkable businesses. We also pay attention to several new multi-billion-dollar companies (many of them “profit free” but full of promise) to be listed in the coming months. The excitement will come and go. Profitable companies are likely here to stay, and if we pay reasonable prices for them, we may even benefit from their success. Chasing rising stocks, and giving in to the fear of missing out, didn’t work for our Isaac Newton three hundred years ago, and won’t likely work today.

Whenever we don’t know what the future may hold, we like to pick up yet another history book, and this might prove to be the best use of our work from home time, and Virginia Cowles – The Great Swindle: A History of the South Sea Bubble is not a bad place to start.

Happy Investing!

Bogumil Baranowski

Published:

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 clientspecific 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.

 

Boring Stocks for Exciting Times

Recently we had the pleasure of hosting an investment idea Zoom call. Normally, we’d have an intimate “idea lunch” in our Manhattan high-rise overlooking Central Park and the Hudson River. This time, our team and a number of guests (friends of the firm) all tuned in from around the country and as far abroad as Mexico and Bermuda! Only their backgrounds of trees outside the window, beautiful bookshelves, and nautically themed paintings could reveal where they might be. Among the stocks we discussed, we came up with some interesting ideas that we call boring stocks for exciting times.

Hosting an idea lunch before required everyone to be in Manhattan at the same time. With everyone’s busy schedules it’s never been an easy task. This time a virtual Zoom idea call was a breeze to organize. We picked a few dates, and times, and everyone just called in from wherever they are. We may be remote, even far from each other, but thanks to technology we are able to stay connected, and tuned in, possibly more than ever!

There is no question that this year has been full of surprises. From market highs, we proceeded to multi-year lows, followed by a sudden recovery back to new highs. The economy, profits, and employment are still in the midst of a slow recovery. The political backdrop, with presidential elections in November, remains highly uncertain. If that wasn’t enough, the pandemic that has caused enormous disruption in our lives, the economy, and politics seems to be far from over. If these aren’t “exciting times,” we don’t know what are.

Why should boring stocks be appealing in “exciting” times though? We could argue that the stock market has become largely disconnected from the fundamentals. We would even argue that March lows were a more accurate reflection of the economic backdrop than today’s highs.  On one hand profits dropped while on the other, stock prices rose.

But lately the stock market has been a tale of two worlds. One represents a small group of tech companies — asset-light or even asset-free – whose business, clients, and operations are seemingly both everywhere and nowhere. The services they offer have suffered limited headwinds during the COVID lockdowns. The other group — the majority of publicly-traded companies — has suffered from the impact of lockdowns and a drop in economic activity. At best they have been able to hold their ground, even if they couldn’t show growth and expansion. Some are in a position to weather the storm, even taking market share to prosper, while others may yet fail, disappointing investors.

The market, in the near term at least, has favored the high-growth exciting companies vs. the steady but slower businesses. The top five tech stocks (FAAMG: Facebook, Amazon, Apple, Microsoft, Google) have been up some 35% this year, while the remaining 495 stocks of the S&P 500 are down 5% (as of late July). On relative basis, the five tech companies may look like heroes with a 2% earnings growth vs. 38% earnings drop for the remaining 495 S&P 500 stocks.

Does a 2% growth deserve a 35% price rally? And does a 5% price drop accurately reflect a 38% profit decline? In our opinion, both answers are “no.” Simply said, both groups seem overpriced in aggregate.

However, a careful look reveals a good number of stocks with steady businesses that still may have to face some pandemic-related headaches, but are positioned to thrive beyond the current situation. Among those, we still find investment opportunities. On the whole these are quality businesses whose stocks may have rallied lately. Given their high profits and attractive valuations, we see only a minor disconnect between price and value with these stocks. We could even argue that there is a compelling discount between what we pay and what we get. We see them as offering better potential for capital growth and preservation than most of the investment opportunities capturing investors’ attention these days.

Markets have a tendency to change their minds quickly. Today’s FAAMG rally is no different from earlier market enthusiasms. The Nifty Fifty of the 1960s and 1970s present an excellent example. These were fifty U.S. large cap stocks considered one-decision investments that should be bought at any price. They subsequently crashed, and their valuations were brought down. Many – including formerly familiar brands like Polaroid, Sears, and Digital Equipment Company — have vanished or become shadows of their former robust businesses. I highly recommend my partner’s François Sicart’s recent article for more history lessons from past market darlings – RCA, NIFTY FIFTY, AOL and FANGs.

Among the “boring” stocks we currently favor, you’ll see major pharmacy chains, telecoms, food companies, and substantial players in agribusiness, among others. We do supplement this group with more “exciting” businesses, but only if the price makes sense to us.

The next six months may bring surprises, but we remain very comfortable with our portfolio positioning: ample cash ready to deploy, a good-sized gold position to weather the uncertainty, and a thoughtful selection of companies that includes many boring stocks for exciting times.

Happy Investing!

Bogumil Baranowski

Published:  8/27/2020

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 clientspecific 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.

 

Risk-Free Rate, Rattlesnakes, and the Revolutionary War

In these Covid-era days, we often have to make unfamiliar choices, many of which involve deciding among levels of risk. Megan and I like to break up our work routine and step away from our laptops now and then. Situated as we are in the woods, hiking has become a pleasant escape. Some trails pass right by our cabin, and we can reach others a short drive away. What we’ve learned is that we have a choice between busier trails and less-frequented ones. The former carry a risk of running into someone sick, so we carry masks. But the latter sometimes present the unpleasant surprise of big fat rattlesnakes basking in the sun. Either way, we have to accept a certain risk, and realize that even an innocent hike is not really risk-free!

At some point in my finance education, I was introduced to the notions of a risk-free rate and a risk-free investment. I don’t know if it was my skeptical nature or my nascent contrarian bone, but they just didn’t sound right to me. Intuitively, I believed investment always involves a risk, and only sometimes offers a reward. I also thought, and still think, that not all rewards are worth the risk they entail. Finally, I realized that not all risks are immediately visible — like that big rattlesnake camouflaged by its surroundings.

Speaking of rattlesnakes, once I encounter a new risk, I like to understand the odds of harm and the way to address it. Although there are only 7,000 snake bites a year in the U.S., the averages don’t tell the entire truth. A competent statistician would insist that we are more likely to win a lottery than to suffer a snake bite, or even encounter a snake! However, if you’re hiking in our current neighborhood, the odds tilt dramatically toward a human/snake confrontation every single day. Let me tell you, that doesn’t feel like a lottery win at all!

I have also learned that the best snake bite emergency tool kit is … a phone and a car key. Unfortunately, an encounter may happen miles from a parking lot, with no phone signal, and a long drive to a hospital. Experts advise the bite victim keep his or her heart rate down to slow the spread of the venom. (My heart rate goes up at a mere sight of the reptile!) The victim has hours to reach a hospital where the antivenom can be administered. The 24 hours following the bite are apparently very unpleasant, and recovery may take weeks or months.

All of this is by way of pointing out that there is no such thing as risk-free hiking. All the same, some of my professors as well as many investors still claim there is such a thing as a risk-free rate, as well as risk-free investment. Such an investment has scheduled payment(s) over a fixed period of time that are assumed to meet all payment obligations; a government bond is one example.  Many financial models (such as the discounted cash flow model and the Black Scholes model among others) use the so-called risk free rate to price other assets such as stocks, options, bonds etc.

Anyone who grew up in a country that has defaulted on its debt (including yours truly in Poland) would never consider a government bond risk-free. U.S. investors haven’t had that experience. Over 200 years ago, in the aftermath of the Revolutionary War that brought the U.S. independence from the Kingdom of Great Britain, the country faced a dilemma: should it honor its war debts or not? Alexander Hamilton wanted to do the former, while James Madison had other ideas. The debt was trading at a big discount to face value, and Madison wanted to pay only the current price. Hamilton won the argument in favor of repaying the debt at full face value. This historic move restored the world’s confidence in the infant nation’s ability to pay its debts!

Since then, we’ve come to believe that the U.S. can’t default on its debt. Almost 10 years ago, the former Federal Reserve chairman Alan Greenspan told us there was no chance of a U.S. default. Why? Because we can’t print more money, he told us. That may be true, but as Poland’s example demonstrates, printing money to pay government debt can lead to a devasting hyperinflation. Many countries, many civilizations (including the Ancient Greeks, the Ancient Romans, and the Chinese emperors) tried to debase their currency to get out of debt. The practice is as old as money itself. Technically default may be avoided, but the value of the money we get back could be a fraction of what we initially lent to the government. That doesn’t sound like a risk-free investment at all, does it?

Today, U.S interest rates hover just above zero, and the allegedly risk-free rate on a 10-year US Treasury bond is paying a mere 0.55%. In other words, if you lend the government a million dollars for 10 years, you’ll get paid $5,500 for each year. The return would have been 6 times as much only 18 months ago. Even if we disagree on whether it’s truly a risk-free investment, we can all agree that it’s almost reward-free.

Let’s remember, though, how all assets are priced based on the risk-free rate. The lower it goes, the higher-priced other assets become, including other bonds (including corporate bonds) or stocks. Looking at the post-March 2020 stock market rally, we can see the correlation between asset prices and the risk-free rate. Interest rates dropped; asset prices jumped higher. Investors, seeing stock prices rise yet again (despite falling corporate profits, record unemployment, and rising health risks) start to believe that stocks look like a risk-free investment, too. “If you can’t lose money in a pandemic year, when can you lose money?” a friend asked me recently.

It sounds like a familiar idea. We’ve been told before that home prices could only go up. Now, it seems that stocks can only go up, even if the companies don’t make profits, if their storefronts or factories close, and if their customers have lost their jobs.

In a conversation with my mentor and partner, François Sicart, I brought up the interesting challenge of investing in a world where you supposedly can’t lose money, and everything can be presented as a risk-free investment. As always, he shared his words of wisdom, and told me: “I’ve always said that I don’t invest in things where I ‘can’t lose money.’ Such a market would be a good example.” Our discussion also inspired his last article aptly titled: If I ever retire, I know what the reason might be.

Having ran into some highly venomous snakes in the last few days, I have a new understanding of the risks that hikers take, especially those brave enough to head out on the less frequented, beautiful, but overgrown trails. Just because you aren’t aware of a risk doesn’t mean it’s not there. If you are heading out hiking, take a stick with you, and watch where you step. If you think you’re making a risk-free investment in a bond, stock or real estate for that matter, look again!

Happy Investing!

Bogumil Baranowski

Published:

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 clientspecific 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.

IF I EVER RETIRE, I KNOW WHAT THE REASON MIGHT BE

Some years ago, I advised my clients: “Never invest in something where you can’t lose money”. This was the time when investors were beginning to mistake market volatility for risk, (which has now become a habit) and financial marketing departments were obliging the hungry crowd with a multitude of mathematicians-created products that promised to make you money whether the market went up or down. Face you win, tails you don’t lose.

The problem with the accounting approach to auditing

There were a number of problems with buying these complex products. The most prevalent was that very few people were capable to understand or deconstruct them. Another was that many people did not have the common sense to know that there is no such thing as a profitable but riskless proposition in investing.

Then, there was a minority of intelligent and educated investors, who assumed that they were smart enough to understand everything. By definition, they were incapable to admit: “I don’t understand”. By refusing to acknowledge their limitations, they often wound up losing just as much as the supposedly ignorant ones.

Some of these same people were caught in the Enron scandal (publicized in October 2001), which was the largest bankruptcy in American history at that time, and perhaps also the biggest audit failure, leading to the de facto dissolution of Arthur Andersen, one of the five largest audit and accountancy partnerships in the world.

Enron, a self-described new-era energy company, had for several years reported stellar profits. However, they had done so, it was discovered, by using accounting loopholes, special purpose entities, and questionable financial reporting, and were able to hide billions of dollars in debt from failed deals and projects.

Two of my partners at the time, who were extremely knowledgeable about energy, went to visit the company twice. Both times, they came back saying: “We just don’t understand”. This is why we never bought the stock in spite of growing pressure from younger clients seduced by the company’s glamourous aura and its officers’ very public contempt for those who dared question them…

This should serve as a reminder to be wary of the “accounting” approach to auditing, which aims to make sure that the reported figures match mathematically, but forgets to understand how these results are generated. In doing so, they ignore the precept that John Maynard Keynes apparently borrowed from a less-famous 18th century author: “It’s better to be approximately right than exactly wrong”.

(After graduating from business school and assisting for a year two tenured professors, I did a stint for a year teaching accounting to candidates to the French equivalent of the CPA. Since I soon realized that they knew the required “entries” better than me, I decided to teach them the “philosophy of accounting’. I don’t know how they did at their exams, but it made me very popular with my class… and perhaps helped some students become better auditors.)

More recent and perhaps more extreme was the Madoff scandal. Bernie Madoff had been, among other things, a market maker and former non-executive Chairman of the NASDAQ until Bernard L. Madoff Investment Securities, which he created and chaired, was convicted of operating a massive Ponzi scheme, in December 2008.

The Madoff investment scandal defrauded thousands of investors of billions of dollars over more than twenty years. The irony is that the outstanding returns his firm reported were never actually achieved. His small staff created false trading reports, based on the price performance of stocks chosen after the fact. One of the back-office workers would then enter a false trade report with a previous date and enter a false closing trade in the amount required to produce the profit demanded by Madoff. The figures matched, but the trades were phantom.

I don’t think I would have been tempted to invest with him, but I was fortunate never to have heard of Madoff before the scandal burst into the open. After it was discovered, a few investment bankers I knew admitted to have oriented many of their clients to him but they all claimed that they had performed all the necessary due diligence before doing so.

Only one felt guilty enough to commit suicide. But, for all, the “due diligence” consisted in checking the reported numbers without checking how they were arrived at. Only a small team, whose board I had joined at the time, had not invested with Madoff because they had tried to virtually replicate the system Madoff claimed to follow, and concluded it was impossible to produce such superior results with such unfailing regularity.

This, I am afraid, is the kind of accounting-based due diligence that most fiduciaries and consultants still perform today.

 

Eliminating the risk in investing

What led me to write this paper was an article that my partner Bogumil Baranowski forwarded to me, which asked what money managers should do if the Federal Reserve, in order to fight the deep recession induced by the current pandemic, started to buy every security in sight.

After broadening its original mandate from trading Treasury bills and notes to buying other fixed-income securities and, most recently, even high-yield (junk) bonds, the article wondered if the “Fed” might go further and start buying common stocks as the Bank of Japan has started experimenting.

Already, the routine of announcing and implementing a policy of near-zero interest rates eliminated the risk of losses for bond buyers should interest rates rise.

Now, buying junk bonds, usually issued by financial “zombie” companies eliminated a new risk layer from the panoply of instruments money managers can buy or sell. If the Fed started buying a portion of the stock market, there would be almost no instrument left where you could lose money.

You may ask why it should be bad to eliminate risk from financial markets? One of the essential roles of the stock and bond markets, for example, is “price discovery”. This is the process through which the interaction of buyers and sellers in the marketplace determines the price at which an asset will change hands. If the central bank substitutes for one of the participants, price discovery will be potentially dictated by the government and the odds for an investor of beating “the market” will be distorted.

The original advice I offered my clients concerned individual investment products. But if the Fed decides the price at which stocks should trade, the true performance game will be over for money managers and then I will probably retire.

 

François Sicart – August 5, 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.

RCA, NIFTY FIFTY, AOL and FANGs

Back in 1999, at the peak of the dot.com bubble, I wrote an article for Tocqueville Asset Management, the firm I had founded in 1985. It was entitled “AOL, RCA and The Shape of History” (Tocqueville Asset Management, December 1999) and was inspired by the chart below, borrowed from that Thanksgiving’s issue of The New Yorker. It compared the 1920s bubble in the shares of RCA to the stock performance of AOL in the late 1990s:

AOL 1

As a preface, I quoted from a report prepared for RCA in 1929 by Owen Young, then Chairman of General Electric, about radio in the 1920s: “[It] has helped to create a vast new audience of a magnitude which was never dreamed of… This audience, invisible but attentive, differs not only in size but in kind from any audience the world has ever known. It is in reality a linking-up of millions of homes.”

It was clear to me that radio — especially when combined with the growth of automobile and air transport — revolutionized the perception of space and time in the 1920s, just as the Internet and globalization are doing today. It also reminded me of a piece of sage investment wisdom: never invest in a company that promises to change the world. The point is not that the most promising companies do not deserve their reputation. Rather it is that, once a business’s prospects are widely recognized, those prospects affect its stock price, often dramatically. This makes the risk/reward ratios unacceptable.

The story of radio is instructive: it did change the world and “disrupted” traditional news and advertising media.  In the six years between 1922 and 1928, sales of radio sets rose from $60 million to $843 million! RCA, as the largest manufacturer of radio sets and also the leading broadcaster, saw its earnings grow from$2.5 million in 1925 to $20 million in 1928; its stock price rose from $1.50 in 1921 to a high of $549 in 1929. Yet few of radio’s early developers and participants made lasting gains from this, as competition and industry changes eroded the hoped-for profits.

As Mark Twain is reputed to have said: “History does not repeat itself but it rhymes.” My own explanation of the shape of History is illustrated in the following graph.

AOL 2

In this illustration, point B will display enough similarities with point A so that economists with a good memory will experience a strong sense of déjà vu. Yet, between these two periods, many structural changes will have taken place – in societies, in world trade and in technology, for example. As a result, point B will resemble point A, but it will also be different enough that precisely forecasting what C will look like or when it will occur is all but impossible. The only certainty (for me) is that there will be a point B.

Investors in RCA at the top of the 1929 speculative boom were right about radio’s fundamentals: the number of households with radio sets grew from 2.75 million in 1925 to 10.25 million in 1929 and, through the Great Depression, to 27.5 million in 1939. But the investors were wrong about RCA’s stock price. As we see in the chart below, included in a November 2002 follow-up paper, the fate of AOL’s stock following the 1990s dot.com boom was not very different.

AOL 3

AOL was selected to illustrate what happened more generally to internet stocks once the dot.com bubble burst. I hope the following graph will awaken in our readers some memories of how history often rhymes:

AOL 4

Source: Wall Street Journal Data Group

What triggered the current article was my watching the stock market performance of many of the new industries, as illustrated by the so-called FANG stocks (Facebook, Amazon, Netflix and Google) as well as those of some other “disruptors.”  The chart below of the performance of the S&P 500 information technology index relative to the total S&P 500 index gives some idea of the disparate performances of the “disruptors” against the overall index. The ratio of the two is close to the level it had reached at the top of the dot.com bubble, in 1999.

AOL 5

Source : FT Market Forces, JUNE 29 2020

Particularly striking is the fact that the technology and health care sectors now represent 40% of the total capitalization of the S&P 500 index. Furthermore, the four companies in the so-called FANG index account for 22% of the total capitalization of the 500 companies in the S&P index. (Note: this index only counts 4 companies since both shares classes of Google, which are listed separately, are included). If we also included Apple and Microsoft, the so-called FAANGM would add up to 25% of the capitalization of the S&P 500.

AOL 6

Source : BESPOKE 4/20/20

Needless to say, the weight of these new-era leaders in the leading indexes has been a major factor in the behavior of the market as we usually follow it. For example, the “narrow” FANG index has risen almost 62% year-to-date while the total S&P 500 index has gained only 4.8%. Furthermore, since the FANGs are included in the broad index, we can infer that the rest of the market has not gained much in this “great” recovery.

One of the most reliable signals of market excess is its narrowing breadth – when the performance of a relatively narrow sample of companies takes off, while the broad market fails to follow. The “Nifty Fifties” in the 1970s were such a sample, which few of today’s investors can remember first-hand. Major institutional investors had been traumatized by the unexpected 1969-1970 recession on the heels of a long and prosperous expansion that had led a number of reputable economists to declare the economic cycle vanquished and recessions a thing of the past. As a result, these institutional investors had concentrated their portfolios on fifty or so companies of the highest quality. They had potential to grow fast and were considered “recession resistant.” This relatively small sample did temporarily outperform the economy and especially the stock market, hence their nickname of the “Nifty Fifty.” (They were also known as the “Vestal Virgins” because analysts could find no fault in them.)

Something similar happened in the late 1990s with the dot.com companies around the development of the Internet, an episode which many younger investors remember, even if they have forgotten AOL and other Internet pioneers.

Both of these episodes were initiated by smart and sophisticated people, expert at articulating the case for the companies or the industries they were promoting. The problem arose when a large crowd of investors joined them, pushing up prices to unreasonable levels. In each of these examples, a small sample gained a price advance against the market at large, which is why the breadth of the market advance deserves attention.

In my view, a similar fad has developed with the FANGs or FAANGMs today. The details and the techno-socio-economic environment may differ, but we should not forget that History usually does rhyme… eventually.

François Sicart – July 3rd 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.

Liquidity vs. Reality

As I began writing this paper, the following headline flashed on CNBC.com: Wall Street rally gains steam, with the Dow up 900 points after record surge in US jobs. It didn’t take long for the media to endorse a new narrative: Trump declares jobs coming back on heels of surprise labor report (FoxNews.com) and Trump: This is a ‘rocket ship’ recovery (Yahoo.com), for example.

To me, these are just the latest instances of how, in the last few years, financial markets have been interpreting any kind of good news, or even the simple promise of good news, as a signal to jump onto the bandwagon of the decade-old bull market and, in today’s language, to adopt a risk-on investment posture.

As these headlines popped up, 30 million workers were still collecting unemployment benefits in the real world. In an interview with the Washington Post Jay Shambaugh, an economist at the Brookings Institution, pointed out that  “… a 13.3 percent unemployment rate is higher than any point in the Great Recession. It represents massive joblessness and economic pain. You need a lot of months of gains around this level to get back to the kind of jobs totals we used to have.”

A combined look at the two charts below makes it clear that the recent stock market bounce is disproportionate to the small downtick in unemployment.

LR 1

 

LR 2

In their May 15, 2020 Market Perspective, Charles Schwab strategists recall that “Some investors were surprised by US stock market gains in April and early May, during a period of dismal economic news. Although the US unemployment rate surged to 14.7% in April, a month in which 20.5 million jobs were lost, the S&P 500© index rose 13%.” Yet, as we know, the bad news continued into late May and early June, and on Jun 6, 2020 The Journal Times of Racine, Wisconsin recollected:

“On March 23, 3.3 million people had newly filed for unemployment under lockdown efforts. At the time, 31,000 Americans had been diagnosed with COVID-19, and about 400 had died. On that date, the S&P 500 hit bottom, down about 34% from the high on Feb. 20 …Fast-forward to today, and there are almost 1.8 million confirmed COVID-19 cases, more than 114,000 Americans have died, and millions more people are out of jobs as unemployment has skyrocketed to almost 15%. Yet the market is 37% higher than it was 10 weeks ago.”

On top of this, in the last two weeks, millions of protestors – mostly peaceful but sometimes violent – have confronted the police and the National Guard, barely avoiding a controversial call for the military to intervene to “dominate” the civilian insurrection.

As a contrarian, I subscribe to the old adage: “Buy when there’s blood in the streets.” However, I usually find it safer to be a contrarian on financial markets than on fundamental economics or politics. And, given the recent behavior of the financial markets, it is more tempting for me as a contrarian to be cautious than to join the crowd of investors afraid of missing out.

In their paper mentioned earlier, the Schwab strategists explain:

“… one of the more powerful forces driving markets has been the massive injection of liquidity from both the Federal Reserve and Congress. The Fed’s balance sheet has grown exponentially, surpassing $6.7 trillion as of May 6, as the central bank bought securities in an effort to support prices and flood markets with cash [See chart below]. Meanwhile, Congress has reacted to the COVID-19 pandemic by doling out more than $2.5 trillion …  to taxpayers and businesses in the form of direct relief payments, loans and grants.” They conclude that section as follows:

“At the March lows, stocks were pricing in the kind of economic collapse we’re currently in the midst of. However, the subsequent rally was less about economic optimism, and more about Fed-provided liquidity.”

LR 3

Recent Bloomberg.com articles (June 3 and 9, 2020) pointed out that much of the most recent stock buying came from (small) brokerage customers. Trading activity among individuals has almost tripled this year, according to data from retail brokerages compiled by Goldman Sachs.

Apparently, retail investors’ buying power has replaced the share buy-backs of corporations, which reportedly were a main factor behind the 2018-2019 stock market advance but have since subsided.

I have long been convinced that there was at best a loose relationship between economic activity and the stock market. Certainly, the financial markets are much more volatile over short or medium-term periods, and the dichotomy between the two can persist for many years.

 

LR 4

I am fully aware that, historically, the stock market tends to turn up or down ahead of the economic cycle. But it seems to me that from a cyclical point of view, the market has discounted by a wide margin any significant recovery from the COVID-associated recession.

In his June 5 “On My Radar” newsletter, Steve Blumenthal mentions that the S&P 500 median P/E ratio now sits at 24.6 times trailing 12-months earnings vs. a 52-year average of 17.3 times. Now that the S&P 500 and the NASDAQ 100 have approached or exceeded the levels reached at the February 2020 stock market peak, the real questions are whether the economic recovery will be as fast as the market seems to have anticipated, and whether some unanticipated developments might still rock share prices.

It is wise to remember that price/earnings and other valuation ratios are not very useful as predictors of the stock market over the short-term but can give a very good idea of future returns over a 7-10-year horizon. (See Crestmont Research et al.)

As for the speed of the recovery, I am willing to accept the scenario of a sharp bounce from the bottom of the recession, when a significant share of the economy was shut-in. But I find it hard to imagine the previous peak in economic activity being equaled or exceeded while many labor-intensive businesses (travel, hotels, restaurants, and possibly shopping malls and office space rental) will not fully recover or fully re-hire their past personnel any time soon.

In terms of unanticipated developments, they are by definition hard to forecast, but they might occur in weak parts of the economy. For example, the May 16, 2020 issue of The Economist foresees “a wave of bankruptcies” ahead, and Steve Blumenthal cites James Bullard, President of the Federal Reserve Bank of St. Louis, warning that: “You will get business failures on a grand scale” (May 12, 2020). Edward Altman, Professor Emeritus at NYU’s Stern School of Business and inventor of the Z-score for predicting bankruptcy, also expects at least 165 large firms with more than $100 million in liabilities to go bankrupt by the end of 2020.

The more I watch the rapidity of daily developments in the economies and the financial markets, the more I am tempted to prepare for a continuation of a W-shaped behavior for the US stock market in coming months. As we observe the appearance of economic green shoots in late 2020 and early 2021, it will be prudent to watch for any over-discounting of the economic recovery by the financial markets.

François Sicart

June 12, 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.

 

Train wreck or a train you can’t miss?

To most of us, the March stock market sell-off might have felt like a train wreck, but today in early June the fast stock market rally may feel like a train you can’t miss. Which one is it then?

These were the thoughts I walked away with from a talk I gave at Intel to some five hundred attendees recently. No, I didn’t hop on a plane to see them in person, as I would have only a few months ago. Instead I joined them over Webex from the comfort of my makeshift home office. The event was hosted by a good friend, Yedu Jathavedan, who is a fellow investor and a true stock market enthusiast. I shared the virtual stage with Jake Taylor, another good friend and fellow investor as well as an author and a podcast host.

The last time I saw Yedu in person, we were outside Portland, Oregon having lunch with our significant others. My most memorable time spent recently with Jake was when he was fighting with a water hose under pressure that came loose on the boat during our sailing trip. Our Intel event was not quite that dramatic — but it was thought-provoking nonetheless!

***

It seems impossible to discuss the current market without reminiscing about March, April, and May. In March we saw one of the fastest market drops in history, which prompted a dramatic shift in investor sentiment — from peak optimism to peak pessimism. This dark moment for investors was followed by one of the fastest rallies driven by a sentiment shift from peak pessimism to a fresh peak of optimism. But that’s not the whole story, let’s look at some key points to gain a broader perspective.

1: The stock market tends to overreact. It usually responds early to expected drops in economic activity, and it often recovers ahead of actual improvement. If you see the stock market as a place where you can acquire ownership of a business, and you see businesses as streams of profits, then it becomes logical that when economic activity shrinks, profits tend to follow. Depending on the nature of the business, sometimes a small drop in sales can lead to a significant drop in profits. It’s referred to as operating leverage. There are certain costs that a company can’t cut quickly (rent, for instance), and profits get squeezed. Not all companies have the capacity to withstand a drop in profits (let alone actual losses) and in times of distress such as an economic recession, they risk going out of business if they can’t pay their bills. In addition, if they have borrowed significant sums of money over the years, the debt burden makes them even more vulnerable, and bankruptcy might be inevitable. It’s something we’ve seen with major retailers lately, but not only, even Hertz, the 102-year old car rental company, recently filed for bankruptcy with some $19 billion in debt.

2: The stock market and the economy are not the same thing. The economy encompasses the entire complex activity of all its participants – earning, spending, investing money, time, and resources, while the stock market represents ownership in a selected number of businesses that play roles in the economy. Another way to frame the distinction is activity (the economy) vs. ownership (the market). Many businesses are not represented in the stock market, mostly because they are too small to have public shareholders. Nevertheless, they may play a very meaningful role in our lives and in the economy. They employ tens of millions of workers, pay taxes, and provide goods and service we value. Think of your local grocery store, your favorite restaurant, your hair salon, et cetera. Small businesses represent about half of private sector employment.

At the same time, the U.S. stock market isn’t just American anymore. Many of the listed companies have presences around the world. When we look at the aggregate sales of the S&P 500, a little under half of their sales come from foreign countries. If you choose to own a representative slice of those 500 S&P-listed companies, you are directly exposed to their success and failure in 100+ countries. Some of them are mature and developed – European Union, Japan, Australia — while others are emerging. When you walk past a Coca-Cola fridge in a remote town in Southeast Asia or South America or Africa, spare a thought for the stream of profits making its way to you, the shareholder, half a globe away.

The peculiar nature of the stock market is the availability of the price of all listed companies every minute of every weekday while the market is open. In the U.S. that’s 9.30am to 4pm, Monday through Friday. Buyers and sellers make their investment choices from locations all over the world. If they like the prospects of a business, they buy, and when they get worried, they sell. As long-term patient value investors, we at Sicart follow Warren Buffett’s wisdom: “Be fearful when others are greedy and greedy when others are fearful.” We know exactly what we want to buy, and we zigzag our way through the markets. We tend to buy when others panic, and trim our holdings when we witness boundless unfounded optimism.

3: In March, the stock market felt like a train wreck heading for further disaster. The stock market drop was triggered by the looming economic recession driven by nationwide shutdowns. With constrained ability to earn and spend money, individuals and businesses were expected to come under a lot of pressure, and so they did. The March drop was an attempt to gauge the extent of the economic damage to come. Now, in early June, we are looking at over 40 million jobless claims, and the biggest plummet in corporate profits since the 2008 recession, 13.9% in the first quarter, with the second quarter likely to be worse. We saw a slowdown on Covid-19 cases, and some states have started to gradually reopen their local economies.

4: Based on the macro fundamentals and the actual earnings trends of U.S. companies, we are far from being out of the woods. We’d like to see the second quarter results, and we understand that there is a very real risk of a second wave of the pandemic later this year. With a second wave, we shouldn’t be too surprised to see further lockdowns. China and South Korea have already selectively restored restrictions in response to repeat spikes in Covid-19 cases. The level of uncertainty in March was so high that legendary investor Warren Buffett, with his 90th birthday around the corner and a dozen market crashes under his belt, decided to not make any purchases in March, and as a matter of fact he made a number of sales. He exited his airline holdings and trimmed his bank ownership. He chose to wait on the sidelines with an ample cash holding ready to be deployed down the road.

5: In late March/early April, investors shifted from peak pessimism to off-the-charts optimism. U.S. stock indices recorded a swift recovery with the tech index Nasdaq reaching a new an all-time high. It almost looks as if nothing had happened. The economy and the labor market have a long way to recovery. Easing lockdowns may offer some relief. It’s hard for us to imagine such an abrupt stock market recovery, and shift in investor sentiment without the unprecedented multi-trillion dollar fiscal and monetary stimulus – more government spending, lower interest rates, and the Federal Reserve’s massive intervention in the markets. This intervention has gone as far as buying high yield bonds, otherwise aptly called junk bonds.

6: A major price vs. value gap. If you see the stock price as what you pay, and value as what you get, today, we are looking at one of the biggest price vs. value gaps. The value of a business comes from its ability to generate sustainable and hopefully growing profits. The profits dropped dramatically for many companies recently. Their new normal level is possibly lower than what we are used to. Despite this backdrop, the stock prices rose back close to the levels recorded early this year, when profits were growing and reaching historic highs. It’s difficult to miss the growing disconnect here, and thus it becomes clear that the stock market as a whole is far from a bargain. In a current moment, the stock market price feels to us like a hugely oversized shoe with a small foot representing the value. The foot has a long way to grow into its shoe or the price level. It’s not impossible for the profits (and the value) to catch up with an excessively high price. If history teaches us anything though, this experience may be a very bumpy ride, and sets us up well for a high likelihood of a sideways market at best. It doesn’t mean though that there won’t be investment opportunities ahead, there will be many, but they will take an extra effort, and caution to find.

***

One of the questions that came up after my recent Intel talk was about our investment principles. The audience wanted to know if they had changed since the March turmoil. As we’ve written in earlier articles discussing investing in times of a pandemic, our principles remain unchanged. We are looking for quality businesses that we can buy at attractive prices and hold for at least for 3-5 years, if not forever. We want to get the most, and pay the least, while avoiding the risk of a permanent loss of capital.

We are reminded here of Benjamin Graham’s wise words, the father of value investing: “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.”

Train wreck or a train we can’t miss? Where others see rising prices and want to jump in at any cost, we see a growing disconnect between stock prices and the value or the fundamentals. Where are we headed next, then? We have a long wish list of investment ideas and we bought a number of stocks in March and early April. We even made minor additions in May, and even now in June. We are far from building full positions in our new holdings, though; we’ve slowed or even paused our purchases. After sales of certain long-term holdings, we still hold a sizeable cash position ready to deploy, and a gold holding which we see as a hedge against uncertainty, and a potential source of cash when needed. Our stock holdings have done a lot of heavy lifting in the last few months making what we consider to be a respectable contribution to the performance.

We may all have more questions than answers when it comes to the second half of the year, but what we at Sicart know for certain is what kind of businesses we’d like to own, what kind of price we are willing to pay, and most of all, what’s really at stake here – the financial well-being of our clients and their families today, and for generations to come. In these uncertain times, we stand by our investment principles, and we intend to act decisively, but as always with a high degree of caution.

 

Bogumil Baranowski

Published:  6/11/2020

 

 

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 clientspecific 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.

 

Preparing to be prepared

I began my investing career in 1969, following the value philosophy enunciated by Benjamin Graham in his seminal book Security Analysis (1934) and the later (and lighter) The Intelligent Investor (1949).

One of the earliest and simplest approaches advocated by Ben Graham was to buy shares of companies selling at or below their net working capital, which he calculated as adjusted current assets minus total liabilities. “Adjusted current assets” included cash and cash equivalents at full value, accounts receivable reduced for doubtful accounts, and inventories at liquidation values. Graham’s reasoning was that, following that formula, you would buy a company at or below its strict liquidating value and would receive for free all its other assets (land, buildings, equipment, etc.).

That original approach was therefore derived almost entirely from the companies’ balance sheets. Less weight was given to profits and even then only actual, realized earnings were included, rather than estimated or projected ones.

From Value to Contrarian Investing

In those ancient times – before 1981 — there were no personal computers. The machines then available were bulky, expensive, slow, and lacked today’s omnipresent and user-friendly software. Similarly, large financial databases were mostly distributed in printed format (like the traditional phone book!) or for use only on very powerful computers; generally, they were not accessible to small users. If you were able to consult the few existing databases and had the patience to search them for the stocks offering the kind of value I define above, you were one of a relatively small number of professionals and life was good for value investors.

Unfortunately, in subsequent years, technology ruined the idyllic advantage enjoyed by early value investors.

First, the introduction of cheap and very fast personal computers, the digitalization of large financial databases and the development of filtering tools put the calculation and sorting of simple ratios such as Graham’s “share price to net working capital” within the reach of even unsophisticated investors and run-of-the-mill financial journalists.

Second, as industry became lighter and supply chains more global, we were still using 19th-century accounting to assess the businesses of the 20th and 21st centuries: traditional accounting, invented when raw materials and manual labor constituted the bulk of business costs, ceased displaying an accurate picture of modern companies’ results and financial strength. In particular, asset-light companies in electronics, service industries, and eventually those involved in or using the Internet had fewer hard assets on their balance sheets. Furthermore, the values of the assets they reported (such as patents, know-how, contracts and other so-called intangibles) were difficult to appraise. Even profit and cash-flow figures increasingly became subject to management choices and interpretations.

Thirdly, in an era like the present when many industries are new or are disrupted by new entities with novel business models, it has become difficult to assess “value” Perhaps as a result, corporate managements have begun to promote criteria other than the traditional profitability to analyze the performance of their companies. Not surprisingly, the financial media and many financial analysts have begun to focus their reporting on these new yardsticks, which now often overshadow more tangible results.

When I started in the investment business, the terms “value” and “contrarian” were practically synonymous: If the shares of a company sold at a low price compared to their calculated value, it indicated that this company was not in great favor with investors and thus presumably cheap. Over time, one could hope to make a significant profit at a relatively low risk if and when the market brought prices more in line with intrinsic values, or sometimes above them. As the notion of value was slowly being eroded by the changes described above, I have found it useful to emphasize the contrarian aspect of my investment discipline, while keeping measures of value as checking tools to preserve the rationality of my stated contrarian/value approach.

The Rise of Contrarianism

In recent years, behavioral finance has taken center stage in the analysis of human strengths and weaknesses in investing, in particular thanks to the awarding of Nobel Prizes to two leading practitioners of the discipline: Daniel Kahneman and Richard Thaler. One of the interesting distinctions that has arisen as a result of all this work is the one between momentum investing and contrarian investing.

Momentum investing consists of buying securities that have had high returns in the recent past, on the assumption that superior price performance tends to continue… for a while.

Contrarian investing consists of purchasing and selling contrary to the prevailing sentiment of the time. The assumption is that crowd behavior among investors generates excesses of optimism and pessimism that create exploitable episodes of mispricing in securities markets.

The paradox I have observed over the years is that momentum investors are right most of the time – especially in rising markets — as what has gone up will usually continue to go up for a while. Since it is difficult to recognize when excesses have become unsustainable, momentum investors can make steady albeit relatively small gains during bull markets. However, since trees don’t grow to the sky, they usually miss the major turning points in a costly way. In contrast contrarian investors usually forego the speculative phases of rising markets, but can realize big gains when it counts, i.e. when bubbles burst and in their aftermath.

A Major Turning Point?

The Coronavirus pandemic and its increasingly predictable economic consequences are likely to trigger a change of tone in the markets after the economic recovery from the 2008-2009 “Great Recession”, in which the decade-long spectacular performance of the stock and bond markets has been recently interrupted by trading volatility. This may foreshadow the imminence of a major turning point in financial markets.

Given the difficulty of evaluating the future in the midst of the current crisis, the question we ask ourselves is how to be a successful contrarian investor today. Without going into the details of specific industries and companies, we discern several macro trends that are likely to affect all major sectors of the economy if and when they reverse.

Interest Rates as a Contrarian’s First Choice

After a peak at more than 15% in 1981, the yield on 10-year Treasury bonds has been in a relentless decline to almost zero at this writing. This means that bond prices have been in an unprecedented bull market for 38 years.

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Declining and very low interest rate, in my observation, tend to make things look easy. Some beneficiaries simply take it for granted, while some speculators and would-be entrepreneurs optimistically credit their early successes to their business acumen and view it as an encouragement to take more risk.

As a rule, we at Sicart do not sell short, though we have very occasionally used “inverse” Exchange-Traded Funds (ETF) that move in the opposite direction to their underlying securities. Nevertheless, it is tempting to look for investments that would benefit from a recovery or “normalization” of interest rates.

I should remind readers that the argument for interest rates bottoming out could have been made at almost any time in the last few years – and it was, including by me. Now, many other economies have engineered negative interest rates, where lenders actually pay you to borrow money! Perhaps more importantly, some credible economists, including Harvard professor and former IMF director of research Kenneth Rogoff, have argued “The Case for Deeply Negative Interest Rates.”

With central banks desperate for new monetary tools, the suggestion may seem attractive, although it is not clear that countries which have adopted that approach (including Japan, Switzerland, and several European Union members) have benefited a great deal. One of the risks of “deeply” negative interest rates is that they would be an incentive for populations to save rather than spend, with obvious recessionary or deflationary implications — at a time when global governments are trying to engineer an acceleration of their economies.

Deflation or Hyperinflation?

Readers will not be surprised to see on the graph below that the U.S. inflation rate has followed more or less the same pattern as interest rates (shown earlier). When inflation rises and erodes the purchasing power of money as a result, interest rates must also rise to compensate savers.

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 My experience with high inflation is rooted in the 1970s, and when I see huge government spending programs and gaping budget deficits, I am reminded of President Lyndon Johnson’s “Guns and Butter” policies during the Vietnam war years, which ushered in the inflationary bubble of the early 1970s. Indeed, it is hard for me to envision how today’s massive income-maintenance policies and the further programs to stimulate the world economies could not, in time, cause a re-acceleration of inflationary pressures.

On the other hand, a number of prestigious economists foresee a continued period of slow growth, over-supply of both goods and labor, and overall dis-inflation if not deflation (declining prices). In particular, Lacy Hunt of Hoisington Investment Management Company and Harvard University’s Kenneth Rogoff point out that rescuing already-overindebted governments by issuing more debt causes a decline in the stimulative power of the new debt and a slowdown in the growth trend of the borrowing countries. Accordingly, some economists anticipate years of dismal growth ahead for the United States and other leading economies.

At this juncture, I find it hard to discern whether inflation will prevail as a result of the massive sums thrown at the world’s economies or if, on the contrary, weak demand and oversupply of goods and services will send the global economy into a decelerating spiral accompanied by debt defaults and declining prices. For someone who, like us, prefers to “be prepared” rather than make predictions, both scenarios are credible and can be envisioned, possibly within different time frames.

Is Gold an All-Terrain Vehicle?

Before I joined him at Tucker Anthony, my mentor and later partner, Christian Humann had already established investment positions in gold mining shares, when gold was trading in the low $40s per ounce, if I remember well. In my early years as an analyst, inflation was accelerating and the portfolios under our supervision benefited accordingly. This lasted for a number of years, but Christian often asserted that gold offers protection in inflationary periods but would do the same under deflation.

Since, at the time, I was primarily concerned about inflation, I did not pay too much attention to the deflationary argument, even though in the late 1970s I authored a report somewhat pompously entitled “Between Inflation and Deflation – The Dislocating World Economy.” The principal benefit from that report was that one day I received a letter from René Larre, then the General Manager of the Bank for International Settlements, congratulating me on my analysis and pointing out that he had made similar arguments in a recent speech. That was the beginning of a stimulating relationship that lasted several years until his retirement.

We usually met for lunch once a year at a restaurant close to the BIS tower in Basel (Switzerland). Because of his participation in regular meetings of the world’s leading central bankers, Mr. Larre was very careful never to share with me anything sensitive. Similarly, by courtesy, I avoided any questions dealing with his classified activities. We just chatted about economics and the general state of the world.

By the late 1970s, however, the price of gold had risen exponentially to around $800 per ounce and had become the talk of the town in financial circles. I casually asked Mr. Larre what he made of this and he answered just as casually: “Of course, I have no particular information, but gold looks a bit toppy to me.”

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Mr. Larre and I were so used to avoiding sensitive topics that I paid no attention to what, in retrospect, could have sounded like a very timely piece of advice. As can be seen from the graph above, it took more than 20 years for gold to resume its 1980 price. I did sell Christian’s very successful investment in gold mines sometime later but my obliviousness to the sagacious opinion of my lunch companion at what turned out to be a major historical top demonstrates my preference (at the time) for theory over trading practicality.

As a result of mulling over these events, I called my former partner John Hathaway, one of today’s foremost experts on gold, to see if he might elucidate Christian Humann’s claim that gold could protect investors in both inflationary and deflationary times. One of the points that stood out for me from a lengthy and learned conversation is that, besides being a hedge against inflation, gold tends to be a refuge against chaos and uncertainty. The kind of deflation that experts like Lacy Hunt and Kenneth Rogoff envision in coming years is likely to be accompanied by many corporate defaults and generally deteriorating balance sheet values. With interest rates at zero or below and the solvency of corporations in doubt, investors will be hard-pressed to invest their savings or their pensions. At that point, gold may once again appear as the ultimate safe haven.

A Contrarian View of Oil

One reason for the strong performance of gold in recent months is that it has benefitted at the same time from a rising price for the commodity itself and flat or declining costs of its two main mining inputs: labor and energy. For different reasons, almost the opposite can be said of petroleum.

Normally, supply and demand for a commodity will trend together, although with significant leads and lags, which cause the main fluctuations in price. This is because increased demand tends to eventually attract higher production, while decreased demand will eventually result in a cut of productive capacity, after shutdown costs and delays.

Atypically, in early 2020, a major disagreement caused a price war between the two leading members of the OPEC-Plus oil producing group – Saudi Arabia and Russia. Russia refused to join the production cuts demanded by Saudi Arabia and the kingdom retaliated by massively  increasing its own production, pushing down oil prices accordingly. When the Coronavirus pandemic then practically destroyed many sources of demand for oil, the world was simultaneously faced with an artificially-inflated supply, and a depressed demand for petroleum.

When oil is not selling, production continues and the excess oil produced must be stored. In April, we reached a point when all storage space, including empty tankers, had been filled. With the resultant shortage of storage capacity to contain the incoming supply of oil, desperate traders and producers briefly had to accept a negative price to get rid of their production and inventory.

 

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Since then, assisted by OPEC-Plus members’ production cuts and some “re-opening” in the most visible world economies, the price of oil has recovered somewhat to around $33 — but well short of the more than $60 it commanded less than a year ago. Judging by the tone of specialized media, the investor consensus for the longer term still contains a hefty dose of skepticism and pessimism about oil. This is why the views of natural resources experts Goehring & Rozencwajg make an interesting contrarian argument.

Goehring & Rozencwajg estimate that, sometime in May, global oil consumption was oversupplied by 21 million barrels per day. If world storage remains around full capacity, “a good portion of that 21million barrels per day will have to be shut in.” This is significant when compared to global oil consumption of probably around 100 million barrels per day before the trade war and virus crisis, and around 80 million barrels per day in April.

They offer an array of reasons why oil production is set to decline sharply in the next few years, if not sooner. Once global storage is full, the global petroleum supply chain will be forced into a “just-in-time” mode, where supply must equal demand. The recent cuts agreed on by OPEC-Plus are not sufficient to balance global supply and demand, but the recent events will also force producers everywhere to quickly shut in marginal or unprofitable wells. For example:

— Old and small “stripper” wells with declining production and estimated lives

— Expensive heavy-oil production from Canadian oil sands

— Production from offshore locations such as the Gulf of Mexico

— Shale oil production from “fracking”, which has boosted US capacity dramatically in the last couple of years but needs constant investment to prolong the life of its fast-depleting existing reservoirs. (In any case, other studies had previously pointed out that much oil shale production was uneconomical below prices in the mid-40s, which few experts are currently anticipating in the foreseeable future.)

According to Goehring & Rozencwajg, most of the diminished production will never be restored because of the costly investment to revive it or the damage to reservoirs. They also point out that the US oil-rig count has fallen 45% in the last six weeks. Such a decline is not rapidly offset once skilled personnel has been laid off.

To end on a silver lining, the reduction in oil production should also reduce the supply of natural gas, which had not benefited from the bull market in oil. According to a note from Mauldin Economics, 32% of total US natural gas production comes from wells that primarily produce oil. They mention that Goldman Sachs expects natural gas prices to double by the end of the year.

* * * * *

Good luck being prepared!

 

François Sicart – May, 27 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 clientspecific 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.

 

Power out, lights out!

Whenever I speak about investing to audiences across the country and around the globe, there is a question that almost always comes up.  For years now, I’ve been asked about the 2008/2009 financial crisis. Someone in the audience usually wants to know what I was thinking at the time and how investing felt in those days. In the coming years, if anyone asks me how March 2020 felt, I have my answer ready– power out, lights out!

As you may know from my earlier emails, Megan and I have temporarily traded our city comforts for cabin life. We have running water up here in the woods, but it’s not drinkable. Instead, we carry 5-gallon water jugs uphill every week or two. These are the same kind of jugs we are used to carrying around marinas provisioning sailboats for trips among tiny islands in the Caribbean. Our internet connection is surprisingly strong – maybe even stronger than the one in our apartment. I suspect our neighbors’ video conferencing and Netflix-bingeing might have had something to do with that! Internet, and water aside, the other essential that we don’t think twice about back in the city – is power!

Only last week, with stronger spring winds, and heavy rains, we had the joy of experiencing a sudden power outage. From a moment to a moment, our life went from busy work with phones charging, laptops on, our old fridge humming – all of which we took for granted — to the complete darkness and silence of the woods. It was a very disorienting feeling for us, city folk, and that’s exactly how March felt to many investors. Darkness and silence, power out, lights out. Impossible to tell which way to go, and what might be right ahead of us.

We at Sicart didn’t know how long the correction would last or how far the stock market would drop. But we did know just what we wanted to buy if prices got interesting. We took advantage of the sharp declines, and started a collection of new investments that we plan to hold for the next 5-10 years and beyond. These are businesses we know well and have been following for years, but we weren’t comfortable with their prices until March. As a matter of fact, I was able to see managements of a few of our new holdings as recently as late February.

The market drop wiped out three years of growth in three weeks. Then the sudden correction was followed by an equally dramatic rally, bringing substantial rapid gains in many of our new holdings. As you know from our earlier articles, we tend to buy stocks only when the price is right.  That doesn’t happen often, so although our trading activity is usually very infrequent, it is decisive. During March and at least half of April, we were active almost every week, nibbling on stocks we like.

At the same time, we had a few “sell” candidates. Some were businesses we had held for a few years which were trading at multi-year or all-time highs. They had already done well, and given the nature of products they sell – canned goods or household necessities — they received an extra boost from investors searching for safety in the midst of turbulent markets.

Other “sell” possibilities were holdings that we refer to as “market protection,” mostly exchange-traded funds that rise in value when volatility or risk aversion spikes. The only market protection holding that we increased in March was our gold holding. We took advantage of the price drop as many investors sought liquidity. With gold prices rising in response to the Federal Reserve’s money printing, this turned out to be a well-timed decision. Gold may remain a long-term holding as an alternative to cash — dry powder ready for future use.

Lights go out, lights come back. As of early May, with US stock market indices having recovered a good portion of March losses, it may seem that the trouble is behind us. But we are not so certain. We are not public-health experts, but from what we are learning, the pandemic may continue for months if not longer. There is also a looming risk of a second wave in the fall, bringing the dangers of premature reopening.

When I have questions about the future, I hardly ever look for answers in the daily news. Rather, I turn to history. Recently Megan lost me for countless evenings to a dense but fascinating read – The Great Influenza: The Story of the Deadliest Pandemic in History by John M. Barry.  It’s over 500 pages long, covering everything you could possibly want to know about the 1918 pandemic, also known as the Spanish Flu. I still believe that Mark Twain was right in saying, “History doesn’t repeat itself but it often rhymes.”

Apart from reading dense history books, we at Sicart spent the last few weeks listening to earnings calls of many publicly traded companies. We were curious not only about how our holdings were faring in these difficult times, but also about how the most vulnerable business sectors are weathering the storm. Those calls reminded us that the first quarter included only one month of lockdowns; the second quarter may look more difficult. We are encouraged, though, by the prompt strategic decisions made by many companies to adapt to the current environment, and position well for the future.

At the same time, we are well aware that a long journey lies ahead of us. Health risks may linger well into the next year.  In response, lockdowns may come and go for some time. If that’s the case, the economic impact will continue, and corporate earnings will reflect it.

For now, the stock market is trying its best to look far beyond the near-term challenges. Some may say it’s too optimistic. Our stock buying wish list remains long, but we have slowed our purchases as prices rose. We plan to remain cautious, acting only when the time is right. Although March and April might have felt like a decade, they were not. The volatile markets may provide us with more windows of opportunity in the coming months.

We cannot predict whether it is the entire market that will drop, retesting March lows, or pockets of the stock market will experience headwinds one at a time. We remain ready to take advantage of either situation. What we do know is that the size, the strength, and the depth of the US economy will ultimately prosper for decades to come, because within that economy there are many wonderful businesses worth owning. We are happy with our market protection holdings, our cash holdings, and a good selection of stocks that we started to replenish in March. We are comfortable holding cash in the short run, but as you know, in the long run, we’d rather own quality businesses with growth potential and pricing power.

Back in the cabin, our first power outage was followed by another one, when one more tree fell nearby. We had learned from experience, and now we keep our flashlights always at hand. And though we might feel we are out of the woods in the stock market, we can’t be certain. There may be more dips, possibly even another bottom for this market before we can say that it’s all behind us. But we’ll be ready: we know what we want to own, and we won’t hesitate to buy it.

As one of our newer clients reminded us recently, turbulent markets could be the best of times to start thinking about your nest egg, your family fortune, and position it well for years to come. We are always here when you need us.

We are hoping you are staying safe and well, and making the best of these peculiar times.

 

Bogumil Baranowski

Published:  5/8/2020

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 clientspecific 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 sprint, a marathon or a very long hike

As I’m sitting today on the porch of a tiny rustic cabin situated next to a creek in thick woods, just a short walk from the Appalachian Trail (a 2,200-mile (3,500 km) hiking trail, the longest in the world, that stretches along the Eastern United States from Springer Mountain in Georgia to Mount Katahdin in Maine), I start to think about the sprints, the marathons, and the very long hikes in life and in investing.

IMG_4766 (1)

None of these scenarios are superior to the others, but it’s helpful to know which one you are in. I enjoyed sprints in high school, especially when my sudden growth spurt gave me a brief competitive advantage over my colleagues. I’ve watched many New York City Marathons as they passed near my previous two Manhattan apartments. And annually, if my schedule permits, I enjoy long hikes in the Polish Tatra Mountains. Each of these three requires a different kind of preparation, mindset, and stamina. A hiker may look slow next to a marathoner or a sprinter – but he’s part of a completely different race.

In investing, we at Sicart have a very clear goal: to keep and grow the family fortunes of our clients over generations. An investor trying to beat the market in a week or a month can resemble a short-distance winner sprinting to his finish line. Others who want to rank high in 1-, 3- or 5-year portfolio manager rankings can be likened to marathon runners. We, on the other hand, keep moving forward long after those shorter time horizons have been passed. Selecting individual investments and constructing an entire portfolio with a very long-term investment horizon in mind requires a different kind of preparation, mindset, and stamina.

Certain investment opportunities are available to us that can be out of reach for sprinters and marathoners. Certain risks that are unacceptable to us are tolerated by those with more short-range investment horizons in mind. We can buy a piece of a promising business and wait for it to turn around and prosper, while few other investors would have the patience. The last two months, we have been gradually collecting stocks that we plan to hold for the next 5-10 years if not longer. We believe that the businesses we own will not only survive this trying time, but also thrive again. At the same time, as always, we choose not to accept any obvious risks of losing it all, a permanent loss of capital in any of our investments. We can’t avoid all possible risks, but we always do our best to limit their impact on the financial wellbeing of our clients.

***

Speaking of hikes… on a warm, sunny April day about a year ago, I went on a beautiful hike in New York’s unforgettable Central Park with my dear friend Jake Taylor, who is a fellow investor, author, nature lover and the host of a number of very popular investing podcasts. A few minutes into our walk, we stopped on a convenient bench, clipped in our microphones, and started recording a hike interview (you can listen to it here).

Jake’s first question was about my childhood. I described the summers we spent in our small lakeside cabin. I would go on long walks with my dog, an eager ginger English cocker spaniel who loved to chase every hare and duck in a 5-mile radius, as he was always convinced that every walk was a hunting expedition — which it wasn’t.

I knew that what Jake was really after was a peek into my earlier childhood during the last years of communism in Poland. He was curious about shortages, empty shelves, lines outside stores and severe travel restrictions, followed by big government spending, and money-printing leading to a devastating hyperinflation. He wanted to know how that experience shaped me as an investor. I had no way of knowing at the time of our interview how soon those two childhood memories would rhyme with our contemporary reality.

As I’m writing to you this week, in the last days of April, 2020, I’m sitting in a rustic cabin in the deep woods of the Appalachian Mountains. Megan and I traded city comforts of our high-rise apartment with a partial view of Lower Manhattan for just the essential comforts available in a forest setting.

At the same time, in recent weeks, many of us have endured product shortages, empty shelves, and long lines outside stores to shop for basic necessities. The US has stopped issuing passports, banned travel and immigration, and the government is embarking on the biggest spending and money- printing spree since WW2. We are too busy with near-term concerns to worry about inflation or even hyperinflation just yet, but if history were to rhyme not only with my early childhood days but with every money-printing experiment in history, the risk of inflation is a given.

The current pandemic shortages in the US or Europe don’t compare with the unbelievable malaise of the 1980s shopping experience in communist Poland, but do offer a flavor of those days. The one thing they certainly have in common is toilet paper becoming a hot commodity!

***

When the 10-year bull market was approaching its peak in the early 2020, many investors were acting like sprinters, celebrating each week’s success. Now that 3 years of gains have been wiped out in 3 weeks, those investors that plan to stick around may feel like they’ve joined a marathon. True wins in investing don’t come quickly, they realize. But it may be helpful to see investing as a very long hike, not very different from traveling the Appalachian Trail. It will take a different kind of preparation, mindset, and stamina to get all the way from Georgia to Maine — or all the way from the midst of one of the most dramatic economic corrections in decades back to a thriving, growing economy.

In the midst of today’s pandemic waiting game (whether it comes to developing a cure, reopening the economy or rushing back into stocks), we need to remember in what kind of race we are. Some of us will consider it a sprint or maybe a marathon, but I believe we are somewhere between Georgia and Maine, pacing ourselves for a very long hike.

We can make the best use of this time though. I’m inspired to see how many of us are doing their very best to stay healthy and productive in trying times. Talking to friends around the world, I also see a great burst of creativity in how things in our personal and business lives are accomplished in new, better, faster ways. I certainly trust that most of the lasting change that will come out of this period will be positive. I also believe that soon enough we will all be able again to meet, talk, and celebrate – face to face.

Bogumil Baranowski

Published:  4/28/2020

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 clientspecific 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 we there yet?

I remember taking long road trips with my parents as a kid. We would pack our small Fiat, and head out. Once we visited the lake country in the northwest corner of Poland, and another time it was the beautiful coast of the Baltic Sea. My favorite destination was the charming, often snow-covered Tatra mountains in the south. And like any other kid, the longer the drive, the more often I’d ask — Are we there yet?

Feels familiar, doesn’t it? Our experience of the last month and a half has felt like a long road trip, a detour from the road we thought we are on to a road we had to actually take. We all had an agenda for this year, I certainly did, but this year had an agenda for us.  Megan and I traded a few trips we planned for a lot of time at home, catching up on reading as well as bringing the world to our table by learning new recipes. My usual hours spent behind a desk have turned into a migration pattern: from the dining table to the couch to the living room floor, with my laptop in tow.

Are we there yet, though? We all want to know when we can resume our daily routines – go back to our offices and gyms, our favorite restaurants and coffee shops. When will we see friends and family in person, instead of on computer screens?  At the moment, opinions on the topic range from weeks to as long as 18 months.

We also want to know when our economy will get back on track. When will stores and many businesses reopen? When can they start rehiring? Finally, in the investment world, we want to know if the worst is behind us and our stocks can breathe again.

This pause in economic activity feels like an airplane stalling. This is a maneuver when the pilot intentionally slows the aircraft and, points the nose high enough to make the plane start falling from the sky. Just like a plane, the economy needs to remain in motion to stay up in the air. Stalling an airplane is my least favorite maneuver, but it’s a required part of the training. I’m not a fan of it, and my stomach definitely doesn’t like it either. Stalling economy gave many of us all a similar sensation.

When it comes to the economy, all the restrictions in movement, and social activities have made it harder to spend money. No one is shopping or dining out or going to the movies. Worse, for a large segment of the population it’s now also harder to earn money. The pain is not distributed equally, but large swathes of the economy are clearly “stalled” at the moment. The silver lining here lies in the fact that we know exactly what caused the stall – self-imposed economic shutdown. We also know what will undo the stall – letting the economy rev up, and resume flight! And finally, we’re all aware that completely lifting restrictions too early could cause more harm than good.

The stock market tends to respond in advance of events. When an economic slowdown is expected, the market drops precipitously. When better days are expected, it usually rallies long before actual economic improvement can be seen. We’ve seen two market extremes lately, a swift sell-off followed by a speedy rally. But we may not be out of the woods just yet.

With poor earnings visibility many companies have suspended their earnings guidance, while others are hinting at much weaker results. Still other companies have yet to report their results and give us a sneak peek of the extent of the slowdown. As patient value buyers, we have been taking advantage of the market drop adding a good number of new holdings, yet we have been acting slowly. Bear markets are a great buying opportunity, but caution is required.

We know well what caused our current economic trouble and stock market turmoil. We also know what will help undo it.  In the meantime, let’s make the best use of this time both by learning new recipes at home, and buying up some great businesses in the stock market, when appropriate opportunities arise.

Bogumil Baranowski

Published:  4/20/2020

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 clientspecific 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.

Buying companies when they lose money

One of my early and most influential mentors, Walter Mewing, began his career before the Great Depression as a messenger on Wall Street. Reportedly, just before the onset of the Depression, he sold all the stockholdings he had managed to accumulate from his small savings in order to buy a chicken farm. Upon returning to Wall Street in the early 1930s, he embarked on a career as a financial analyst and investor. Somehow, he became a partner with my other two (much wealthier) mentors and the much younger Christian Humann, who eventually became my boss and, ultimately, partner.

Walter Mewing had one passion in life: financial analysis. He was devoted to the philosophy of Benjamin Graham, the Columbia University professor who is widely considered the father of value investing. But Walter was no academic. I believe he was self-taught, and had acquired his knowledge in the field and by reading endless annual reports (including the SEC-mandated footnotes to the financial statements). By the time I knew him, he assiduously attended the daily meetings of the National Association of Security Analysts, where listed companies would make presentations and answer questions. Even his vacations were usually spent visiting companies.

On a few occasions, as we were discussing companies going public out of venture-capital firms, he had advised me, “When a company has no earnings yet, there is no upper limit to its share price, because it is selling on the basis of dreams. But be careful when it starts making money, because it will then begin selling on the basis of hard figures from its income statement and balance sheet, and its price is likely to fall back to earth.”

Today, with the recent years’ popularity of “unicorns” (billion-dollar start-ups), many of which are still not earning any meaningful profits, there is a plethora of shares to avoid if an investor wishes to follow Walter’s advice.

On the other hand, I remember that in the late 1990s, when the dot.com boom was raging, the price of many industrial metals had collapsed and many mining companies were losing money. My then-partner John Hathaway asked for a meeting of the senior members of the firm to make his case for what a mining company like Phelps Dodge could earn if only the price of copper returned to the level it had reached several times in previous years. I don’t have a detailed recollection of the episode, and no longer have access to Phelps Dodge trading at that time. But — based purely on memory — John’s case was very convincing to me because I had witnessed this kind of cycle on a few occasions.

When business is good and the price of copper is high, all producers tend to open new mines at the same time, eventually resulting in overcapacity and low prices. Subsequently a few financially-marginal producers might close, while stronger ones simply cut capital spending. As a result, the supply/demand balance is restored. Then a new investment boom will generally get underway, but it takes several years to build new mines and reopen operations, so that copper becomes scarcer and thus more expensive.

The following chart will give an idea of the situation at the time. I believe the price of copper had collapsed to around 65 cents per pound and stayed in that range for a while. But by the early 2000s it doubled to levels it had previously reached in the late 1980s and mid-1990s. (As can be seen from the chart below, it then went on to attain much higher prices, but that is another story and by then our firm had probably sold out of our copper investments.)

Copper Price                     $/lb.

        Buying companies 1

The lesson I retain from that episode is that cycles in industrial commodities prices take time to unfold. Yet because producers tend to behave as a crowd, investing and cutting back at roughly the same time, lagging behind the physical supply/demand dynamics, these companies also tend to oscillate between rich profits and deep losses. Of course, this is my opinion and history does not always repeat itself. But it tends to “rhyme”.

So, how does this apply to the current situation?

The Coronavirus pandemic and its dramatic effect on the world economies pretty much guarantee that some economic sectors will be losing money for at least a couple of quarters and possibly longer. My observation, over the years, is that most financial analysts and the investors who follow their advice do not look much further than a few quarters in advance, if that much. This is especially true when corporations themselves stop issuing projections, as is now the case. Thus, we believe it is likely that the shares of companies in the sectors most affected by the developing economic vacuum — such as hotels, restaurants, airlines, shipping, and many companies involved in tourism or international trade — will sell as if they would never recover.

Of course, some companies will go out of business in the industries most directly affected. Nevertheless, the financially stronger ones will probably survive to enjoy the next boom in demand for a diminished supply of their products or services. As often in periods like this, it will be important for investors to select, not companies that felt comfortable and aggressive when liquidity was plentiful and readily accessible, but those that have low debt, ample reserves of cash, and the ability to survive several quarters of negative cashflow without curtailing essential operations.

One last memory flash: the 1973-74 bear market erased almost 50% of the Dow Jones Industrials value in almost two years before it was concluded by a double (or W-shaped) bottom in the three months between October and December 1974. In view of the rapidity and violence of both the decline and recent bounce in 2020, a similar pattern would not be overly surprising. Please also note that the 1974 economic recession only ended officially in March 1975.

 

Dow Jones Industrial Average from January 1974 to February 1975

Buying companies 2

Source: A History of Stock Market Bottoms – TheIrrelevantInvestor.com — Dec 27, 2018

 

* * *

 

Just as those patients with otherwise good physical health will likely survive the Coronavirus pandemic and recover from intensive care to prosper and possibly help other patients thanks to a newly-acquired immunity, the financially-stronger and more resilient companies will likely be the survivors from the economic recession and contribute to the future recovery of the country’s whole economy.

François Sicart – April 15, 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 clientspecific 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.

Rethink, Reset, Restart

One way or another, we have all paused in the last few weeks. It’s been over a month since Megan and I were sitting on packed suitcases ready to fly first to Paris, and then to Warsaw. Our return flight would have been just a day before the ban on flights from Europe was imposed. Looking back, we are glad we decided to forego our trip. Since then though, with the first day of spring already behind us, we have all had a chance to rethink, and reset as we wait to restart our daily routines.

On the investment side, our approach and our philosophy haven’t changed one bit. We manage family fortunes over generations. We are disciplined, patient investors, and we see ourselves as business owners. Even if the stock market were only open once a month instead of every business day, even if benchmarks and indices didn’t exist, even if the news stopped reporting on the market’s ups and downs, we would invest exactly as we have for decades. We buy quality businesses for their streams of profits, and we want to pay the lowest price possible for them.

With the major indices currently down 25%-30%, and the median U.S. stock price reduced by almost 50%, the current pricing of many businesses looks a lot more compelling. Yet while we have started to “nibble” on many stocks we like, we remain cautious. We still hold ample dry powder to deploy (cash, market protection, and certain holdings we could liquidate to raise cash; for details please refer to our earlier posts). After a closer look, we see that the weakest companies have indeed fallen a lot in the last few weeks, but the highest quality stocks (with some exceptions) have yet to give up large percentages of their bull market gains. If history is any guide, all bull markets come to an end eventually. However, they often bottom out gradually, as investors try to still hold on to their stocks. I’ve heard this phenomenon compared to a cozy bull market turning into an uncomfortable bull ride as volatility spikes.

It’s a good reminder that at the end of each day, every single share of every single company traded on the stock exchange has an owner. There are no shares that nobody wanted that were somehow left behind. This was true even on the worst of recent days, March 16, 2020, when the U.S. stock market dropped 13%. It was the second-largest daily drop since 1987, yet at the closing bell, all shares had an owner, too.

So, who are these new owners, in bear markets? Legendary banker J.P. Morgan is believed to have said that: “In bear markets, stocks return to their rightful owners.”

Then what do these “rightful owners” look for? There are at least three qualities to evaluate in a potential stock investment: profit, growth, and the balance sheet.

When the market is rising, everyone forgets the profit and the balance sheet; what seems to matter most is growth at all cost. WeWork (co-working spaces) was a prime example of the growth frenzy of the last bull market. Long before the pandemic kept us at home and froze much normal economic activity, public markets started to wise up and resoundingly rejected the WeWork initial public offering. It was a swift transformation from a $50 billion valuation to a near bankruptcy.

In times of distress, balance sheets come to the fore. How does a business finance its operations? How much has it borrowed, how much does it owe, when does it have to pay, how much can it self-fund its operations from its profits? These are the questions on everybody’s minds today as we watch convulsions in the credit markets. Until recently, all assets seemed risk-free. Investors chased an incremental percentage point of yield, conveniently overlooking whether or not the company would be able to pay back its loans. That’s changing now, as investors rethink their investment choices, resetting their expectations and risk preferences. It’s helpful to remember that a 30%+ drop in the market will take a 50% rally to recover to a starting point. A 50% drop will take a 100% rally to recover. The importance of not losing money has come to the forefront of everyone’s attention.

Beyond market’s constant mood swings from optimism to pessimism, though, what we believe truly counts in the long run is a company’s profits. Do we own a business with lasting, growing profits (otherwise called cash flows)? And finally, what do we need to pay for each dollar of annual profits? As value buyers, the less we have to pay, the happier we are.

To make good investment choices, we think in terms of the next 3-5-10 years, trying to see where the businesses we buy could be in the following years, as pent-up demand is unleashed and our former lives restart.

***

Our daily routines have changed for now. In the first days of our self-imposed lockdown, Megan asked me how I would send my shirts to the dry cleaners. I told her that I wouldn’t be needing fresh shirts every day for a while. I haven’t actually worn a suit in over a month, which might be a record in my adult life.

As you might remember from my earlier articles, I find daily news, and minute-to-minute updates highly distracting. In the first days of the self-imposed lockdown, we spent way too much time trying to track each new development. Since then I’ve returned to re-reading annual reports, refreshing my memory about so many good businesses on our wish list.

Since I’m saving somewhere between five to ten hours a week on my commute, I’ve found another replacement for the daily news. I signed up for online courses with Udemy, which I highly recommend. I’ll share more in the coming weeks, but if you need a healthy distraction for your mind in these peculiar times, taking an online course could be an idea worth entertaining!

All the same, we at Sicart have had full days in these last four weeks. Between calls with clients, research, and trading, days seem to fly by. I have also been writing, and preparing some items on weekends to have a head start before each new week. For us as stock pickers, it’s been a fruitful and exciting time.

While we remain uncertain about the near future, and long to know when we’ll be able to resume our social activities that we once took for granted, let’s not forget what remains certain. However long the pause, we believe that the businesses we own will continue to sell goods and provide services everyone wants, and our investments will once again, we believe, deliver respectable returns, pulling our portfolios forward.

Maybe this crisis will bring a silver lining, too. In many ways it has brought us closer, made us more compassionate, allowed us to slow down. Meanwhile we’ve been relying on technology to keep us connected, keep us working, and keep us entertained. Until it’s over, let’s stay home if we can, let’s avoid crowds, and let’s make this a time to rethink, reset, and restart.

Bogumil Baranowski

Published:  4/7/2020

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 clientspecific 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.

Second-Order Thoughts

The always-stimulating Farnam Street blog recently discussed the classic example of The Chesterton Fence. In a 1929 book, The Thing, English writer G.K. Chesterton, offered the following advice:

“Do not remove a fence until you know why it was put up in the first place.”

As Chesterton explained, fences don’t just happen. They are built by people who had some reason for thinking they had a purpose. Until we establish that reason, we have no business taking an ax to them. This observation has become one of the pillars of a discipline that has recently become popular in action-oriented thinking circles: second-order (or second-level) thinking.

As it applies to investments, second-order thinking was clearly illustrated by Howard Marks, in his book The Most Important Thing (Columbia Business School Publishing) and his periodic letters to clients of the firm he co-founded, Oaktree Capital Management:

“First-level thinking says: ‘It’s a great company, let’s buy the stock.’ Second-level thinking says: ‘It’s a good company, but everyone thinks it’s a great company, and it’s not. So, the stock is overrated and overpriced; let’s sell.’”

From my point of view, the second-order approach has several attractive features:

  • It clearly is different from the usual approach and, by definition, to be better than the majority of investors, you must first behave differently. (See Howard Marks, above)
  • It is contrarian, but in a thoughtful way rather than merely as a reflex.
  • It forces one to look beyond the immediate future, which is one way in which we at Sicart try to differentiate ourselves from the crowd of analysts.

So, how should we look at today’s situation from a second-order perspective?

Most world economies have struggled to recover even partially from the so-called Great Recession of 2007-2009. Now, the economic consequences of the Coronavirus pandemic almost guarantee that the world economy is about to fall into recession. Forecasts of recovery and future growth are being scaled back accordingly. So, the consensus looks to and prepares for a recession of still unknown length and depth.

However, to offset the fast-deteriorating outlook, most governments are devising (and promising to soon start implementing) stimulus programs of unprecedented sizes. These programs include what central banks can still do with their few yet-unused tools to sustain liquidity in economies and especially financial markets. But they also incorporate large fiscal spending to sustain jobs and incomes, as well as unprecedented programs to protect or boost activity in industries threatened by the pandemic.

Unfortunately, if there is one thing that history has taught us, it is that it is easier to throw money at a deteriorating economy than to “take away the punch bowl just as the party gets going,” as the late Fed Chairman William McChesney Martin famously advocated. There is a good chance, therefore, that pandemic-relief and stimulus programs will continue well after the health of populations and economies have turned around and started to recover.

To summarize, a first-order look at the current situation tells us that we are taking the measures required to fight a developing global recession. A second-order look tells us that these measures will likely outlast the recession, eventually turn out to threaten budget balances, and possibly trigger a revival of inflationary pressures.

Today, inflationary pressures are very far from the minds of younger observers. The last peak in U.S. inflation was almost 40 years ago and we have since experienced declining and then stubbornly-low inflation, so that younger analysts and investors may have read about it in history books but they don’t remember personally experiencing it.

s 1

Most current observers are more likely to draw parallels with Japan’s contemporary struggle against deflation than with Germany’s hyperinflation under the Weimar republic, between the two world wars.

s 2

s 3

My First Encounter with Inflation in the Midst of a Recession

Between January 11, 1973 and December 6, 1974, the Dow Jones Industrial Average lost over 45%. The crash came after the collapse of the Bretton Woods system over the previous two years, then the US dollar devaluation, the Watergate political crisis, and the first oil crisis in October 1973.

As I was trying to remember this first experience of my career with inflation rising in the midst of a global recession, I came across a paper on “The 1972-75 Commodity Boom” which confirmed that paradoxical occurrence (Brookings Papers on Economic Activity Vol. 1975, No. 3, 1975 – Richard N. Cooper, Robert Z. Lawrence).

Thanks to the foresight of my mentor and boss at the time, the late Christian Humann, our portfolios had been holding large positions in shares of raw materials and energy producers. They continued to rise as the overall market decline got under way, significantly helping our performance that year.

In their paper, Professors Cooper and Lawrence summarized: “An extraordinary increase in commodity prices occurred in 1973-74. Even leaving aside crude oil as a special case, primary commodity prices on one index more than doubled between mid-1972 and mid-1974, while the prices of some individual commodities, such as sugar and urea (nitrogenous fertilizer), rose more than five times.” They added that the sharp rise in commodity prices had startled most observers, as it came on the heels of apparent oversupply in 1970-71.

The mechanics of the cycle in industrial commodities need to be kept in mind. Capacity closures are not easy or cheap to implement and are thus often delayed. But once they have been made, it usually takes several years to plan, build, and ramp up new capacity. So, the workings of supply and demand are not well synchronized and can be slow to develop.

 The Intriguing Case of Oil

Even though oil was excluded from the 1975 Brookings study because of the volatility caused by the oil embargo and the creation of OPEC in 1973, it has proven to be an excellent case study of such cycles.

The two charts below are of particular interest.

The first one illustrates that, after the investment boom that followed the second oil shock, triggered by the 1979 Iranian revolution, oil prices began a 20-year, 60 percent decline, except for a brief rebound during the Gulf War.

The second shows that the oil price is now back to its 1990s level of around $20 per barrel.

s 4

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Of course, there is little doubt that there is a long-term tendency for the world to move from fossil fuels such as oil, gas and coal to alternate sources of energy such as solar, wind, etc. But in a medium-term perspective, for cost/price and infrastructure factors, as well as regional and economic development considerations, this transition is likely to remain relatively marginal for a number of years.

The proximate causes of the recent price decline are:

  1. The destruction of demand in travel, tourism and transportation activities due to the Coronavirus pandemic
  2. The feud between Saudi Arabia and Russia for effective control of the OPEC-plus group

Presumably, these two influences may have some lasting impact, but they should nevertheless prove temporary. With regard to the Russian-Saudi feud, although the two main protagonists disagree on many points, they seem to agree, openly or not, that a lower oil price will help reduce or eliminate the threatening competition from America’s rising production of shale oil.

It seems that this part of their agenda is meeting with some success. According to brokers Wood Mackenzie, a tenth of the global oil production may become uneconomic at current prices. This would represent about 10% of the global supply, estimated at 100 million barrels per day by the International Energy Agency. Heavier oil production from Venezuela or Mexico requires prices above $55 a barrel; Canadian oil sands need $45 a barrel. RS Energy Group estimates the break-even price for oil from the best shale-producing areas is $43 a barrel. Meanwhile, Saudi Arabia or Russian oil may cost $10 a barrel or less to produce. (All above data from the Financial Times, 3/22/2020)

US shale operators will suffer rapidly because their reservoirs tend to be depleted over much shorter cycles. The shale revolution allowed the US to become the world’s biggest oil and gas producer, with a record oil production of 13 million barrels a day — estimated by some analysts to shrink by 2.5 million barrels a day by 2021. Meanwhile, capital spending across the shale sector will fall from $107 billion last year to $64 billion this year, according to the consultancy Rystad Energy.

Jamie Webster, of the BCG Center for Energy Impact, summarizes his view of the situation as follows: “Shale thrives at $100 a barrel, survives at $50 and dies at $25.”

There will come a time when the Coronavirus pandemic is only a very bad memory. Meanwhile, both Russia and Saudi Arabia reportedly need oil at prices much higher than the current price-war levels in order to meet their governments’ budgetary obligations. It seems likely that, sooner or later, they will declare victory and settle on an acceptable oil price. Then, the lowest-cost and financially strongest shale producers may not “thrive” but they are likely to survive profitably after their weakest competitors have disappeared and global demand volumes have recovered.

My experience with highly cyclical producers of industrial commodities (such as copper and other metals) is that the best time to buy shares of the financially stronger companies is when the industry is losing money. The recent behavior of the oil price has not escaped the media, who shape our view of the world, as the Financial Times, among others, reminded us on 3/24/2020:

OIL INDUSTRY FACES BIGGEST CRISIS IN 100 YEARS

 This may be a good time to remember the famously contrarian record of the most sensational newspaper headlines.

Second-order Look: Watch for a New Inflationary Cycle?

Price inflation is often described as “too much money chasing too few goods.” While it is clear that money and liquidity have been plentiful in recent years (quantitative easing, zero percent interest rates, etc.), it would be harder to argue that there have been too few goods available to buy. Globalization, the offshoring of production to cheaper manufacturing regions, as well as progress in productivity and logistics have made ample supplies of most goods readily and cheaply available.

On the other hand, recent experience may have radically altered the most efficient supply chains that were developed in the last couple of decades. This, and maybe some new protectionist trade policies, may reverse the race to the cheapest possible products.

Meanwhile, trillions of dollars are in the process of being injected into the world’s leading economies and further stimulus is already being planned. As I mentioned, it will be easier to spend that money than to withdraw it when it is no longer needed for non-inflationary growth.

William White, former Head of the Monetary and Economic Department at the Bank for International Settlements, and Deputy Governor of the Bank of Canada, just wrote a paper for the Official Monetary and Financial Institutions Forum, in which he discusses, among other topics, the unintended consequences of past policies (OMFIF, 23 March 2020). He concludes that “It would be wrong to assume a zero threat of higher future inflation.”

The drawback of second-order thinking is that it may suggest investment opportunities for a time horizon well beyond the impact of first-level thinking. But it takes time to stand out from the crowd, and we plan, as always, to be patient.

François Sicart – March 30, 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 clientspecific 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.

Investing in times of pandemic

The last few weeks have felt like years to most of us. Out of nowhere, we have been wakened from a low-volatility, 11-year-old bull market to a stormy market crash. We’ve seen record-breaking daily moves, mostly downward. Three years of gains have been erased from the major indices in as many weeks, a process that feels like taking a slow escalator up and a fast elevator down.

To me the wakeup call came in the last day of the most recent conference I attended. It was in late February in Florida, and after spending a few days with CEOs of major US companies, I finally saw the headlines reporting town lockdowns in northern Italy. In response I soon decided to cancel my trip to Europe … then two more trips. Not long afterward, we all started working remotely.

Last week, from the comfort of my home, I had the great pleasure of joining MOI Global’s John Mihaljevic for an impromptu virtual Q&A session aptly titled “Intelligent Investing in Crisis Mode.” Among John’s guests sharing their perspective were Howard Marks, Tom Russo, Guy Spier, and other highly respected value investors from around the world.

Before we dove into the topic of building a portfolio in the time of crisis, John asked me how my daily routine had changed in the last few weeks. My answer: I stay home, I save an hour on my daily commute, and Megan and I have time to bike almost every day to get some exercise. I also admitted that until a day or two ago, I was reading far too much daily news keeping up with the incessant pandemic updates. I decided to change that. Otherwise, it’s business as usual – patiently looking for ideas.

As you might know from our earlier posts, we at Sicart entered this treacherous time in what we believe is a very favorable position. We have ample cash. In addition, we hold what we call a “market protection” in the form of gold holdings, and certain exchange-traded funds that go up when volatility and risk spike. We positioned the portfolios this way not over the last few weeks, but over the last few years.

Ahead of a likely economic slowdown, we had also consciously pruned our portfolio to eliminate overvalued late-cycle names, replacing them with stocks chosen on the basis of their financial strength. We had no way of knowing that a pandemic was around the corner, but we have been cautious for a while. We wrote and talked about it extensively. Market valuations were undeservedly high, fundamentals were stretched, and we believed that we were due for a reality check in the form of a market correction. The panic selling triggered by the virus, followed by the expected drop in demand and diminished economic activity, happened to be the catalysts.

Just as we had no way of knowing when the record-breaking bull market would end, we can’t predict the duration of the current accelerated market sell-off.

As we always have, we will respond slowly and gradually. Mirroring the way we’d been trimming our holdings during the market’s rise, we will begin adding to current ones, and starting new holdings as we wait for the market to bottom. I’ll emphasize “gradually.”

The slow pace of acquisition saves us from having to time the market or attempting to call where its top or bottom might be. At the same time, it gives us the opportunity to build long-term positions in great businesses that would otherwise be too expensive to offer a sufficiently attractive return. This is a moment to start building a portfolio for the next 3-5-10 years and beyond.  

We see that a median U.S. stock is already down 50% (Bloomberg, Value Line Geometric Composite Index), and that market benchmarks are off by one-third. As dramatic as that drop may seem, we believe there is room for further correction, especially among stocks that have been part of the most recent market rally. The ultimate sign of capitulation would be a sell-off in the market darlings of the last few years as panic-stricken investors sell to raise cash. This may not occur soon, and it’s possible that the market darlings might be safe this time around. If we do see a sell-off among the high fliers of the last few years, we believe, it would be an indicator that the bottom is closer.

As we wait for the market shakeout to play out, we started to “nibble” on some stocks. We have a long wish list of those that we’d like to own at the right price.

What are we buying? There are at least three big buckets of opportunities ahead, in our opinion. The first are companies that should experience limited impact from the demand drop triggered by travel and movement restrictions. That group includes a number of companies that fell as much as the market or more. We believe that their sell-off was driven mostly by investors selling indiscriminately, regardless of the underlying quality of the business. These stocks were further hurt by investors who quickly needed to liquidate their holdings under pressure. We’ve made some small acquisitions in this segment of the market.

The second group consists of companies that will experience some impact from current restrictive policies, but should endure on the basis of their position, financial strength, and business quality. Among them, we find a number of stocks whose prices have already come down. This gave us the opportunity to initiate small positions, but we believe we may see lower prices down the road. These are companies that are often too expensive for a disciplined investor, but in times like this may be within reach, and offer sufficiently attractive returns from current prices.

The last group are companies more directly impacted by the economic shutdown. This group has likely the largest possible upside given their turnaround potential in the future. However, they could also carry the real risk of a permanent loss of capital. We are currently refining a short list of companies that we may buy as a basket in order to diversify the risk while still capturing the potential — and possible — growth. Naturally in the last group, we will do our best to avoid any companies that demonstrate an obvious high risk of a total loss.

How will we fund our acquisitions? We have three sources of capital ready to deploy. Despite some minor purchases in the last few weeks, we still hold ample cash. It can be used on whatever timetable appears most productive. The second source of dry powder will be our market protection, which is playing its role for now. Our third source of capital will come from a number of holdings we’ve added over the years which not only held up well in the sell-off, but also offer products and services that are considered necessities. Demand for them will probably remain steady or even spike as shoppers stock up on canned soup and toilet paper, or churn through their phone and data plans as they work from home or binge-watch TV shows.

***

Yes, this is a “staycation” we didn’t ask for. For us, as disciplined patient investors managing family fortunes for generations, it presents one of the most compelling buying opportunities in our investment careers. While many market observers obsess over where the bottom of the market might be, we act slowly but decisively. There has never been a bottomless market in the history of investing, and this one will have a bottom, too.

As one of our newer clients told me recently, “If I wasn’t with you already, this would be the perfect time to join!” In fact, we are on-boarding a new client in the midst of this turmoil. If you aren’t yet one of our clients but feel that you’d like a steady hand in these times, we’d would be delighted to have you join us.

***

With a stock market sell-off in background, and a looming economic slowdown, policy makers are searching for quick immediate fixes, utilizing zero interest rates, open-ended quantitative easing, multi-trillion-dollar bailouts — unprecedented money printing, borrowing, and spending. We might be trading one problem for another down the road. When too much money is chasing too few goods, inflation usually follows. This reminds us again that investing constantly requires us to see not where the ball is, but where it will likely be.

The government’s strategy may help soften the economic impact of the current situation but we might need to wait months or even longer to see a real improvement. Let’s keep it in perspective, though: this may feel like wartime in the stock market, but no production capacity is being destroyed and no bridges have been burned. It’s just that some assets may change owners at a lower price.

My grandma, a woman of boundless optimism, told me this week, “I was born during the Great Depression, lived through World War 2, the Nazi occupation, 45 years of communism, and martial law in 1980s Poland — this too shall pass.” It’s a good time to call your family and friends, since they too might have wisdom, and a new perspective to share in these unusual times.

I was supposed to go to Italy in May to attend the wedding of dear friends. That’s not going to happen now. I like to think that it was postponed rather than cancelled, and they have already rescheduled it for May 2021! It’s easier to look at everything else around us as postponed rather than cancelled. The world will go on. Pent-up demand will return. In the meantime, our best choice is to stay home and stay out of the way, for our health and that of everyone else.

Bogumil Baranowski

Published:  3/23/2020

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 clientspecific 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.

Bring out the towels

Warren Buffett has famously quipped that we only find out who has been swimming naked when the tide goes out. During the spectacular bull market since 2009, many “professionals” and people relying on their advice have insisted that we at Sicart were holding too much cash in our accounts. Our guess is that many naked swimmers who followed their advice are now beginning to sell shares indiscriminately, prompted either by panic or lack of liquidity. Nothing new there: this is what typically happens after periods of greed, thoughtless complacency, or fear of missing out in a rising market.

In our view, the Coronavirus epidemic was not directly responsible for the recent upheaval: for a while, the stock market had been looking like a bug in search of a windshield. Following Minsky’s hypothesis, we believe that financial corrections and crashes do not need a proximate cause in order to happen: in free markets, there is a natural tendency for investors and business people to oscillate between periods of excessive optimistic risk-taking and periods of fear-driven financial timidity or retreat.

Famous Keynesian economist Paul Samuelson used to joke that the stock market had predicted nine of the past five recessions. Nevertheless, it has now become clear that the Coronavirus crisis will transform whatever financial correction we might have suffered spontaneously into an economic recession.

We have lived through a dozen-odd bear markets since the1960s. Most have caused losses equivalent to the current decline of around 25% from the stock market high in February. But a few suffered larger and/or more extended losses, notably:

36% in 1968-1970 in 18 months

50% in 1973-1974 in 21 months

28% in 1980-1982 in 21 months interrupted by an energy-related spike in 1981

34% in 1987 in only 3 months

49%% in 2000-2002 in 30 months

56% in 2007-2009 in 17 months

(Sources: Global Financial Data; msnbc.com research)

 As it happens, though I certainly do not accept responsibility for these setbacks, I witnessed all of them as a concerned investment professional. Except for the flash crash of 1987, all were accompanied or preceded by economic recessions. This is why I mentioned in my previous paper that bear markets associated with economic recessions tend to dig deeper and last longer than those resulting from a mere correction of asset price due to a change in the investing crowd’s psychology.

At the moment, enough damage has already been done to all industries that benefited from the world’s globalization (including labor-intensive airlines, shipping, hotels and restaurants, tourism and leisure activities, as well as products resulting from complex and far-reaching supply chains, such as electronics) to all but ensure a recessionary environment for at least the balance of 2020. GDP will slow or temporarily decline and, in all likelihood, so will profit margins and corporate earnings.

To counterbalance these considerations, it is now clear that, in a more or less coordinated manner, most major economies are in the process of devising and beginning to implement very strong measures to halt the progress of the Coronavirus and mitigate the impact of the pandemic on employment and living standards.

As usual, the sequence of events will determine the extent and shape of the damage or the success of these countervailing measures. My guess is that the progress of the virus and of the market correction will initially be faster than the benefits of any fiscal stimulus, especially where infrastructure projects are contemplated. So it is likely that we will see statistics of declining economic activity before the main benefits of the planned stimulus programs are fully visible.

Between the heightened market volatility and the sharp losses of the past couple of weeks, it is tempting for contrarian/value investors like ourselves to use the near-panic to buy more aggressively. As I mentioned last week (https://www.sicartassociates.com/the-point-and-challenge-of-being-prepared/), we have already used the first, emotional phase of the decline to put a portion of our cash reserves to work by adding to some existing positions and starting a few new ones. The main idea was to wait for confirmation of an economic recession, assuming that (as they often have in the past) it might drive the markets lower and create even better buying opportunities.

Besides confirmation of an economic recession, the other signal I would like to see is a much bigger correction of the FANG-related indexes (Facebook, Apple, Netflix, Google and a few others). These bull market favorites, after driving the overall market higher for a few years, have participated in the most recent decline, but not to the extent that previous bull market favorites did after reaching greatly overvalued prices.

As panic spreads, however, it will probably put disproportionate pressure on stocks that account for a large proportion of major indexes: the mutual funds or exchange-traded funds that own large positions in these index stocks will have to sell them as the funds are liquidated by hard-pressed, overextended investors.

Things may have moved a little too fast for comfort, but major investment opportunities seem to be coming closer and closer.

 

François Sicart – March 18, 2020

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 clientspecific 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.

Dealing with Uncertainty

“Investing is dealing with imprecise assumptions tainted by an imperfect world haunted by uncertainty” – that’s how I described investing in my 2015 book – Outsmarting the Crowd: A Value Investor’s Guide to Starting, Building, and Keeping a Family Fortune.

Uncertainty is always a part of investing. We never know exactly what the future holds, but when it comes to specific quality businesses that we like to own, we can make the best educated guess about their future, and if we buy them at the right price, the odds are in our favor that they will turn out to be good investments in the long run.

Last few weeks, and likely the coming months, will probably be one of the most uncertain times in our investment careers. It is important to understand well the nature of this uncertainty though. There are at least three sources of uncertainty we are facing: the impact on public health, the impact on the economy, and the impact on the stock market.

Of course, at very top of our concerns is a very real public health risk associated with the spread of the new virus. We hope that all the right steps will be taken to slow down the spread, and offer care to those in need. We understand that the very least we can all immediately do to help as individuals is stay home, work remotely if possible, and otherwise avoid crowds. Needless to say, if anyone who is not feeling well should stay home as well.

The impact on the economy is a big open question mark. We see it in two dimensions though. How deep of a cut in the economic output we may expect, and equally important, how long it will last. We will continue to have a better understanding of both dimensions as time passes. The bright light at the end of the tunnel for us is the recovery that will follow though. What encourages us the most is the pent-up demand that will be unleashed once it’s safe again to not only go back to our normal routines, but maybe even treat ourselves for the time spent in four walls with Netflix and some hastily chosen snacks. Let’s think for a minute of all those small and big pleasures we are saying no to these days — from lovely dinners with friends to trips to sunny Italy!

The impact on the stock market is much more visible and immediate than the impact on the economy. Stocks trade five days a week, and every second of the trading day all participants try to do the impossible — guess the short-term impact of the virus on the economy, and corporate earnings.

As investors, we see ourselves as business owners. When we buy a business, we want to hold it ideally forever, but at least for 3-5 years. As you know well from our earlier articles, when we buy a business, we buy its stream of profits from now until the end of its existence. One quarter, one year even have a limited impact on the long-term earning power of a business. That quarter though, especially a weak quarter has a big impact on the stock price. That’s where short-sighted investors panic, and sell a stock, while long-term investors come in and buy the stock to hold it for the long run.

As dramatic as the daily stock market moves can be, we never see volatility as risk, but as an opportunity for a patient disciplined investor. The risk to us is a possibility of a permanent loss of capital. In times like this, the shareholders of the more vulnerable companies with weaker businesses models, and higher leverage can experience a permanent loss of capital or close to it. That’s a loss that can’t be recovered. The stock price drop in a strong quality business is just a passing paper loss though.

In any market sell-off or times of economic weakness certain industries may be affected more than others. This time around anything related to travel has taken the biggest, and the most immediate hit. Airlines, cruise lines, hotels, restaurants have all experienced a big, and sudden drop in demand, thus a drop in revenues, and given their high fixed costs, likely big losses. Some of them might be in a position to weather the storm, others might not be so lucky. We don’t own any stocks in those industries. We made a frequent point in our previous articles that what we don’t own matters as much as what we do own.

After few weeks of record market swings, the obvious question arises – when does it end? Where is the bottom of the market? Now, if you followed our articles over the last few years, you know that we couldn’t time the top of the market. Today, we won’t be able to time the bottom of it either, we will do what’s possible though, which is gradually buy, the same way we were gradually selling. We are slow when we want to be, and we can act fast, and be decisive when we need to be. We plan on building positions in existing holdings, and expand our portfolio with new picks from our long wish list.

Over the last few years, we grew increasingly uncomfortable with the stock valuations, and the excessively high level of the stock market. For that reason, we grew our cash position, we also added what we call – market protection in the form of a gold holding, and a few exchange traded funds that go up when volatility and risk aversion spike. That gave us a softer landing in this dramatic sell-off, and has already given us dry powder to deploy. Again, we are acting very slowly.

We are long-term patient disciplined investors, and we manage family fortunes over generations. The last few weeks, we have heard from many of our clients who appreciate the steps we took at the top of the bull market, and the steps we are taking now. We even have a new client join us in the midst of these uncertain times, and we are grateful for this vote of confidence.

We know that many of us have seen empty shelves in our local stores, many of us stocked up on canned food, cancelled trips, changed plans, and severely curtailed our daily and weekly routines. Let’s not forget though that it’s not forever, it’s just for now, the same way, the economic weakness, the stock market sell-off are not forever, just for now. The U.S. economy is big, strong, diverse, and the vast majority of the U.S. businesses are here to stay, and they will prosper for generations to come. In the midst of this storm, we may have a rare chance to buy many more of them at enviable prices, and we will do so. Again, very slowly.

We hope you and your families are staying safe, and taking necessary precautions. We are always here; we are always reachable if you need us.

Bogumil Baranowski

Published:  3/16/2020

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 clientspecific 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 Search of Calm

The last few weeks have been anything but calm. We keep on learning more about the coronavirus spread around the world, and the decisions made to address it. We certainly hope that all the right steps will be taken to not only slow it down, but also to provide sufficient help, and care to those in need.

We feel that if anything, this peculiar time has brought many of us closer. We heard from many of our clients, some called, some emailed, some let us know they are keeping up with our updates. We are always here if you need us. In the last few days, we also spent more time talking to our families, our friends around the world, including those we haven’t had an opportunity to talk to in a while. I even had a chance to chat with a good grad school friend who recently relocated to Vietnam.

Megan and I have been taking daily long walks along the Hudson River waterfront. This weekend, we also took our bicycles out for the first time this season. If you are feeling overwhelmed with the news flow, a nice walk, a bike ride can do more good than any dose of hand sanitizer.

In times like this, our ability to remain available to our clients, and our ability to conduct business as normal are our priority. We remember well, how Sicart Associates was launched from our respective living rooms in the summer of 2016. I was sitting at home in my shorts and flip flops, with my laptop, and a phone ready to embark on this new adventure. Building a new firm, we made sure we use the right technology that can enable us to work, and stay connected even if we are apart, and we need to work remotely. We plan to lean on that capability more in the coming weeks.

On the investment side, it’s a good time for a reminder of what we do, what our approach is, and what our values are. We are long-term patient disciplined investors, and we manage family fortunes over generations. We are stock pickers, and business owners. To us, shares of companies represent ownership in real businesses. Businesses that provide goods and services that people need, and want.

When we buy a business, we see it as a purchase of its stream of earnings from now until the end of its existence. A few months, or even a year-long drop in earnings, has little impact on the long-term earning power of the business, in our opinion. It may have an impact though on the quoted stock price, but the lower the price we pay, the better returns we can expect in the future. The businesses we buy we intend to hold for at least 3-5 years, and if possible, forever.

The businesses we like are here to stay. Looking at the businesses we own today, we can say with a good degree of confidence that consumers will still buy soap, tomato sauce, make phone calls, use the internet or receive packages. In some businesses, we may actually see a pick up in demand as shoppers briefly adjust their preferences, and habits in response to recent developments.

This week, the bull market would have had its 11th birthday. Instead of new market highs, we have seen a big increase in market volatility with big daily drops, and rallies. The stock market indices in the US dropped by about 17-20% from their highs.

For passive index investors or those who are always fully invested, there are very few options left other than waiting it out without giving in to panic selling.

For a while now, we have held ample cash preparing for a potential market correction given inflated market valuations, and the stretched fundamentals. We have also emphasized in our stock selection the resilience of the businesses, and their financial strength. We also used a variety of market protection tools – we hold gold, and in some cases exchange traded funds that go up when the market drops or the volatility picks up.

The cash holdings served as a buffer on the way down, and now can be very gradually used to buy stocks at lower prices. We have a list of stocks we would like to own, and prices in mind that we are willing to pay. The volatility and the market drops may create further buying opportunities in the coming weeks and months.

We hope you and your families are staying safe, and taking necessary precautions.

If you have any questions, we are always here to help.

Warmest wishes,

Bogumil Baranowski & the Sicart Team

 

 

Published:  3/9/2020

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 clientspecific 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 Point and Challenge of Being Prepared

Beyond the traditional choice of our investment management style between categories such as value or growth, fundamental or technical, trading or buy-and-hold, we have tried to abide by two precepts:

  • One is that it is futile to try and predict the future, especially with regard to its timing. What is more important is to be prepared for what may happen, no matter how unlikely.
  • The other, derived from the work of Prof. Hyman Minsky, is that financial crises do not require a proximate cause: they are a natural consequence of the free-market cycle where the investing crowd becomes first increasingly complacent; then willing to accept excessive risk; and eventually succumbs to panic, at which point when the liquidity that seemed to make everything so much easier dries up.

For the last couple of years, these beliefs have led us to push back against the increasingly strident pressure from some fiduciaries, consultants and, fortunately, very few clients, who had been clamoring for us to reduce our large, prudential cash reserves.

Picture1

The over 4,000-point decline in the Dow Jones Industrial Average in less than two weeks did not merely erase a full year of previous gains. More importantly, it raised an additional question:

“What do you do with your prudential cash reserves when their use becomes justified?”

Although financial crises may not require a proximate cause, investors and observers often have little difficulty finding culprits after the fact.

There is little doubt that the current market correction was at least triggered by the spreading Coronavirus panic, which seems a legitimate concern. Still, judging from historical examples, while affected populations will undergo considerable suffering, it seems likely that the health problem will abate and hopefully be solved in a matter of months — or perhaps a couple of years.

From an economic point of view, however, the problem is the advanced level of globalization that the world has achieved in recent years. Today, most products are the end result of complex and far-reaching supply chains. Difficulties in any one of the countries making parts or supplies for an end product can badly disrupt the supply of that product around the world. Even if the supply chains can be restored, the process will take time and money, and cause labor displacement.

So, there is a chance that what could have been an economic hiccup will morph into a global recession. From an investment perspective, we believe, bear markets associated with economic recessions tend to dig deeper and last longer than those resulting from a mere correction of asset price due to a change in the investing crowd’s psychology. Past examples are all over the map but a typical correction might produce a 15-20% stock market decline, while one associated with a true economic recession could be as high as 50%.

Since we don’t know how things will eventually turn out, we need to be prepared for both the short term and the longer horizon.

In recent years, it seems that investors have put their steady faith in the power of central banks. At the first signs of weakness in financial markets, central bankers could be counted on to pump liquidity into their economies. With the physical economies remaining lackluster and resisting incentives to invest in plants and equipment, most of that added liquidity tended to flow into financial markets. That tendency largely explains the bull markets of the years following the Great Recession of 2008-2009.

Today, with interest rates close to zero (or even lower in much of the world), investors’ doubts have begun to appear as to how much more central banks can do to fight recessions. Even some central bankers seem to wonder how much dry powder they have left. Nevertheless, it is possible that, in a central bank last hurrah, a coordinated stimulus effort could produce a violent (and probably short-lived) stock market bounce back, based on investors’ remaining faith in the infallible power of central bankers to direct at least the stock and bond markets, if not the economies.

Without entering into a dangerous exercise in short-term trading, we have decided, for clients who are in a position that makes it possible, to invest about 10 percent of their current excess cash reserves in shares that are down 40%-50% from their highs. Most of these companies will typically be ones where we already own positions in our portfolios. However, we have also included a couple of companies with high growth profiles that, although still expensive by our traditional “value” standards, are seldom available at very low valuations.

For a portfolio that might have had cash reserves of 30% of its total value, for example, this recent decision would now leave it with 20% in cash and equivalents.

Beyond this first adjustment, committing the rest of our excess cash will probably await the kind of deeper decline typically associated with economic recessions – whenever one comes. But I have noticed, over a number of past bear markets, that the deeper and longer ones tend to produce a compression in the range of valuation measures such as ratios of price-to-earnings, price-to-cash flow, etc.

This means that in a major bear market, many companies with superior growth and profitability sell at valuations which, while not as low as those of classic “value” stocks, are much closer to them than in normal or more ebullient times. Often, these episodes constitute a rare occasion to acquire the shares of superior companies at reasonable prices.

Being prepared does not mean making decisions in advance. We have not yet reached compelling valuation levels for shares that have until recently remained quite expensive. But we have intensified our research on such companies, so that we may seize opportunities when their prices seem right. When this happens (and in full-fledged bear markets it can happen quite fast), we will be prepared with reserves of cash, and thus well-positioned to upgrade the long-term potential of our clients’ portfolios. Stay tuned…

 

François Sicart, March 2, 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.

Always keeping a steady course

We talked about it, we wrote about it, but now that it is happening, it’s never fun to watch. We discussed how the market valuations are inflated, how the fundamentals are stretched, and how 2019 eye-popping stock performance was driven by prices going up, not by earnings rising. We knew that it’s a matter of time when the market catches up with the reality. What is always impossible to say is – when.

We took the best approach that worked in the past, and was likely to work in the future. We took money off the table, pruned the most vulnerable positions, held excess cash, avoided the highest-flying stocks that have the most room to fall.

We wrote how cash is not only a buffer on the way down, but most of all dry powder that we can use when the market or individual stocks drop.

The last year and half, we slowly added a number of new holdings whose prices dropped to multi-year lows. We took advantage of the December 2018 sell-off, few other corrections since. This week, many of you intuitively knew already that we have been slowly, but consistently putting more money to work as the market started to drop.

This week we have witnessed one of the fastest corrections on record. Earlier this week, we shared a study showing how historically bear markets can quickly reclaim the bull markets’ gains. What we have seen so far is the market taking back the entire gain recorded since last summer, including the Federal Reserve sponsored rally. Historically, the faster the rise we enjoy, and the less substantiated by fundamentals it is — the more dramatic the fall.

For a while, we had believed that U.S. equities had entered a bubble territory, and it was a matter of time what “pin” will pierce it. There were many clouds on the horizon, but nothing was able to slow down the climb. Today, it seems that it’s the coronavirus scare that broke the camel’s back.

Now, we have no way of knowing what the end impact of the virus will be on our health, the economy, and the stock market. We are well aware of the global exposure of U.S. companies, and we would expect a meaningful, but hopefully short-lived impact on earnings, thus also stock prices in the near future.

In many conversations over the last months, and years, our clients asked if we anticipate one big sell-off or a sideways market. We always said that we are ready for both, and will adapt to either, and do what we do best — identify quality businesses, and buy them at attractive prices. We also emphasized that stormy markets show who was lucky, and who is doing the work, and conducting a diligent stock selection. In a rising market, everybody seems to be a hero. In a difficult market, there are many more opportunities, but not for passive investors or “index huggers”, but for those who know what to buy, and when to do it.

Calm markets or stormy markets, we are always keeping a steady course. As we wrote on many occasions, we have an extensive wish list of businesses we would like to own, and when others panic, and prices drop, we have a tremendous opportunity to buy them at very attractive prices.

Our patience always eventually pays off. We have been in no rush to chase the market to its top, and we are in no rush to jump in, but you will see us take very decisive, but gradual steps adding to our holdings in the coming days, and months.

Slow and steady wins the race.

If you have any questions, we are always here to help.

Warmest wishes,

Sicart Team

 

 

Published:  2/28/2020

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 clientspecific 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 don’t time the market; we don’t know how

Recently I had a conversation with a prospective client who wanted to know about our experience managing family fortunes over generations. Coming from a money manager who always likes to be fully invested, he was intrigued by our choice of holding some cash on the sidelines, ready to invest. “So, you’re timing the market?” he asked. I answered with a smile that we don’t time the market, we don’t know how.

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As we at Sicart see it, “timing a market” would be an attempt to stay fully invested all the way to the top, yet at the same time hoping that we would be able to sell early enough to avoid the pain of a drawdown.

My friend Jake Taylor, in his recent investor letter, shared a chart (see below) that I found eye-opening. It shows what fraction of bull market gains were “repossessed,” or dissipated in the following bear market. Since 1933, five bear markets have wiped out more than 100% of preceding bull market gains. One of those times happened during my career, and two happened in the first five years of my partner’s François Sicart’s career (1969, 1973).

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Source: UPFINA and January 2020, Investor Letter, Farnam Street Investments

In my almost forty-year lifetime, the U.S. market has endured 5 bear markets that took away half or more of preceding bull market gains.

As of early 2020, the S&P 500 hovered at 3,300 — a long way away from the low of 666 reached almost 11 years ago on March 6, 2009. If the index were to give back half of the gains earned during this longest-ever bull market, we would see a round 40% drop from current levels. If it were to relinquish all of its gain, we would see an eye-popping 80% drop from here. We certainly hope that won’t happen. However, we can’t help remembering that 2009 lows dipped below the previous low mark, when the S&P 500 dropped by 50% after the Internet Bubble burst. If history teaches us anything, it is that past downturns don’t necessarily represent the floor for even the most dramatic drawdown.

We are not trying to scare anyone away from the stock market, quite the contrary. If anything, we strongly believe that everyone should be a lifelong investor. We also believe that stock investing is a great path to not only preserving, but also growing family fortunes over generations.

However, the movements of the stock market are sometimes irrational. Extreme optimism follows extreme pessimism, greed alternates with fear. We wish we knew how to call market peaks and troughs but it’s harder than it looks.  We remember well how some observers believed that early 1999 would bring the market peak, only to see NASDAQ (the technology index), double in the following 12 months. The bubble didn’t burst until March of 2000. Until not long ago, we have been hearing how just because the market has gone up a lot, it doesn’t mean it can’t go higher. Many have believed the Fed hasn’t finished pouring gas on the fire. In the meantime, short-sighted investors have been calling for more corporate buybacks that further bid up stock prices. Could we see the major indices climb another 100% from here? It’s not impossible. Anyone suffering from FOMO (fear of missing out) may get sucked in to the market frenzy.

Now, more recently, investors traded the risk of a market melt-up for the risk of a sudden sell-off. When I started writing this article, the U.S. stock market was reaching new highs with no signs of slowing down. As I’m putting finishing touches, we just witnessed a 1,000-point daily drop in the Dow Industrial Average with all major US-indices deep in red.

A melt up, a sell-off, just correction? The important question remains how can we know when to get in, when to get out? We honestly confess that we don’t know. We also suspect that anyone who believes they do is deceiving him- or herself — not to mention anybody listening to them.

The best approach for us has been to gradually take money off the table, trim our most overvalued positions, and, if possible, replace them with holdings that are more attractively priced.

We don’t time the market because we don’t know how to. Instead, we choose each investment based on its merits. Our securities (stocks) are selected based on quality, purchased based on value, and held with the business owner’s mindset. When the picking gets slim, we let the cash position grow. In turbulent times, we shop for bargains with the cash we’ve kept on the sidelines for this very purpose.

We are patient and prepared for the shopping spree of a lifetime.

Happy Investing!

Bogumil Baranowski

Published:

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 clientspecific 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.

Value and momentum: the tortoise and the hare

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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 clientspecific 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.

 

Tesla and the Dark Alleys of Investing

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.

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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 19th century. They were popular at first, and even held a vehicular land speed record for some time. But then roads improved in the early 20th 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 clientspecific 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 if this market will go up forever?

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 clientspecific 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 fortunes are made, when fortunes are lost

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 11th 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 clientspecific 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 Ultimate Argument for Holding Cash

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 5th, 2019

Disclosure:

This article is not intended to be a clientspecific 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 Tale of Two Books

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 clientspecific 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 Art of Cashing Out

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 clientspecific 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 rich, but income poor

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)

asset rich 1

 

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

asset rich 2

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)

asset rich 3

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

asset rich 4

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 30th, 2019)

asset rich 5

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.

asset rich 6

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 4nd, 2019

EXPERIENCE, PRINCIPLES AND STRATEGY – PART II

Part I of this paper (July 30, 2019) concluded that conditions have gathered for a “Minsky Moment” (the time when apparent financial and economic stability turns into instability and eventually financial crisis or recession). The wait may be long for that precise moment to materialize, but since, as the saying goes, “trees don’t grow to the sky,” education and experience can give us a pretty good idea of the ultimate outcome. Thus, the main challenge lies in determining the likely timing of that moment, which is what we are going to investigate in this Part II.

I have not yet come across a model or formula allowing investors to predict stock market turning points with any accuracy. On the other hand, many studies by reputable analysts and research organizations are useful as backdrops to exercise one of our principles: “You cannot predict the future, but you can prepare.”

Understanding The P/E ratio

From its 2009 low of 677, the S&P 500 index has now gained more than 300%. Because earnings were temporarily suppressed by the Great Recession, it is difficult to compare gains in earnings and those of the stock market. But even using more “normal” dates such as July 1, 2007 (before the crash) and April 1,2019 (close to the recent high) the index progressed 90% while the S&P 500 earnings gained less than 30%. This is a useful reminder that big moves by the stock market are driven principally by changes in the Price/Earnings ratio (P/E), an indicator that is easy to understand and to monitor.

Two of the best researchers and writers about the stock market, John Mauldin and Ed Easterling, recently joined forces to write: “Valuation Determines Return” (in John Mauldin’s Thoughts from the Frontline, 3/15/2019)

One of the most useful graphics, from Easterling’s Crestmont Research, which keeps a wealth of economic and financial statistics, illustrates how the stock market “total return” is generated:

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The authors further make the essential point that:

Over 10–20 years, the P/E [Price/Earnings ratio] can dramatically increase or decrease, resulting in a significant addition or reduction in total return. In the secular bear market of the 1960s and ’70s, the decline in P/E virtually eliminated the return from earnings growth and dividend yield. In the 1980s and ‘90s, the increase in P/E more than doubled the return for many of the decade-long periods during that secular bull market.

The Future Can Be Told…

In his March 8, 2019 newsletter “On My Radar”, Steve Blumenthal of Capital Management Group reviews many studies of what current equity market valuations can tell us about coming long-term returns (7 to 10 years or even 20 years, depending on the study). Morningstar does the same in the 2019 edition of its annual “Experts Forecast Long-Term Stock and Bond returns.”

For most of these studies, valuation is measured by the current Price/Earnings ratio, although many use a moving average of earnings to calculate the P/E. This tends to understate the earnings (when previous years’ profits were lower) and to overstate the resulting adjusted P/E ratio; but it generally eliminates the effect on profits of most cyclical fluctuations. The following graph illustrates how Yale University’s Robert Shiller (CAPE P/E 10) and Crestmont Research, for example, smooth earnings to calculate their versions of the Price/Earnings ratio.

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Using Shiller’s CAPE (Cyclically-Adjusted Price/Earnings ratio), Crestmont Research tallied 110 decade-long periods between 1900 and 2018 and grouped them by quintiles. The chart below shows how starting valuations strongly influence the S&P returns in the following 10 years. As the market’s starting valuations rise, future returns decline:

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Ned Davis Research conducted a similar study using the stock market’s median P/E, e.g. the P/E with as many numbers above it as there are below. The median tends to be less influenced by extremes in a sample than the average, for example.

Using data from 1926 to 2014, median P/E was sorted into five quintiles. Quintile 1 is the lowest 20% of all month-end median P/Es and quintile 5 is the highest. In the following table, next to each quintile is the annualized nominal returns over the following 10 years.

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The most important thing to remember from all these studies is that today’s valuation can give an excellent idea of the likely future stock market returns.

… But Not in Detail

The problem is that forecasting, for example, an 80% gain for the stock market over the coming 10 years (roughly equivalent to 6% per year) does not tell you when this performance might be achieved. For example, a two-year 56% gain could be followed by a 44% loss, then another gain and so on, with the ten-year net change totaling 80%.

For those readers whose memories may have been numbed by the central bank-engineered, momentum-driven stock and bond markets of the last ten years, the following graphs from Crestmont Research (1965-1981 and 2000-2016) may remind them of what volatility feels like in real life:

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Even Warren Buffett’s Berkshire Hathaway (presented here as a case study, not an investment recommendation) endured this kind of volatility which, of course, he viewed as opportunity.

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This, as can be seen below, did not hurt Buffett’s long-term record of building wealth. Yet his shareholders who did not have the courage or the patience to endure the volatility and sold Berkshire Hathaway during those episodes probably suffered the fate of the so-called “dumb money.” There is magic in having ready cash when opportunities arise.

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Strategy

Value investors have traditionally been more focused on stock-picking than on macro analysis of the economy. But when my friend Jean-Marie Eveillard and I had lunch in July and were reminiscing about the financial crisis and Great Recession of 2007-2009, we concurred that it would have served us well to pay more attention to the macro environment.

This conversation got me thinking and I reviewed the main stock market declines of the past few decades. I observed that the general difference between “corrections” and “bear markets” was that full bear markets tended to be accompanied by economic recessions and were often longer and deeper (30%-40% declines or more), whereas mere corrections, up to 20% declines, could be purely financial phenomena, not fundamentally affecting the country’s core economic activity.

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Source: Seeking Alpha – Dec. 26, 2018

Note: 1998 was in the midst of the Asian currency crisis and 1987, while traumatic, was a one-day stock market crash, too short to turn into a recession. Economic activity in 1962 felt the impact of a major strike.

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Nobel Laureate Paul Samuelson famously quipped that the stock market has predicted nine of the past five recessions. Indeed, whether they come from the private sector, academia, central banks or the International Monetary Fund, forecasts of economic activity have historically been inaccurate. Thus, we should view prediction of a possible recession and its timing with a grain of salt.

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After remaining relatively sanguine about economic activity early in the year and even worrying about a re-awakening of inflation (prompting the adoption of higher interest-rate policies), a majority of economists has now been shifting to concern about a global recession, on the backdrop of weakening global economies and the trade wars initiated by the American government.

Of course, when both governments and central banks focus primarily on preventing stock market declines, as they have done recently, the distinction between financial crisis or bubble-bursting and economic recession may become moot. Economic policies may delay the pain, only to make it more acute later.

The Asian currency crisis of 1997 not only awakened my interest in Asia and particularly China, it also made me realize that the trigger of a financial crisis may be an apparently remote development (such as the devaluation of the Thai Bath) that is followed by a domino effect of other, bigger crises. The globalization of finance affects institutions and their clients in unpredictable places.

At the moment, among our worries are a large number of bonds and loans that are hover just above the “junk” label and which could be downgraded in coming months, especially if  global economies continue to weaken. This development would prevent major pension funds and other large fiduciaries from holding these investments in their portfolios and could trigger a massive selling wave, putting into question these institutions’ liquidity. Somewhat related, for many corporations and governments outside the United States who borrowed in dollars, a continued appreciation of the U.S. currency may also mean the difference between apparent solvency and default. In addition, the ultimate effects of the current trade war, tariffs game, and now-threatened competitive or retaliatory currency devaluations are beginning to be felt in overall economic decisions and activity.

From our perspective, this is a good time to be prepared, for both the volatile environment ahead and the opportunities that it may create for investors with cash to invest.

 

François Sicart

August 12, 2019

 

Disclosure:

This article is not intended to be a clientspecific 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.

EXPERIENCE, PRINCIPLES AND STRATEGY – PART I

This review of what shapes our investment strategy could have wound up being quite long. We therefore elected to first review some lessons of experience and the unbending principles that guide our attitudes toward investment over the cycles. In a coming paper, we will describe how the two interact to yield our investment strategy.

EXPERIENCE

A few weeks ago, I had lunch with my old friend and colleague Jean-Marie Eveillard, an investment manager whose career has been as long as mine and quite successful, including the stewardship of one of the first global funds from $15 million to $50 billion and a Lifetime Achievement Award from Morningstar. But his feat I envy most is his statement during the Internet bubble of the 1990s, which we both shunned, that: “I would rather lose half my shareholders than lose half my shareholders’ money”.

Over lunch, we naturally wound up reminiscing about the speculative bubbles we had lived through and their aftermaths.

The Nifty Fifty Stocks and the Two-Tier Market

Of course, we remembered the beginning of the 1970s, early in our careers, when 50 stocks, the “Nifty Fifty”, came to be viewed as “one-decision” stocks due to their assumed continued fast growth, high margins and perceived resistance to recessions and disruptions (most of them had survived well the 1970 recession, shortly after a leading economist had proclaimed “we have conquered the economic cycle”).

As a result of this extrapolation, these fifty stocks were aggressively accumulated by major institutions and were largely responsible for the extent of the bull market of the late 1960s and early 1970s. But that performance came at a price. In 1972, the S&P 500 Index’s P/E already was 19, but the Nifty Fifty’s average P/E had reached 42x with Polaroid at 91x, McDonald’s at 86x, Walt Disney 82x and Avon Products at 65x.

Not surprisingly, in the stock market collapse of 1973-74, the Dow Jones Industrial Average fell 45% in just two years while, for example, Xerox lost 71%, Avon 86% and Polaroid 91%.

The Japanese Bubble

Not surprisingly, Jean-Marie and I both had vivid memories of the 1980s Japanese bubble as well, perhaps, I believe, because neither of us participated in that stubborn episode to any extent. At the time – as may be happening with China today — Japan was portrayed as an irrepressible force and the greatest economic threat to the United States, whereas economists and politicians were becoming increasingly aware of a hollowing out of US manufacturing and a widening bilateral trade deficit.

Experts and specialists found many reasons to rationalize the elevated prices of Japan’s stocks — from the more conservative quality of Japanese reported earnings to the very low interest rates already prevailing in that economy. Most of these arguments were legitimate but the ultimate bursting of the bubble was a stark reminder that, in the end, it is the prices you pay that count.

The bubble was multifaceted: land prices, according to Stephen S. Roach, a senior fellow at Yale University’s Jackson Institute of Global Affairs (May 27, 2019), had increased 5000% from 1956 to 1986 even though consumer prices had only doubled in that time: by 1990 the total value of the Japanese property market had reached roughly four times the real estate value of the entire United States. Even golf club memberships could fetch as high as the equivalent of $2 million in 2019 dollars.

Also overlooked was the fact that Japanese share prices had increased three times faster than corporate profits during the 1980s, as their Price-to-Earnings ratios were exploding on the upside. In 1989 the P/E ratio on the Nikkei reached 60x earnings but, rewarding the patience of those who had had the conviction to wait, the Japanese stock market lost roughly 80% of its value over the next decade.

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Similar experiences followed in the late 1990s and early 2000s (the Internet bubble) and eventually in 2007-2008 (the subprime crisis, followed by the “Great Recession”, of which the consequences are still being worked out). Those episodes are recent enough that many of today’s market participants probably don’t need to be reminded of them here, but the story of speculative euphoria and its aftermath continues to “rhyme” over the cycles.

In a January 2019 white paper (“Is the U.S. Stock Market Bubble Bursting”, January 2019, GMO), GMO argues that bubbles are discernable not only by elevated valuations: “they are also about animal spirits captured in stories of euphoria” such as, for example, the recent enthusiasm for crypto-currencies, Big Data, Artificial Intelligence and (my addition) perceived “disruptors” of established industries. The reluctance of many market participants to libel the current environment as a bubble is due to the absence of market-wide euphoria because irrational exuberance is only visible and measurable in selected speculative pockets.

Backdrop: Paradigm Shifts

In the United States today, the employment rate is near a record while inflation seems to remain hibernating. Yet, digging a bit deeper below the surface, it feels like there are two distinct economies, with savers/investors enjoying a prosperity that mirrors the performance of the stock market or the quick access of new technologies to easy money, while salaried workers in traditional industries are having trouble navigating today’s economic schizophrenia. To a degree or another, similar trends seem to be affecting most other major economies.

When I look at today’s sometimes puzzling world economic order, I am reminded of the American Agricultural Revolution. Over 200 years ago, 90 percent of the U.S. population lived on farms and fed mostly themselves but today, just two percent of the population produces food not only to feed the country but also to be a major exporting sector. During that process, farming appeared to shrink in importance when measured by employment, but was really experiencing an extended surge in productivity, producing a 2018 trade surplus of $10.9 billion. Through the use of technology, each farmer is now able to feed 155 people, versus only 19 people in 1940.

Economic history is full of such periodic paradigm shifts, although few extended over such long periods as the agricultural revolution. In my experience, these shifts can render some of our traditional economic and financial statistics temporarily confusing or outright misleading.

In the mid-1980s, near the peak of the Japanese bubble, many experts were proclaiming the death of American manufacturing. This contrasted with what my team was observing on our visits to factory floors, with new disciplines such as just-in-time, cell-manufacturing and total-quality being actively taught and implemented. We became convinced that, instead of dying, American manufacturing was in fact being reborn. Interestingly, only the American Manufacturing Association and the Japanese Chamber of Commerce were interested in our theory and both invited me to speak to their constituencies.

Robert Kaplan, now Emeritus Professor of Leadership Development at the Harvard Business School, was one of the leading academics who helped us investigate this discrepancy further.

Traditional management accounting had been developed when materials and direct (manual) labor made up the bulk of industrial companies’ costs. Those were relatively easy to measure and the practice developed of allocating so-called “overhead” costs, such as marketing, R&D and administration, in the same proportions as those easily-allocated direct costs. But, as industrial activities became lighter, cost structures evolved: by the 1980s, for example, in the growing electronics industry, materials and direct labor no longer represented more than 10%-15% of total costs.

Prof. Kaplan commented that U.S. companies were still using a 19th-century accounting framework to measure their activities in the 20th and soon-to-come 21st centuries. This misallocation led to the wrong investment decisions at the corporate level and, in the aggregate, the wrong assessment of U.S. competitiveness.

A New Paradigm?

It is possible that we have entered another paradigm shift, with so-called “asset-light” companies taking the leadership of the economy and certainly of the financial markets, while activities such as heavier industry and even traditional brick-and-mortar retailing are struggling.

The new leaders often spend more on acquiring or creating intellectual property than on traditional assets and infrastructure. Moreover, as they often are so-called “disruptors”, who aim to replace traditional, formerly entrenched businesses, they are currently keener to quickly acquire significant market shares than on attaining traditional profitability levels. Their benchmarks, which they have convinced a majority of analysts to adopt, are sales revenues and growth, the number of users of their services, etc. These benchmarks tend to ignore or inflate reported earnings per share, such as the lack of significant investment depreciation, the dilution from executive options and other incentives and the boost to reported earnings per share from massive share buybacks on the stock market.

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The impact of asset-light companies and their accounting on the S&P 500’s reported profit margins can be induced from the chart and table above. It seems doubtful that a continuation of recent advances can be caused by a further increase in profitability.

PRINCIPLES

One overwhelming principle that drives our investment philosophy is that you cannot predict the future, but you can prepare. What does this mean in practice?

Hyman Minsky and the Random Timing of Financial Crises and Recessions

Hyman Minsky was a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College but, until the subprime crisis and the ensuing Great Recession of 2007-2008, which brought him relative though posthumous fame, his writings had remained relatively confidential. Minsky’s Financial Instability Hypothesis was that financial crises (and the recessions that often accompany them) need not be triggered by outside events:

A fundamental characteristic of our economy, is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles. (September 15, 1974 — “Our Financial System is Fragile” — Ocala Star Banner)

In prosperous times, when corporate cash flow rises beyond what is needed to service debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. In the aftermath of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts. This time of reckoning is sometimes labeled a “Minsky moment”.

If we cannot forecast the future, including the Minsky moments, how can we estimate future returns from the stock market? The answer is that we cannot predict the timing of Minsky moments but we can be assured of the ultimate outcome of these oscillations between stability and fragility.

Testing Minsky’s Hypothesis

According to the McKinsey Global Institute (courtesy of Mauldin Economics’ Thoughts from The Frontline (6/8/2018):

From the Great Recession’s beginning through Q2 2014, global debt grew $57 trillion to $199 Trillion, including household, corporate, government, and financial debt. This sounds like the prelude to a Minsky Moment.

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Throughout my career, I can’t remember any instances when global debt stopped growing durably, but there still has been a litany of warnings that the ratio of debt to GDP had reached unsustainable levels in various countries. For example, in A Decade of Debt, Carmen Reinhart and Kenneth Rogoff argued that public debts in the advanced economies have surged in recent years to levels not recorded since the end of World War II, surpassing the heights reached during the First World War and the Great Depression and that, historically, high leverage episodes have been associated with slower economic growth and a higher incidence of default or, more generally, restructuring of public and private debts. (National Bureau of Economic Research – 2/2011)

It is true that countries such as France, Japan, Finland, Sweden and the Netherlands have reached ratios of domestic debt to GDP well above the danger levels set by Reinhart and Rogoff without running into trouble. My conviction, however, based on observation of both human nature and crowd behavior, is that an increase of debt indicates that one has lived beyond their means and that, sooner or later, they will either have to go on a painful spending diet or go bust…

Liquidity and Negative Interest Rates

It used to be that a liquid entity meant one with ample reserves of cash or readily saleable (short-term) assets. In the 1980s and 1990s, as interest rates declined from record highs toward historical lows, debt became fashionable and liquidity increasingly was defined as the ability to borrow.

Supported by central bank policies, that trend accelerated after the recession of 2007-2008: today, there are around $13 trillion of bonds outstanding with negative yields — ones that do not pay you interest but, instead, where you have to pay for the privilege to invest. According to Bloomberg and Mark Grant, of B. Riley FBR Inc., some 40% of global bonds are now yielding less than 1%, including government and corporate bonds – some of them high-yield or “junk”.

This has two consequences:

– One is what was often referred to in the early 2000s as TINA (There Is No Alternative). With secure bonds yielding very little, most investors needing income or institutions faced with actuarial goals have no choice but to take more risks than usual.

– The other is a tremendous incentive to borrow to invest since your debt indebtedness carries little or no immediate cost.

The extent to which debt has become apparently painless is illustrated by the U.S. government. According to Treasury Direct, U.S. Government debt has grown a whopping 280% from less than $6 trillion to $22 trillion between 2000 to 2018. Thanks to steadily declining interest rates, however, the annual interest expense on that debt has only increased 44% from $362 billion to $523 billion in that same period.

Mauldin Economics points out (6/8/2018) that 60% of new corporate debt is in the form of new bank loans with maturities averaging only 2.1 years, at which point they will need to be refinanced. It also points out that many emerging market businesses and financial companies borrowed money in dollars to take advantage of the then relative weakness of the U.S. currency and its very low interest rates. For many, a stronger dollar and higher interest rates could prove lethal.

Among other, anecdotal signs of increased risk-taking, there already has been a sharp increase in corporate defaults among smaller, less-well capitalized, energy companies, especially some that were acquired by private equity funds, which often add debt to already rather leveraged companies.

Margin debt (buying stocks on credit) as a percentage of GDP has already exceeded its record levels reached at the market peaks of 2000 and 2008.

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Thus, the question today is not whether we will face a Minsky Moment, but when? That is a question we will try to investigate in PART II of this paper.

 

François Sicart

July 30, 2019

 

Disclosure:

This article is not intended to be a clientspecific 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.

Fighting the currents; a metaphor for the next decade of stock investing

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.

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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 clientspecific 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.

Where did my trillion dollars go?!!

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 17th 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 clientspecific 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, BEING RIGHT IS NOT ENOUGH: THE OTHERS MUST BE WRONG

 

We question some “certainties” held by the investing majority because, as Mark Twain said:

“It ain’t what you don’t know that gets you into trouble.

It’s what you know for sure that just ain’t so.”

                                                            * * *

In recent months, we have revisited the performances of some of our accounts as well as those of a few other portfolios managed by highly successful long-term investors.  The periods under review ran between 20 years and 40-plus years: anything shorter would not include enough cycles to be instructive and anything longer, unfortunately, tends to be scarce.

Our aim was to try and distillate some wisdom about how long-term performance is achieved and, especially, to dispel some widespread assumptions or preconceived ideas that may lead us to use less-than-optimal tools and techniques for achieving it.

Being Right Is Not the Same as Building a Fortune

One of our favorite titles for an investment book, is Being Right or Making Money, first published in 1991 by Ned Davis Research, which tests and publishes a wide array of economic and financial indicators and tools for managing risks and making money.

We particularly like the contrast Davis’ book draws between being right and making money: The two are usually assumed to go hand in hand but, in fact, they often represent very different outcomes of the research and investment process.

Investment markets are auction markets, where companies’ fundamentals and investors’ emotions are constantly interacting in intricate and, at times, seemingly contradictory ways.

For example, after a company’s stock has risen for an extended period on a string of good results, its price reflects not only all its measurable qualities, but also investors’ psychological extrapolation of future progress.  Then, unless the company’s fundamentals keep improving faster than anticipated, its stock’s potential to rise further is limited. On the other hand, any shortfall from investors’ growing exuberance may cause significant corrections. This asymmetry is why a good company does not necessarily make a good investment.

Beyond that, being right implies a closure marking the end of a finite period after which a new bet must be made to follow the preceding one.  Building wealth, in contrast, does not imply any time limit and refers instead to a continuous process relying on the long-term magic of compounding.

Compounding consists of reinvesting income (interest or gains), rather than paying it out as realized, thus actually earning income on past income. It has been praised as a source of wealth creation by such iconic investors as Warren Buffett and Peter Lynch, but it also reportedly inspired scientists like Albert Einstein, who once said: “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

Much of the difference between being right on the stock market and building a fortune in it thus depends on an investor’s time horizons. Personally, we find analyzing investment performance over shorter periods of time, even several years as do consultants, most media and many fiduciaries, irrelevant to wealth-building and much more akin to some competitive sports or games: good for immediate excitement, but not for value-creation.

Great Long-Term Wealth Builders Have Experienced Bad Years

Another fundamental realization was that most successful, long-term wealth builders have endured periods of significant underperformance or even severe losses, as illustrated by the following table of Warren Buffet’s losing stretches, borrowed from Business Insider (2/24/2018):

Warren Buffett’s Berkshire Hathaway – Truly Major Dips

Be right 1

Referring to these episodes, the Oracle of Omaha himself stated: “Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” And it is a fact that, despite these periodic, huge losses, Warren Buffett has been one of the greatest wealth builders of all time – over the long run.

This snapshot fits neatly into the ongoing debate about risk and volatility. Most consultants and theoreticians would assume that the kind of volatility depicted in the table above was the result of accepting too much risk in the quest for performance.

Successful wealth builders would answer that volatility is not risk, which implies the possibility of permanently losing one’s capital. This is unlikely if one feels confident about the conclusions of one’s analyses, exercises patience and shows character. In fact, with these qualities and adequate cash reserves, volatility can be viewed as an opportunity rather than as a risk, since it allows the owner to invest “when there is blood in the streets”, as the advice goes.

Absolute vs. Relative Returns

In recent years, with the proliferation of handlers of OPM (Other People’s Money), the emphasis in money management has shifted from absolute returns to relative performance.

It is perfectly understandable that operators or even fiduciaries that compete for market share in that universe need to shorten the performance-measurement periods even if this makes them less relevant to wealth-building. “I’ll measure your investment performance over the long-term and report to you every ten years” lacks the decision-making urgency which would appeal to most of today’s financial marketing departments.

Yet, it remains that wealth builders and owners are (or should be) interested primarily in the absolute returns (the end-results) generated by their assets, rather than by the interim scores achieved on the way, which are the main subject of relative-performance measurement.

Perverse  Passivity                                                                                                                                                  

So-called active investing is primarily concerned with selecting individual securities in the hope of outperforming benchmark indexes, whereas passive investing consists of investing mostly in products that mimic leading indexes – as a way of approaching those indexes’ performances, an elusive achievement for a majority of investors.

Unfortunately, most leading indexes are “weighted”, which means that companies with the highest total stock-market values carry the greatest weights in the indexes. When a market or a sector becomes fashionable with investors, the corresponding index goes up and the manager of a portfolio mimicking that index is mandated to add to the portfolio’s individual positions — particularly those already carrying the greatest weight in the index.

The danger of automatically buying stocks as they become more popular – e.g. more expensive – is that they will suffer most when the market psychology changes and overall liquidity shrinks.

So, contrary to the label’s implication, passive investing is not really passive but, instead, transforms portfolio managers into momentum investors and even momentum amplifiers. It also does not allow for building cash buffers to take advantage of unusual opportunities when they arise.

A distinctive decision of active vs. passive management is to not invest when conditions are deemed inadequate and thus to occasionally build significant cash reserves. But…

The Main Benefit of Cash Reserves Is Not to Protect from Market Declines

It is generally assumed that holding significant cash reserves while markets are declining protects portfolios against bear market losses. And it does, mathematically: if the stock market goes down 40% and the portion of your portfolio invested in stocks is 70%, your portfolio will decline by “only” 28%. If, additionally, you are a successful value investor, it is possible that the portion of your portfolio invested in stocks will decline less than the market because it was undervalued to start with.

These assumptions are generally verified over time: value investors tend to underperform during phases of upward market momentum and irrational exuberance but, because they normally invest less as cheap buying opportunities dry up, they tend to build up cash reserves which help them outperform the markets when prices go down.

A closer examination of the portfolios we surveyed did show a tendency of cash-rich portfolios to outperform slightly during declining markets. But more striking was the very significant outperformance of many during the couple of years of recovery after the declines.

Upon reflection, this made sense, too. If you hold cash while a majority of stocks are declining from overvalued prices to undervalued ones, you are in a position to buy aggressively when stocks approach compellingly low prices and to fully benefit from the initial post-decline bounce. Of course, fully-invested managers will also see their portfolio bounce but remember: it takes a 100% gain to recover a 50% loss. [You start with $100. You lose 50% to $50. You then must double to return to $100.]

Fish from an Empty Barrel?

In recent weeks, our regular Sicart research meetings have generated more investment ideas than in the last couple of years, at valuations not too distant from levels where we might start buying shares in earnest.

Since we have been careful not to deplete our cash reserves with the stock market hovering near an all-time high, we questioned what had changed to generate such opportunities. Upon further investigation, we unearthed the following facts:

As recently as a year ago, the market’s overall volatility was at a record low, with most stocks close to their all-time highs. Today, we are seeing 3-4% moves in opposite directions day after day, sometimes within a single day. And the number of stocks that are down 10%, 20%, 30%, 40% from their all-time highs has more than doubled in the last 12 months.

Be right 2

A stealth bear market seems to have been developing, obscured by rotating exuberance in groups such as the notorious and capitalization-heavy FAANGS (Facebook, Apple, Amazon, Netflix, Google), now correcting, and a number of other niches with superior growth — real or hoped for.

The Great Minsky Experiment

Economist Hyman Minsky hypothesized that crashes do not need a specific trigger because they are a phenomenon inherent to the capitalist system — a parallel with Marx that made him suspect to the profession until the 2007-2008 debacle.  According to Minsky, stability feeds instability: the longer things stay stable, the more businessmen and investors become willing to ignore risk and become reckless – usually through a massive increase in the use of financial leverage (borrowing).

Whether they burst of their own pressure, or they are bared by the disappearance of liquidity (the ability to refinance), debt bubbles are thus the main source of recurring financial crises and recessions. Unfortunately, there is little in the theory that helps foresee when the bubble will burst – only that the more we inflate it, the closer we get to the bursting.

Not surprisingly, borrowers seldom acknowledge that they are undertaking more risk and the prelude to bubble bursting often looks like mere complacency rather than like outright speculation. We believe this is the case today.

Back in the early 1980s, US interest rates for various maturities reached between 15% and 18%; they currently hover between zero and 5% as a result of quantitative easing and other interest-rate restraining policies by leading central banks.

Be right 3

We believe that observers tend to underestimate the massive changes that have taken place in the perception of risk by consumers, businesses, investors and governments over the last nearly 40 years of declining and then repressed interest rates.

One example of this recurring loss of investor memory is that Argentina, which had defaulted on its debt seven times in the past 200 years and three times in the past 23 years, was nevertheless able to sell to the public in June of 2017 almost $3 billion of bonds with a 100-year maturity. Not too surprisingly, with the country now in the midst of a major currency crisis, the bonds have already lost more than 20% of their value in a matter of 12 months.

Another example of investor amnesia is the relationship between interest rates and the US Federal budget deficit. According to the New York Times of September 25, 2018: “Already the fastest-growing major government expense, the cost of interest is on track to hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office. The federal government could soon pay more in interest on its debt than it spends on the military, Medicaid or children’s programs.”

Government borrowing is supposed to be countercyclical – expanding during recessions and declining during recoveries. But the US economy has now fully recovered from the Great Recession of 2007-2008 and yet the deficit is soaring, meaning that the stimulus is pro-cyclical, and that the government will have less room to maneuver when the economy slows.

As government spending, deficit and debt soared, in recent years, the cost of servicing (paying interest on) that debt did not increase proportionally because the Federal Reserve suppressed the cost of money by keeping interest rates artificially very low. Now, any inkling that interest rates might “normalize” at higher levels threatens to trigger a panic revision of future deficits upward. But until that happens, complacency reigns.

In a related set of assumptions, a number of observers have begun to worry that higher US interest rates might strengthen the US dollar and that the combination of a stronger dollar and higher interest rates might make it very difficult for emerging countries to repay the dollars they borrowed heavily during the most recent crisis.

We believe that we are currently in the midst of one of the long periods when Minsky saw apparent stability feeding instability. The results, when they become apparent may be described as “Black Swans” – rare and destructive events that could not have been anticipated. But one observer remarked that they could not have been anticipated mostly by those who did not want to look for them.

Where to next…

If not for a last-minute rally, October would have ranked among one of the worst months in global equity markets since the 2008/2009 financial crisis. We believe it may soon prove to be only an early preview of what may follow.

We have no way of knowing if that leads to a prolonged major sell-off or a series of more erratic price declines in various segments of the market, while the overall indexes remain range-bound trading sideways. Our patient, focused, disciplined approach prepares us well for both.

On one hand, we are keeping higher cash levels ready to deploy, and compelling opportunities are already starting to appear, on the other hand, we consciously continue to avoid potentially highly risky investments in the winners of the last few years.

 

François Sicart & Bogumil Baranowski

 

Disclosure:

This article is not intended to be a clientspecific 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.

Zeromania. From a trillion to zero in 10 days?

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 clientspecific 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 to do when nothing works?

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.

Buy the dip, don’t buy the dip?

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 clientspecific 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 bull market crashed. Now what?

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 1st, 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 9th or 10th 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 23rd, 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 clientspecific 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.

CAPITULATE OR “PERSEVERATE”?

In a comment on my recent paper (Picking daisies under a fuming volcano, 11/30/2017) a European colleague with some affinity for our investment style nevertheless reminded me that “for us, asset managers, timing is of the essence” and that “clients will resent our missing another year of rising markets.”

This warning was sent before the recent rout in the global stock markets, but it does not affect my strong views on the difference between short-term and long-term investing.

There is no indication that measuring performance over shorter-term periods — as do many consultants, boards of trustees and others without their own money on the line — would produce superior long-term results. As Joe Wiggins, who is responsible for running a range of multi-asset fund of funds at Aberdeen Standard Investments, writes in his blog Behavioural Investment (1/31/18):

“It is not only that headline performance consistency is a deeply misleading means of assessing the ability of an active equity manager, but as a  characteristic, it is the exact opposite of what fund selectors should be seeking.  By definition, long-term … conviction investors will not deliver performance consistency over the short-term.  There will be periods (often prolonged) when their style is out of favor and the ‘market’s perception’ diverges materially from their own.  Through such spells of challenging performance, we should expect them to remain disciplined and faithful to their philosophy and approach; not wish them to latch onto the latest market fad in an effort to achieve improved short-term returns.

Consistency is absolutely paramount to the assessment of active equity managers, but we are focused on the wrong sort of consistency.  Rather than obsess over the persistence of short-term outcomes; we should focus our attention on the consistency of manager behavior relative to their stated philosophy.”

This being said, I do not need to be reminded of clients’ occasional impatience with idle cash, especially in ebullient markets. I launched the Tocqueville Fund in January 1987, when still under the auspices of Tucker Anthony/John Hancock. Since my partner and I were relatively unknown to the public and we did not do any marketing, the few early investors were mostly traders and brokers of Tucker Anthony, who had known and followed me for more than a decade.

1987, John Authers points out in the Financial Times (1/26/18) was the last time the S&P started a year as strongly as it has this year. But, in early 1987, I was already very wary of the stock market because of valuation, some signs of economic slowdown and fallacious promises of “portfolio insurance” through derivatives. Much of the early inflow into the Tocqueville Fund thus stayed in cash.

Until that is, I began receiving phone calls from my friendly investors pointing out that, if they had wanted to own a money market fund, that was what they would have bought! So, I yielded and invested most of the Fund’s cash only weeks before Black Monday (October 18, 1987). By the end of October, the US stock market was down almost 23%, with several foreign markets faring even worse.

In the past, bear markets associated with economic recessions suffered even greater, and usually longer, declines. In this case, the US economy never fell into recession and 1988 was an excellent year if you had the cash to invest. In fact, by early 1989, the market was back to its pre-crash high — though many professionally-managed portfolios were not.

As I write this, the ranks of pessimists among investors have been shrinking fast.

Some have simply joined the index-hugging crowd under cover of politically-dictated arguments: economic stimulus from tax cuts, short-term budgetary help from the repatriation of accumulated foreign profits, empowerment of business through reduced regulation, and promised huge infrastructure programs. There are as many reasons to doubt as to believe the validity of these arguments but for the moment, the arbiter seems to be the stock market. In fact, what this group of optimists really believes is that stocks should continue to rise because they have been rising.

More intriguing is the “temporary” capitulation of a (much smaller) number of estimable, historically successful investors. These longer-term investors usually subscribe to Ben Graham’s definition that, in the long run, the market is a machine that weighs fundamentals, but that, in the short run, it is merely a voting machine.

These elite investors do believe in fundamental analysis but recognize that recently, central banks have prodded, first the US market and now most advanced economies’ markets, with artificial, excess liquidity (ZIRP, QE, etc.). As a result, with quality bond yields and sometimes even junk-bond yields hovering around zero, we have been in a TINA — There Is No Alternative (to stocks) — environment. That era may be coming to an end (see chart below), but until central bankers are absolutely sure, they may continue to flood the stock markets with excess liquidity – an attitude that might be reinforced by the recent mini-correction.

1 capitulate

 

Many investors are well aware that current valuation levels call for sub-par results from equities over the next decade. A number of models illustrate the link between asset valuations at the beginning of a decade and the return from those assets in the following ten years: GMO, Oaktree, Crestmont Research, John Hussmann and of course Nobel Laureate Robert Shiller’s CAPE (Cyclically Adjusted Price/Earnings).

These models never were intended to become timing tools but, rather, mere indicators of likely average future returns over long periods. Yet the longer their warnings have been calling for sub-par future returns in the face of rising markets, the more criticism (of one aspect or another) of these models has proliferated.

Fortunately, a report published this month by Robert D. Arnott, chairman of Research Affiliates LLC, with his team, dismisses most of these critiques. (1) Research Affiliates specializes in quantitative investing. They have thoroughly studied how various investment styles and selection criteria work over time, and currently advise over $160 billion of institutional investment assets (2015). So, when they claim that “It’s NOT different this time”, it is worth paying attention.

On the other hand, given the global economic recovery, no signs of imminent economic trouble and ample central bank liquidity, several of the sophisticated investors mentioned above have been considering the possibility of a market “melt-up.” As its name implies, this would be the opposite of a meltdown: a bubbly last hurrah of the long bull market that started in 2009.

I cannot entirely discard this possibility but I believe that stock markets now are mostly in their “voting machine” mode. In other words, they depend almost entirely on the psychology of crowds.

In many ways, the 1987 crash was what Nassim Nicholas Taleb later famously labeled a Black Swan: an event that is rare, has an extreme impact and, because it has never happened before, is hard to anticipate. So, a Black Swan may be waiting for us around the corner. Yet comparably rare events are mostly called Black Swans by those who failed to anticipate them or at least failed to protect themselves against their possibility.

If we leave aside “end-of-the-world” scenarios such as nuclear war, or the most obvious areas of blind greed and speculation such as bitcoin, the best way to protect ourselves financially is to heed the warning of Hyman Minsky. He observed that economic and financial stability leads to instability without the need for an external trigger, simply by making people more complacent and more willing to accept risk through the imprudent use debt.

Two obvious areas where complacency and increasingly blind risk acceptance have become the norm since the Great Recession (2007-2009) are:

  • Interest rates They have been “suppressed” (kept artificially low) by central banks, giving consumers and businesses the false impression that their actions are essentially riskless. As one example, the yield spread of junk bonds over Treasuries has shrunk to the point where investors may no longer be compensated for the additional risk they incur by buying “junk.”

2 capitulate

 

  • Stock market valuations Are they merely high, or unsustainably so? It depends where. In some areas of the markets, the answer is obvious. David Stockman, director of the Office of Management and Budget under President Reagan, made the point eloquently in the Daily Reckoning (8/1/2017). He pointed out that in the 31 months between January 2015 and August 2017, the weighted P/E (price/earnings ratio) of the so-called FAANGs + M (Facebook, Apple, Amazon, Netflix, Google and Microsoft) increased by some 50%!

The total market capitalization of the S&P 500 rose from $17.7 trillion to $21.2 trillion. The six FAANGs + M accounted for 40% of the entire gain, meaning that the market capitalization of the other 494 stocks only rose from $16 trillion to $18.1 trillion — only 13% in 31 months vs the 82% gain of the six super-momentum stocks. If that is not a bubble, I don’t know what is!

The irony, of course, is that by imposing as benchmarks indexes that contained these heavy-capitalization stocks, consultants, directors, and trustees forced many money managers to buy more of these expensive stocks as they became ever more expensive. Naturally the reverse dynamic will come into play when the stock market ultimately declines.

* * * *

It is our belief that an advisable policy at this juncture is to look for investment opportunities among the less-inflated segments of the global markets. This is where we are searching for new ideas. Meanwhile, having maintained adequate cash reserves will allow us to seize these opportunities as they arise.

At the same time, one of the rules for making money over time is, first, to avoid losing it. When markets decline, it is hard to escape the outgoing tide altogether. But we hope to minimize losses by avoiding the idolized and overpriced favorites of the preceding advances, as well as steering clear of companies that have burdened themselves with excessive or unnecessary debt (to buy back their own shares, for example).

“Over the years, Institute research has shown active managers, even the best-performing ones, suffered periods of weak returns relative to benchmarks and their peers. But underperformance, up to three years, had relatively little impact on the best-performing funds’ ability to deliver success over 15 years… We think that underperformance in shorter periods—such as one quarter, one year, and perhaps even a few years—can be a normal part of the investment experience, even for funds that perform well over longer periods.”

                          The Brandes Institute, September 2014

 

François Sicart – 2/6/2018

 

 

(1.) CAPE Fear: Why CAPE Naysayers Are Wrong – Research Affiliates – January 2018

 

 

 

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 Bottom-Up Research Helps Top-Down Understanding

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 clientspecific 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.

Picking daisies under a fuming volcano

Today is already the tomorrow which the bad economist yesterday urged us to ignore.” – Henry Hazlitt

In July 2007, near the top of big real estate bubble and only weeks before the Lehman Bros. bankruptcy and the onset of the Great Recession, Charles O. Prince III, then CEO of Citigroup, notoriously declared:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

The following cartoon, recently published by Horizon Kinetics, echoes this past episode and reminds us that contexts may change, but human nature does not.

Daisies 1

Source: Horizon Kinetics.

 

Bubble or no bubble? High valuations are a concern…

Depending on the valuation tool, the current US market could be considered either:

The third priciest market ever…

Daisies 2

Source: Robert Shiller.

The second priciest market ever…

Daisies 3

Source: Robert Shiller.

The priciest market ever…

Daisies 4

Source: Robert Shiller / 720 Global

The general perception, including ours, has been that much of the strong performance of the US stock market in the last ten years, as well as its current statistical overvaluation, can be traced to the increased weight in the major indices of the so-called FANG or FAANG (Facebook, Amazon, Apple, Netflix, Google) and a handful of others.

However, while stressing the worrisome popularity of the FANGs, with dedicated FANG indices and futures now available to so-called “passive” investors and momentum traders, investment manager GMO recently argued that the FANGs are not overvalued relative to the market but that it is the entire US market that is overvalued.

“Cyclically-adjusted earnings multiples have come under criticism because they include the earnings recession of 2009. But when GMO used price/sales ratios using sales for the last 10 years – affected less drastically by the recession – they found out that the S&P 500 was almost as expensive as it was at the top in 2000… So, US overvaluation appears to be real, and it cannot be blamed on the FANGs.” (John Authers – The Financial Times – 11/9/17)

…But bubbles are not only about valuations

High valuations may increase the markets’ vulnerability in a downturn or even be the harbingers of lower returns in the longer run, but they do not necessarily equate with the irrational exuberance of a bubble.

In fact, The Collaborative Fund’s Morgan Housel argues that people who bought Florida property during the 2004-2006 housing bubble, for example, should not necessarily be viewed as irrational.

The high prices did make little sense for traditional home buyers, who typically measure a property’s price against its potential to generate income if rented for a number of years; But, if buyers were purchasing with the intention to “flip” the property within six months, as the graph below implies, then long-term valuation criteria were becoming irrelevant to a growing number of housing market participants.

Daisies 5

Source: Robert Shiller / 720 Global

In the same way, today’s equity investors may be focusing less than historically on valuations because they also have no intention to hold on to their position for much longer than a few months (See the cartoon at the top of the article).

In Housel’s view, bubbles develop when investment horizons shrink, and more and more long-term, fundamental investors capitulate to join the recently successful short-term momentum game. In doing so, they lose sight of the risks that will come when the stock market reverses.

Yet, “flipping” can prove an expensive gamble, as buyers of apartments in “Billionaires ‘Row”, across the street from our office, are now learning with several units being sold or foreclosed at 30%-plus discounts from their $30-$50 million purchase prices a few months ago.

Shrinking horizons, the hunt for yield and greater risk acceptance

With peak valuations, and investment horizons shrinking, investors and speculators alike are increasingly desperate for returns and yield. Growing interest in emerging markets and ever-falling emerging markets junk bond yields are premier example of this phenomenon.

Daisies 6

Source: Bloomberg, Real Vision (left), J.P. Morgan (right).

But desperation and the feeling of having no alternative are no recipe for successful investment in anything.

Maybe not euphoria, but complacency for sure

In spite of peak valuations, shorter investment horizons, and proliferation of risk taking, it is hard to characterize the recent bull market as euphoria-driven. Instead, it has been slow and sustained, with many investors having had no experience of a serious down market or choosing to forget previous crises. This mindset has translated into highly passive and complacent investment approaches. With no down years or months, the most successful choice, so far, has been to remain fully invested.

Daisies 7

Source: ICI, BofA, Rydex, Federal Reserve, Sentimentrade.

Daisies 8

Source: Gallup.

The current low (perceived) volatility, low volume and passive, complacent markets awaken memories of Dr. Hyman Minsky, for whom financial and economic crises did not need an outside trigger, but were a natural stage of the free-market cycle.

 

Stability leads to instability

The Minsky Moment: We know how, but when is another question

According to Dr. Minsky, a period of sustained economic and financial stability encourages risk taking – especially through the growing use of debt – until excess leverage causes a sudden collapse in asset prices, which is a normal part of the credit cycle.

Long periods of stability thus naturally lead to instability, though with elusive timing.

Daisies 9

Source: Economic Sociology

Daisies 10

Source: Michael Roscoe, US Federal Reserve / BIS/ Economist / World Bank

 

The sand pile model

If, according to Minsky, financial crises and recessions do not require an external trigger, why do they develop?

A useful way of understanding the apparent randomness of market crashes is the Abelian sand pile model. The computer model of a sand pile is developed by virtually dropping individual grains from above: it continues to grow, apparently smoothly, until a critical state is reached from which a single grain can cause a collapse of the whole structure.

Daisies 11

Fingers of instability

According to physicist Mark Buchanan, the critical state of the sand pile is characterized by ‘fingers of instability’ that develop through it under the surface.

John Mauldin, who introduced us to the analogy several years ago, further explains that after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into ‘fingers of instability’ of all possible lengths. While many are short, others slice through the pile from one end to the other. So, the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability.” (Thoughts from the Frontline – John Mauldin –  MAY 6, 2013)

We don’t know how to predict which grain will be the one that triggers that avalanche. Similarly, when signs of vulnerability build in the economy or the financial market, it is hard to predict if, or when, their accumulation will trigger a simple correction or a major crisis.

Where would we look today for such fingers of instability? Most likely in areas where published statistics are contradicted by discrepancies below the surface.

Illusion of stability, but below the surface…

With the majority of money managers struggling to keep up with official market benchmarks, more investors have been adopting passive (index-linked) strategies rather than active ones (stock picking). Since major stock indexes are capitalization-weighted, the higher the stock market capitalization, the greater a company’s weight in the index. This is why, in recent years, the overall market performance has been increasingly influenced by relatively few “mega caps” such as the so-called FAANG (Facebook, Amazon, Apple, Netflix, Google). As a result, trading volumes in the rest of the market have collapsed and volatility seems to have evaporated.

Daisies 12

Source: MSCI.

Under the surface of peaceful and calm markets, however, many smaller companies, even in the same industries, tend to trade in a wide range with violent rallies and sell-offs.

The chart below depicts a one-month price action of two of our holdings from the same industry that proved to be surprisingly volatile and erratic despite the calm we see on the surface of the equity markets.

Daisies 13

Source: Bloomberg.

Major indexes keep rising but market breadth is weakening

During a prolonged period of stability, historically, an early indication that a bull market is aging has been when a group of stocks eventually dominates trading volumes, index performances, and the news, while the broader market begins to lag. We saw the Nifty Fifty stocks in the 1970s, the internet bubble stocks in the late 1990s, and today’s we are watching the FAANGs take the spotlight – Facebook, Amazon, Apple, Netflix, Google.

The discrepancy between the volumes of trading in mega-cap stocks and the rest of the markets under passive, index-shaped investing has created a divergence in price performance as well, between the few large-cap winners and the many losers in the current stock market.

Daisies 14

Source: Steve Bregman, Horizon Kinetics, Real Vision.

Daisies 15

Source:  Real Vision, Hexavest, Datastream.

Economic growth borrowed from the future

Despite recent releases of continued strength in the United States and accelerating economic growth in Europe and maybe even China, it seems that much of that growth is being “borrowed”.

For example, if we account for the share of the Federal Debt in US GDP growth, we’ll see that the economy net of borrowing has actually been shrinking since the Great Recession.

Daisies 16

Source: 720 Global.

Furthermore, in spite of its use by some politicians as a measure of the economy’s well-being, it should be remembered that the stock market has greatly outpaced both GDP growth and corporate sales growth. Thus, the real economy may be less robust than indicated by Wall Street.

Daisies 17

Source: Real Investment Advice.

Not only governments, and corporations have borrowed more in the last decade, but also consumer. It is increasingly worrisome how a fragile consumer depends on credit & assistance.

Daisies 18

Source: 720 Global.

There may be some argument about the conclusiveness of the chart above, but there should be none about the following one: delinquencies are on the rise, especially in the last couple of years. We live beyond our means, and for a while now, we’ve tried to maintain the same lifestyle with the help of increased debt, and public assistance.

Daisies 19

Source: Real Investment Advice.

Record help from non-traditional investors

Not only do investors remain complacent, but corporation themselves helped prolong the rally with buybacks of their own shares, partly funded by massive borrowings.

Daisies 20

Source: Standard & Poor’s Corporation.

But, even as corporations’ support of stock prices seemed to abate, Central Banks took the relay, by accelerating a buying spree – not only of government bonds, as traditionally, but now also of corporate bonds and equities.

Daisies 21

Source: Real Vision, Bloomberg.

Daisies 22

Source: BofA Merrill Lynch Global Research.

Daisies 23

Source: SG Cross Asset Research/ETF, Bank of Japan, Bloomberg.

In summary, we have undergone an unprecedented expansion of central bank balance sheets, which has stabilized most economies and propelled many markets to new highs. It would be naïve to believe that a reversal of those policies can leave investors, businesses and consumer unscathed.

The policy challenge: dual economy, one set of tools

Given peak market levels, fragile stability, and borrowed growth, the policy makers are facing a major challenge.

Their policies of further easy money, and more fiscal stimulus may do more harm than good, especially in the today’s world of dual economy. Part of the economy is growing fast, and requires little assets and labor, while the other part, more traditional, seems to be falling behind, because has excess capacity, and it is s asset heavy, and labor intensive.

There is also a mismatch in the supply and demand for labor. The growing economy needs more employees than it can find, while the traditional economy has fewer job openings that those willing to them.

To save the latter, we may be overheating the first. And anyone who still believes there is no inflation, we recommend taking a look at exponential growth in bitcoin price, new, breath taking record in art price sales, and record asset prices all around.

To conclude

That brings us to the wisdom of the father of value investing – Benjamin Graham, who famously said: “The essence of investment management is the management of risks, not the management of returns”

Being optimists at heart, we believe that those high-risk markets are usually if not always followed by some of the best buying opportunity of a generation. We trust that we are prepared for it, and we are looking forward to it.

Francois Sicart & 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 most unusual bull market

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 17th 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 20th, 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.

It’s easier to find someone to blame after the losses than to prepare for adversity

“Shirtsleeves to shirtsleeves in three generations.” United States

“Clogs to clogs is only three generations.” England

“Rice paddies to rice paddies in three generations.” Japan

“The father buys, the son builds, the grandchild sells, and his son begs.” Scotland

“Wealth never survives three generations.” China

 

The universality of the proverb above is the reason why, as investment advisers and family office to several generations, we view it as one of our primary missions to help our client families avoid the “curse of inherited wealth”. A good place to start is to try and avoid speculative bubbles and their fortune-destroying aftermaths.

* * * *

The history of investment markets is punctuated by the building and bursting of speculative bubbles, often accompanied or followed by economic recessions.  Avoiding these dangerous periods should be a major goal of investment for the long-term growth and protection of family patrimonies. In spite of this, after hundreds of years of experience, eliminating the impact of bubbles from truly long-term investment performance remains more an art than a science.

Venture capitalist Morgan Housel recently remarked that, because we do not know exactly when and how asset bubbles build up, our commentaries usually take refuge in the comfort of blaming others, such as the Fed, banks or Congress:

“Bubbles’ outcome is known in hindsight but the cause and blame are never settled on and in hindsight we are more apt to blame than learn”. (1)

Contradicting this natural tendency to blame, one of the originalities of Hyman Minsky’s Financial Instability Hypothesis was to state that “the financial system naturally swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”  The booms and busts that tend to accompany these swings are thus inevitable in a so-called free-market economy and do not need an external trigger, such as policy error, natural disaster or war, to occur. (2)   So. Where should we watch for potential bubbles?

Is Valuation an Anchor?

Many investors accept that bubbles are primarily a psychological phenomenon and thus a product of the “madness of crowds”. (2)

In recent years, this view has been reinforced by work from a newly-popular branch of psychology, behavioral investing, whose researchers hope, one day, to develop precise indicators of irrational excesses of greed or fear that would tell us when to buy or to sell financial assets. Unfortunately, those kinds of signals are anything but precise. The professionals’ favorite tool to detect bubbles probably remains valuation, of which one of the simplest and most widely used form is the price/earnings ratio (P/E).

Two groups have contributed to the upward pressure on stock prices and thus P/E ratios.

Corporations buying back their own shares boost earnings and lower P/E ratios

By buying in their own shares on the stock market, companies reduce shares outstanding and thus boost reported earnings per share, though at the expense of increased balance sheet leverage (equity and cash shrink, while debt does not), so that there is a limit to this trend.

As can be seen on the following graph, corporations have been the most aggressive buyers of their own shares since the stock market low in 2009.

It is easier 1

As If Life Was Not Complicated Enough, Central Banks Enter the Stock Markets

Much discussed, as a reason for high P/E ratios on stocks, is the artificially-low level of interest rates engineered by the world’s leading central banks. Stocks compete with bonds for investors’ favor, so when interest rates are low, P/E ratios tend to be high. And when interest rates are very low…

But, as if ultra-low interest rate policies were not enough, central banks now have begun to aggressively acquire common stocks directly.

In April, Bank of America noted that central banks around the world had already purchased $1 trillion in assets to that point of the year (an annualized rate of $3.6 trillion) and said it was the “best explanation” for record-high stocks. (3)

The Swiss central bank bought $80 billion worth of U.S. stocks through the end of the first quarter 29% more than at the end of last year. (4)

The Bank of Japan is now among the five largest owners in 81 companies on the Japan Nikkei 225 index… and nearly the primary owner in 50 of them. (5)

A recent Invesco poll of currency reserve managers at central banks revealed that 80% of the 18 central banks polled plan to increase their stock holdings. (6)

 Creating the Illusion of Perpetual Motion with a Minority of Stocks

When dealing with stock market indexes rather than with individual securities, the weighing of the stocks making up the index may also hide the fact that “bubbles” are concentrated in some segment of the market. As such, they may not necessarily show up in statistics for “the market” at large. Or, on the contrary, they may artificially boost these statistics. For example:

Goldman Sachs points out that 55% of the Nasdaq’s gains this year (to June 7) have been due to the top 5 large-cap tech stocks: Apple, Google, Amazon, Facebook and Microsoft. (7)

Bloomberg (08-04-2017) reports that large-capitalization stocks have risen six times as fast as smaller companies in the Russell 2000 Index. The advance in mid-size companies is about half the S&P 500.

At the same time, the large positions occupied in leading stock market indexes by recent top performers mean that, as index-mimicking funds attract capital, they have to buy large amounts of these stocks, further fueling their rise.  Howard Marks observes in his July letter:

“In the current up-cycle, over-weighted, liquid, large-cap stocks have benefitted from forced buying on the part of passive vehicles, which don’t have the option to refrain from buying a stock just because it’s overpriced.

Like the tech stocks in 2000, this seeming perpetual motion machine is unlikely to work forever.  If funds ever flow out of equities and thus exchange-traded funds (ETFs), what has been disproportionately bought will have to be disproportionately sold.  It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch.” (9)

Historical Background and Necessary Flashbacks

Valuation measures may not be ideal timing indicators, but when one compares the price of a stock or of an index to a single figure like its last twelve months’ earnings, there is no escaping the logic that the higher the ratio, the more optimistic investors are.

This is why an index’s P/E ratio materially exceeds its historical norm, there must be a strong presumption of a bubble in formation. In his July 26 letter, Oaktree’s Howard Marks points out that “the S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15. The Shiller cyclically-adjusted PE ratio stands at almost 30 versus a historic median of 16. This multiple was exceeded only in 1929 and 2000 – both clearly bubbles”. (9)

In early August, David Stockman calculated that Facebook, Amazon, Google, Netflix, Apple and Microsoft saw their weighted average P/E increase by 50% over the previous 30 months. He recalled the Internet bubble when, at the March 2000 peak, Microsoft’s P/E was 50x, Intel’s was 60x and Cisco’s was 200x: this compares to Facebook’s 40x, Amazon’s 190x and Netflix’s 217x today. Two years later, he reminds us, the four tech giants of the Internet bubble had lost 75% of their value. (10)

Amazon’s 1997 letter to shareholders states: “We established long-term relationships with many important strategic partners, including America Online, Yahoo!, Excite, Netscape, GeoCities, AltaVista, @Home, and Prodigy”.

“Unless you believe Yahoo remains a leading force in that space, none of these “important strategic partners” still exist in a meaningful way today. The super-stocks that lead a bull market inevitably become priced for perfection.  And in many cases the companies’ perfection turns out eventually to be either illusory or ephemeral.  Some of the “can’t lose” companies of the Nifty-Fifty were ultimately crippled by massive changes in their markets, including Kodak, Polaroid, Xerox, Sears and Simplicity Pattern.  Not only did the perfection that investors had paid for evaporate, but even the successful companies’ stock prices reverted to more-normal valuation multiples, resulting in sub-par equity returns. (9)

A Bubble in Complacency

Basically, Minsky’s Financial Instability Hypothesis says that economic stability naturally breeds instability. But it helps to have a fertile soil and, there, debt and borrowing can help:

 

  • When an economy is perceived as stable, people become optimistic.
  • When people get optimistic, they pile on debt in an effort to increase their returns.
  • When they pile on debt, the economy becomes unstable.

Thus, debt plays a central role in the bubble-building process and, from this vantage point, there is reason to worry when the economy appears stable and borrowing becomes overly easy:

In early May, Netflix issued €1.3 billion of Eurobonds, the lowest-cost debt it ever issued.  The interest rate was 3.625%, the covenants were few, and the rating was single-B.  Netflix’s GAAP earnings run about $200 million per quarter, but according to Grant’s Interest Rate Observer, in the year that ended March 31, Netflix burned through $1.8 billion of free cash flow.  According to Howard Marks, “The fact that deals like this can get done easily should tell you something about today’s market climate”. (9)

He goes on to quote a comment from a leading strategist about the return of Argentina to the bond market after five defaults in the last hundred years (one in the last five): “It’s just shocking that they exit default and their bond issue is a century bond”. Nevertheless, the strategist was advising her clients to buy the bonds “at least for a short-term trade”.

Shifting Time Horizons May Explain Bubbles

In his blog article on bubbles, Morgan Housel adds a dimension to the definition of bubbles by bringing into the discussion the time horizons of various investors.

“One of the biggest flaws to come out of academic finance is the idea that assets have one rational price in a world where investors have different goals and time horizons… When investors have different goals and time horizons, prices that look ridiculous for one person make sense to another, because the factors worth paying attention to are totally different”. (1)

Since bubbles are bubbles, Housel’s comments on shifting time horizons apply to the housing market as well:

The following chart shows the percentage of Florida home sales whose previous owner held the property for less than six months. “It’s hard to justify paying $700,000 for a two-bedroom Miami track home to raise your family in for the next 20 years. But it makes perfect sense if you plan on flipping it in a few months into a liquid market with price momentum…  You can say a lot about these investors. You can call them speculators. You can call them irresponsible. You can shake your head at their willingness to take huge risks. But I don’t think you can call all of them irrational.

It is easier 2

Bubbles are not so much about valuations rising. They are about time horizons shrinking. They aren’t so much about people irrationally practicing long-term investing. They’re about people somewhat rationally moving toward short-term trading to capture momentum that had been feeding on itself. (1)

 

Conclusion

Successful long-term investing is primarily about understanding your own time horizon and not being persuaded by the price actions caused by people with different time horizons.

I believe that, by being drawn by consultants and new regulations toward the measurement of short-term “competitive” performance (e.g. performance relative to specific indexes or narrowly-defined competitors), many fiduciaries have been losing track of their long-term responsibilities to family fortunes.

As Warren Buffett may have said: “To finish first, first you need to finish.” And to finish, you must first avoid succumbing to speculative bubbles.

 

François Sicart

September 11, 2017

 

Notes:

  1. Morgan Housel – The Collaborative Fund blog – 6/22/2017
  2. The Jerome Levy Economics Institute of Bard College – May 1992
  3. Charles Mackay – Extraordinary Popular Delusions and the Madness of Crowds (1841).
  4. Business Insider – April 21, 2017
  5. Forbes – May 16, 2017
  6. Bloomberg.com – August 14, 2017
  7. The Daily Reckoning, July 19, 2017
  8. Zero Hedge – June 9, 2017
  9. Bloomberg.com – 08-04-2017
  10. “There They Go Again . . . Again” – Howard Marks – Oaktree, July 26(The Daily Reckoning –  8/1/2017)
  11. The Daily Reckoning –  8/1/2017

 

 

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.

Life in a shrinking economy, a forgotten concept

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 21st, 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.

How can we be wrong?

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?

1

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?

2

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?

3

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.

DANGER FOR THE 20%

According to Bloomberg.com, a luxury condo on “Billionaires’ Row,” across the street from our office, is scheduled for a July foreclosure auction that might be the biggest in New York City residential history.

A shell company bought the condo in December 2014 for $50.9 million and took out a $35.3 million mortgage from a Luxembourg private bank in September 2015. Since the loan was not repaid one year later, when it was due, the bank is forcing a sale to recoup the funds, plus interest.

This news brings a few remarks to mind:

First and foremost, I am reminded of the high risk of investing with borrowed money. If our unfortunate billionaire across the street cannot sell his condo for more than $35.3 million dollars (and who can assess the true worth of a condo?), he will have lost his entire investment.

Second, people like us might have thought that we were comparatively rich – even part of the fabled “one percent.” But we are nowhere near the really rich who can afford the condos on “Billionaires’ Row.” These truly wealthy individuals are often foreigners. Some are American entrepreneurs who recently floated their startups on the stock market, others are those entrepreneurs’ investment bankers or and a few finance-related operators who have closed a major deal or received an exceptionally large special bonus. No one whose lifestyle depends on a salary or another traditional form of income can join the club of the truly rich.

My third point, however, is that the last eight years have been characterized by a steady upward run in stock and bond prices. As a result, (and this is often overlooked), life has been surprisingly comfortable for the relatively small segment of the population that directly owns investment portfolios.

Who are we, the investors?

In “The Dwindling Taxable Share of U.S. Corporate Stock” (taxpolicycenter.org, May 16, 2016), Steven Rosenthal and Lydia Austin reckon that there is $22.8 trillion in stock outstanding in the USA. (1)

Of this total, retirement accounts such as IRAs and pension plans own roughly 37%. Since most of these tax-deferred accounts will not be spent until retirement, I assume that they do not affect Americans’ perception of their current standard of living.

Meanwhile, the authors find that the amount of stock directly owned by individual investors (including taxable funds) has dropped from 80% in 1965 to only about 25% in 2015.

The danger is that the shrinking minority of investment-portfolio owners is increasingly viewed by today’s voters as a privileged elite not representative of the overall electorate.

Future elections may not favor investors

A majority of Americans in the lower income brackets admire high-earnings sports and entertainment stars, as well as ultra-rich business moguls. This was illustrated most recently by the election of Donald Trump to the U.S. presidency.

However, while the visibly, even ostensibly very rich do not seem to attract popular resentment, the story may be different for the merely rich.

NPR’s Steve Inskeep recently reviewed a new book, Dream Hoarders, by Richard Reeves, a senior fellow at the Brookings Institution. The author argues that the top 20 percent of Americans — those with six-figure incomes and above — dominate the best schools, live in the best-located homes and pass on the best futures to their kids:

“We protect our neighborhoods, we hoard housing wealth, we also monopolize selective higher education and then we hand out internships and work opportunities on the basis of the social network.”

According to Reeves, the American upper-middle class is essentially “hoarding the American dream.”

The perception is that the American upper-middle class is making out pretty well from current trends and that it is increasingly detached – occupationally, residentially, educationally and economically — from the rest of society. The fact that its members are not only separate but unaware of the degree to which the system works in their favor strikes Reeves “as one of the most dangerous political facts of our time.”

This is why, although the world’s economic and financial situation has remained worrisome for most, investors should not forget that they have had it pretty good for the eight years since the last financial crisis and so-called “Great Recession.” My partner Bogumil Baranowski reminds me that the net worth of U.S. households fell from a pre-recession peak of $67 trillion to $54 trillion in the midst of the recession, only to recover to $95 trillion today. This adds up to $40 trillion wealth creation from real estate and securities in the past eight years, mostly for the benefit of the upper middle-class.

A Judeo-Christian view of the stock market

My father, who was anything but a religious person, nevertheless taught me that, eventually, we are all rewarded or punished for our actions.

In most cultures, the bad deeds are fairly easy to recognize and are usually explicitly identified by laws or rules of good conduct. But even if we personally stay out of trouble, we may be guilty “by inaction” — allowing other individuals or groups to misbehave, out of complacency, moral myopia or mere denial. In the Judeo-Christian tradition, this complacency is complicated by the notion of guilt – in particular when you allow dubious things to happen that you might subconsciously enjoy or benefit from.

Maybe it is my heritage, or simply my innate contrarian bias, but I also always feel that when things go too well in the economy or the stock market, we do not fully deserve these good times, and we ultimately will have to pay for them.

Currently, the length of the global stock markets’ advances since 2009 puts me on alert, along with:

–the excesses I observe in debt use

–financial risk acceptance under the umbrella of record-low interest rates

–central bank inflationary or bubble-creating policies

–historically-high asset price valuations

–and finally, the complacency of most investors toward these excesses, which make me think, “Beware the day of reckoning!”

ASSETS DECOUPLING FROM INCOME SIGNAL FINANCIAL DANGER

Danger 1

Source: Bloomberg, TCW.

Investing like ostriches

Ostrich syndrome: “Denying or refusing to acknowledge something that is blatantly obvious as if your head were in the sand like an ostrich” (urbandictionary.com). This definition could be a Wall Street sage’s description of current investor sentiment.

One way to play the ostrich is to rationalize whatever the markets do, in an attempt to make it look logical and credible.

The Fed Model promoted by former Federal Reserve Chairman Alan Greenspan basically states that when the earnings yield on stocks (earnings divided by price) is higher than the yield on Treasury bonds, you should own stocks. Many of today’s rationalizers use versions of this model to argue that investors should disregard current overvaluations and continue to chase stocks up, because interest rates are historically extra-low (in fact, negative in some countries).

In a 2003 critique of the Fed Model, Cliff Asness, a founder of AQR Capital Management and pioneer of quantitative asset management, criticizes pundits who illustrate (with a graph or a table) that P/Es and interest rates move together, and who then jump to the conclusion that they have proven that these measures should move together. In this view, which Asness challenges,  investors are thus safe buying stocks at a very high market P/E when nom­inal interest rates are low.

Separately, economist Lance Roberts illustrates that what these pundits really should say is that it WAS a good time to buy stocks ten years ago (May 18, 2017 post, realinvestmentadvice.com). As shown in the chart below, which compares earnings yield (E/P: inverse of the P/E ratio) to following 10-year real returns, when the earnings yield has been near current levels, the return over the following 10-years has been quite dismal.

Danger 2

Source: Real Investment Advice.

For my part, I will just point out that, yes, interest rates have been declining for almost 40 years and are now near all-time lows. But in a cyclical world, low interest rates today foreshadow rising rates in the future.

Reformed Pundits

Even some of the pundits are beginning to worry about prevailing investor complacency. Rob Arnott is the founder and chairman of Research Affiliates. He has pioneered several modern portfolio strategies that are now widely applied, including tactical asset allocation, global tactical asset allocation, and the Fundamental Index approach to investing. With regard to Smart Beta, one of the most fashionable quantitative investment disciplines of recent years, the Research Affiliates website even claims that: “Clearly, Research Affiliates was offering investors smart beta strategies long before the term smart beta even existed.”

In February 2016, however, Arnott published with three  colleagues a new paper: “How Can Smart Beta Go Horribly Wrong?”

The authors propose that the reassuring message of smart beta proliferators has two primary and interrelated flaws:

First, many of these… claims are based on a 10 to 15-year backtest that won’t cover more than a couple of market cycles. Second, such a short time span is very vulnerable to distortion from changing valuations. Our analysis shows that valuation has been a large driver of smart beta returns over the short and even long term. How much can we reasonably expect in future returns from these factors and strategies, net of valuation change?

Generally speaking, normal factor returns, net of changes in valuation levels, are much lower than recent returns suggest… If rising valuation levels account for most of a factor’s historical excess return, that excess return may not be sustainable in the future; indeed, our evidence suggests that mean reversion could wreak havoc in the world of smart beta. Many practitioners and their clients will not feel particularly “smart” if this forecast comes to pass.

 Risk myopia

Michael Lewis’ Liar’s Poker (WW Norton & Company, 1989) is considered one of the books that defined Wall Street during the 1980s. The book is a semi-autobiographic, unflattering portrayal of Wall Street traders and salesmen, their personalities, their work practices and their ethics. However, six months after Liar’s Poker was published, Lewis reports finding himself “knee-deep in letters from students at Ohio State University who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual” (Prologue to The Big Short 2010 – W.W. Norton & Co.)

Obviously, not everyone on Wall Street is crooked or unethical. But there is little doubt that, knowingly or not, many of its influential leaders and innovators are prone to take outsized risks with other people’s money. And, since “other people” is us, we owe it to ourselves to avoid playing the ostriches.

As early as March 26, 2014 Bloomberg.com quoted investor Seth Klarman as saying: “Giddy investors are living an existence where, on the surface, everything seems idyllic. In reality, the manufactured calm — thanks to the free-money policies of Ben Bernanke, Janet Yellen and Mario Draghi — anesthetizes us to the looming trouble. The longer QE continues, the more bloated the Fed balance sheet and the greater the risk from any unwinding.”

This is a stark reminder of economy professor Hyman Minsky’s warning that financial crises tend to arise naturally (without a necessary outside trigger) when a long period of stability and complacency eventually leads to the buildup of excess debt and overleveraging.

Danger 3

Source: Abbas and others 2010: Bank of International Settlements; Dealogic, IMF, OECD.

To try and quantify the stock market risk, I turn to John Hussman, in the Hussman Funds letter of June 26, 2017:

On the basis of the most reliable valuation measures we identify (those most tightly correlated with actual subsequent 10-12-year S&P 500 total returns), current market valuations stand about 140-165% above historical norms. No market cycle in history, even those prior to the mid-1960s when interest rates were similarly low, has failed to bring valuations within 25% of these norms, or lower, over the completion of the market cycle. On a 12-year horizon, we project likely S&P 500 nominal total returns averaging close to zero, with the likelihood of an interim market loss on the order of 50-60% over the completion of the current cycle.

Granted, Hussman has been cautious-to-negative about the stock market long enough to acquire the identity of a perma-bear. But he is also one of the experts who has thoroughly studied the correlation between various levels of stock market valuations and future multi-year returns.

We cannot forecast the timing of the next “Minsky moment” but we should keep in mind that, based on history, it could be painful.

François Sicart

6/27/2017

 

  1. Not including U.S. ownership of foreign stock and stock owned by “pass-through entities” such as exchange-traded funds.

 

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.

The Emperor’s New Clothes – Understanding Today’s Financial World

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.

How to save a fortune, and make money in these perilous times?

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 18th 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.

PREPARING FOR THE SALE OF THE CENTURY — OR JUST BEING PRUDENT?

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 21st, 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