Predicting the markets is tough work. Whether you are attempting to do it on a micro scale such as with individual stocks within an industry or on a macro scale calling individual currencies or country returns, anticipating long term trends is no easy task, even for the most experienced investors.
I worked at a software company as an intern when I was in graduate school and it was a unique experience because it gave me insight into a unique segment of the market. Everyone that had worked there had spent most of their careers in the same, seemingly mundane industry: corporate budgeting software. Yet almost all of them has worked at small start ups that weren’t that dissimilar from the startups many Gen-Z workers want to work at today. The goal was the same then as it is now for many in tech: land a job in a small start up, collect some shares and move onto the next start up for a few years. Hopefully within that time, one of those companies turns into a unicorn and goes public, then you will get a windfall from your insider shares.
I didn’t get rich from that job or remember much of what I did, yet what I remember most were some quotables from the CFO of that company who had the most experience. He said that throughout his career, he had noticed that if an entrepreneur had “got it right” at least once, he could go on making start up after start up and, even if they kept failing, investors would still come back hoping they had that magic for that next best thing.
I think of this anecdotal tale when I read tweets from vaunted investors like Michael Burry of The Big Short fame. It seems that once you have made a billion once, everyone seems to think you have the magic crystal ball and everything you say will come to fruition. Yet the market teaches us that this just isn’t always the case. Really smart people constantly make terrible and quickly forgotten, calls on the market. I have pointed out in many previous posts that there is a psychological incentive to promote fear based news because losing money tends to hurt more than the positive impact of making gains on us psychologically. Burry made a bet a few years ago was on water, seems intuitive but what ever happened to that?
Now he is betting on Tesla’s crash and a massive inflation spike, but neither has shown up to the degree to which he was sounding the alarm. What we need to take into account is what is called survivorship bias. Those who made predictions and struck it rich when they got it right were once part of a cacophony of voices that are constantly trying to tell everyone what the market will do next, and they are often wrong. We tend to fixate on the one winner out of all those losers and put ourselves in their place, thinking if we just mimic their behavior or follow their advice, we too can be great investors and make millions, or even billions. Yet the reality is more sobering. Billionaires are 0.00045% of the US population, the chance that you or I will ever accumulate that much money is almost 0. More practical advice is to try to achieve consistent high single or double digit returns with a large swath of your savings, leaving the moonshot funds for a small portion of that.
In fact, some of the best investors revisit their investments on a regular basis and see where they went wrong. Warren Buffet is famous for this and every year at the Berkshire annual meeting he shares not just his successes but also his failures. I think this is one of the keys to his loyal following among individual investors, his relatability while still being a genius.
Global Debasement
But I digress, all of this occurred to me as I re-evaluated my active investments and how I can adjust them due to market events. One of the more difficult calls this year has been to predict how foreign markets will perform versus the US market both on a local currency and relative equity performance basis. If you recall when we started the year, stocks were still in the early recovery phase of the cycle and had significant upside. The massive stimulus and the QE from the Fed were fueling a serious narrative about inflation that investors seemed to buy wholeheartedly. Earlier in the year, I attempted to capitalize off of these fears through the Vanguard Materials ETF (VAW) which shot up almost 23% through May 2021 from January but has since slumped by over 7% leaving it with a 14.8% return year to date.
Other consensus trades were value shares, which during the beginning of the year consisted of many energy as well as financial shares as well as emerging market shares. Yet year to date, the Vanguard Emerging Market ETF (VWO) is up 8.6% compared to 14.5% for the S&P 500. Meanwhile,the dollar has seen a bit of a small resurgence lately with the prospect of rates rising sooner than previously anticipated. The USD index is up 2.3% in the last month after a slide of 3.8% between March and May. So far, emerging shares and currencies have not matched their hype and the slide in the dollar has been staved off. Being on the wrong side of this bet has meant big opportunity costs compared to the simple S&P 500 index investor.
In contrast, I came across an interesting theory the other day that posits maybe what US dollar bears are chasing is all wrong. What the issue may be is debasement of all fiat currencies not just the debasement of the dollar. We’re you to take this approach, it may change your view on both domestic, foreign stocks as well as real assets.
This theory was posed by former macro fund manager Raoul Pal. In a series of tweets in March, he shared his ideas around how the entire rally in global shares since the crisis and the central bank support of the global financial system.
The correlation between Fed support specifically and asset prices was shared in a chart as well.
Pal thinks that we shouldn’t be worrying how the dollar is performing versus other large currencies or even emerging currencies but since the large quantitative easing is potentially debasing all currencies, then we need to be looking for the assets that are increasing in value even in relation to the ballooning central bank balance sheets.
When Pal looked at typical inflation hedges like gold or other precious metals, they didn’t hold up in terms of increased value when returns were divided by the growth in central bank balance sheets. It was only tech shares that increased in value during this time.
From this information he comes to the conclusion that tech shares are the asset class that will hold up over time if all major currencies are debasing the value of their currency in relation to real assets. This loosely seems to make some intuitive sense but isn’t the most convincing of arguments. Besides, the tech outperformance versus central bank assets can be whittled down to 4 years of returns from 2015 to 2019, hardly something I am comfortable extrapolating out for the next 5-10 years.
Yet there is reason to believe that his argument that all major currencies are being debased simultaneously isn’t a crazy one. 2 weeks ago when the Fed announced that rates may rise in 2023 as opposed to 2024, the long end of the yield curve actually was undergoing a period of flattening since the yield spike experienced in March. This coincided with that dollar rally I mentioned previously and the two do not operate independently.
Low rates and negative rates are the lay of the land in Japan, Switzerland as well as the Euro area, so any bump in rates could potentially be brought down as foreign buyers come in to bid up the (relatively) cheaper USD assets. This is what may have driven down the yield curve from its March highs. It seems that liquidity in the rest of the world matters for the US just like dollar liquidity matters for the rest of the world.
If we were in a situation where only the US had low rates and the rest of the world was humming along with rates of 3-5% then the dollar would likely be experiencing a serious tumble right now. Since much of the rest of the world is in a low rate environment however, it becomes a lot tougher to predict the short and even medium term path of the dollar.
Yet in his simple analysis, Pal left out one thing besides tech shares that can benefit from all the government intervention and that is borrowing. Assuming we can’t always predict what asset will maintain value through all this “debasing” what we can do is spread our assets over shares, bonds, and real assets and then borrow a portion to finance it at fixed rates. Even if these assets just maintain their real value, the holder still gains with borrowing that is just above or at the rate of inflation. In a sense, any return above inflation if it is leveraged this way is a win.
This may be a primary factor driving the institutional interest in buying up single family homes to rent. With mortgage rates so low, even MBS securities don’t yield much, why not just buy the homes outright, get some price as well as the cap rate for income? The leverage is essentially free money as well.
The major question confronting investors when they ask “where do we go from here?” is what assets will be impacted the most by lessening Fed intervention? Despite yet another year of underperformance, I still believe emerging economy shares have factors in their favor when it comes to commodities. Foreign shares still have some room to run as Europe and other large economies catch up in terms of vaccination rates in 2022, France’s CAC quietly has the best performing national stock market this year at 19%. One thing is for sure, it won’t be an everything rally like we saw in 2020.
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