Bargain? Or Devil's Bargain?
No one asked for falling securities prices for the Holidays, but that’s what we got. Then we've had to endure the endless barrage of media interviews with Cassandras preaching that the end is near.
What should you do? Pull in the reins and get more conservative? Or step up and get more assertive? Before doing anything, breathe deeply. A calm awareness of reality is what we need.
The past few years we have written and spoken of our worries concerning “financial repression” at the hands of central banks. This, we have repeatedly emphasized, has artificially depressed interest rates and inflated asset prices. In plain English, financial repression has deprived retirees of income. Concurrently, it has inflated the prices of stocks, bonds, homes, farm land, and even art.
Three years ago, we wondered why so few seemed bothered by financial repression. “The Fed’s zero interest policy is literally stealing from grandmothers. How is this not considered theft of the highest order? How is the term ‘financial repression’ not repeated daily on the front page of the New York Times?” ("End Financial Repression Now", Oct. 2015)
The repression is now ending. As rates rise, this releases some of the hot air levitating asset prices. Will Fed Chairman Powell raise them more? Does he have the stomach for it? Markets surely do not. This is the drama that we're all seeing play out on our brokerage statements.
Financial repression has forced us all into a devil’s bargain: Either pay up and invest at inflated prices or sit in cash and lose to inflation. Which is the lesser evil?
To answer that, here’s the key question we must ask ourselves: Do you believe that cash or assets will perform better over the next ten years and beyond? We believe that central bankers will succeed in their efforts to debase cash. They have the will and the means to succeed. And they must succeed. Debasing cash (whether by inflation, currency debasement, or both) may not be the “high road”, but it is the easy road. Governments globally have made long-term promises they cannot afford to keep, and the bill is coming due. Hence the explosive growth in government debt. Debasing cash allows governments to pay their ballooning debts -- not in real terms, of course, but in nominal terms.
Sitting in cash or investing in inflated markets both sound like bad choices. And they are. But choose we must. As the Rush song goes, “If you choose not to decide, you still have made a choice.” We believe the optimal choice is to balance and own some of both. This needs to be done thoughtfully, proactively, and in a way tailored to each client's unique cash flows, objectives, and temperament.
Ultimately, you want to own real assets (companies and real estate), acquired over time. The key here is to “own it”. You want real equity in things you understand. Although the market price of your assets will fluctuate (at times violently), it is your best chance for preserving your relative wealth and buying power in the years ahead.
How much equity is enough? As much as your situation and temperament allow. Everyone needs some cash and fixed income. The optimal amount may be 20% of a client's assets. Yet, it may be 80% for another client. Every client is different, and so every portfolio should be different.
What to Do Now?
Stock prices are now a bit cheaper. For some investors, this should be a good thing. For others it should be a non-event.
For those still in the accumulation phase: Lower prices should be a blessing for you. You can now buy earnings at a lower price than before.
For those in the harvesting phase: (Those spending the income from their portfolio.) Lower stock prices should be a non-event for you. This presumes that you're spending all of your dividends and will not need to liquidate stocks for spending needs in the foreseeable future.
Note the emphasis on "should be" above. This assumes that you have a thoughtfully constructed portfolio and Investment Policy. This helps you be calmly proactive in such markets, rather than frantically reactive.
More broadly we believe investors should consider the following in this environment:
Avoid “return-free-risk”. Jim Grant uses this clever twist on “risk-free-return” to describe investments that offer very little potential upside, yet entail substantial downside risk. Don’t be tempted by higher yielding alternatives today. We do not believe you’re paid for taking credit risk. We’re thus avoiding most low-rated (junk) bonds and high-dividend stocks. Maybe these will offer compelling value in the future, but not today. It's “return-free risk”. Accordingly, we prefer U.S. treasuries and high-grade municipal bonds.
Be happy being short. Short-term rates have risen a lot, long-term rates have not. This “flat yield curve” means that the greatest “value” is in shorter-to-intermediate term bonds. (Except with municipals, which we believe offer some compelling value in longer maturities.)
Think globally, act globally. Though cheaper, US stocks today are like a sale at Bergdorf’s: less expensive, but no bargain. International stocks, however, are more interesting. Even before the recent pullback, international stocks were not expensive by historic standards. Now they’re even cheaper. We thus see more value in international stocks than US stocks.
Consider hedging where appropriate. For certain investors in certain circumstances, it makes sense to explore the use of a tail hedge.
Don't go "all in". Sitting 100% in cash is not a good idea. Nor is rushing “all in” into stocks and bonds (even at these lower prices). The rational solution is to diversify. Own quality assets (stocks, real estate, etc.), which over the long-term should grow ahead of inflation. At the same time, based on your cash flow needs and time horizon, ensure an adequate allocation to cash and bonds to allow you to both weather a severe downturn as well as to give you buying power to buy earnings streams at depressed prices should they go on sale. But ….
Don’t be cute. Maybe you’re planning to just sit on the sidelines, believing you’ll jump in at a better time. Careful. History is not on your side. The odds are not on your side. Your odds are far higher acquiring and holding an owner’s earnings stream over many years – even if you don’t buy them at bargain prices. You need to be in the game, not on the side-lines. Have a plan and stick to it. Be sure you have a good coach (adviser). It won’t be easy in this new environment. To win, you’ll need to play both good offense and good defense.
As always, let us know if we can help. We're here for you.
Frank Byrd, CFA
Disclaimer: While the information presented herein is believed to be accurate, Fielder Capital Group LLC (Fielder) makes no express warranty as to the completeness or accuracy, nor can it accept responsibility for errors appearing in the document. Fielder is under no obligation to notify you of any errors discovered later or of any subsequent changes in opinions. Nothing herein should be construed as a recommendation to buy or sell any of these securities. It should not be assumed that any of the securities, transactions, or holdings discussed will prove to be profitable in the future or that investment recommendations or decisions Fielder makes in the future will be profitable or will equal the investment performance of the securities discussed herein. Fielder or its employees may have an economic interest in securities mentioned herein.