The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes
Our insights, reflections and musings on the most timely topics relevant to managing your investments.
No one likes corrections, and many investors are downright afraid of them. No one likes seeing the value of what they own going down, even if deep down they know it is temporary. This is the market risk that many investors just do not want to experience. However, there is another risk which is less obvious but far more serious: failing to grow your money at the rate of inflation.
Little things make big things happen, but some details are more important. To the market, the mere idea of oil in the future made a difference, while the detail on timing did not.
It isn’t just Simone Biles who feels the pressure of unrealistic expectations lately: Second-quarter GDP reported on Thursday this week. The expectation was for 8.5 percent, which had already come down from more than 9 percent; yet the economy actually grew at 6.5 percent according to the first reading of GDP. That is a full two-point deduction, which is a little more than simply “not sticking the landing” – this is a huge disappointment. Or is it?
Inflation is a stranger to many. I wrote an article in 2011 about how hard it was to actually have inflation…yet here we are. Why has inflation suddenly returned, and what can we, as investors, do about it?
Wednesday the Consumer Price Index (CPI) came out +4.2 percent over the past year. Thursday morning the Producer Price Index (PPI), which measures wholesale inflation, was announced to be 6.2 percent. More concerning is the reaction of Richard Clarida, the Federal Reserve vice-chair, who said he was, “surprised.”
We have been saying for a while now that the market is in need of a correction. No one likes corrections, and many investors are downright afraid of them. Any sign of downward price movement in their portfolio sends them seeking shelter. This is understandable; no one likes seeing the value of what they own going down, even if deep down they know it is temporary.
This is the market risk that many investors just do not want to experience. However, there is another risk which is less obvious but far more serious: failing to grow your money at the rate of inflation. In the last year the fearful investor who put his money into a safe cash-like investment would have been fortunate to receive a 2 percent return. The rate of inflation through August was 5.3 percent. This investor lost more than 3 percent of his purchasing power and in all likelihood doesn’t even realize it. If one were to continue that strategy, he would very likely end up outliving his money.
This has not really been a concern for a long time as inflation had been tamed; however, with the return to economic thinking that led to runaway inflation in the 1970’s, we are once again seeing a return to inflation coupled with lower economic growth. The Atlanta office of the Federal Reserve has a GDP forecast based solely on quantitative inputs, or in other words it is not adjusted up or down based on any human judgement, it is just the facts. At the end of July, this tool projected GDP growth of 6.1 percent; as of September 27, this tool is projecting GDP growth of just 3.2 percent. This is an enormous drop in GDP expectations in a very short time, and it follows actual GDP missing expectations by 2 full percentage points.
If the rate of growth in economic activity is dropping like a stone, then how can it be that inflation is so high? I’m sure you have heard by now, but the global supply chain is a total mess. According to research by JP Morgan, there are more than 70 container ships in a queue outside Los Angeles. That is a record. So, what is causing the backup? It is the combination of spiking demand and a lack of workers.
One can pass the buck to Covid if she wishes, but the truth is, this is the result of policy decisions. Sure, the pandemic may shut down production in certain areas due to outbreaks, but that would ordinarily reduce demand right along with the reduction of supply. However, policy during the pandemic did not just make people whole, replacing their wages mostly or even dollar-for-dollar, which would ease suffering. No, policymakers decided people need to make more money when quarantined than they would in real life. What did people do? They spent it on stuff, lots and lots of stuff. They might have spent it on eating out or going on vacations, but they were not allowed. Stuff is what they could spend it on, so stuff is what they bought. A large quantity of this stuff is now sitting in ships anchored outside of ports, waiting for the people who bought the stuff to actually come back to work and unload it.
Meanwhile, the experts at the Fed have been telling us that the spike in inflation is “transitory” (which I thought meant temporary or fleeting, but evidently they have a different definition). It is true that the latest inflation reading was 5.3 percent and that was down from 5.4 percent; however, JP Morgan points out that this decrease was mostly from declines in airfare, lodging and rental cars, which can be attributed to the Delta variant. This will likely bounce back, and other categories are still rising sharply.
It appears that people are waking up to this. In the last week or so the interest rate on the 10-year Treasury has risen from the 1.3 percent range to more than 1.5 percent. That may not sound like much to a lay person, but this is a sharp rise in a short period of time. However, even with a 1.5 percent yield, that means a loss in purchasing power of 3.5 percent per year when compared to inflation being more than 5 percent.
In my opinion, inflation is the real risk in the market, not volatility. We are likely due for a correction, but we would see that as a buying opportunity. Stocks are the best long-term hedge against inflation. If the volatility causes investors to run to what they believe are safe havens, then those investors are likely to experience real loss as the cost of living grows faster than their money. In investing, as in life, what people fear and what they should fear are often very different. Don’t fear the sudden drop of a market correction; fear the slow bleeding of inflation outpacing your savings.
Chuck Osborne, CFA
~The Real Risk
“It’s the little details that are vital. Little things make big things happen.” – John Wooden
I love that quote from John Wooden. I would, however, make one addition: all details are not created equal. Some details make a huge difference while others make no difference whatsoever. One of the greatest things about having years of experience in a particular field is that one learns which details matter, and which to ignore.
One great example of this happened in March of 2009. We were at the lows of the market crash, which had been brought on by the Financial Crisis. Then-Fed Chairman Ben Bernanke made a statement that the Fed was not going to allow anymore banks to fail. I remember our next investment committee meeting like it was yesterday. One of our analysts kept saying, “This doesn’t actually change anything, it is just a comment.” She was mistaken; it changed everything.
Bernanke’s comment took zero off the table. When a professional investor analyzes a company, she is looking into the future. No one knows what the future will actually be, so what one does is run various possible scenarios. If one of the scenarios has the business literally folding and the stock going to zero, that will have an enormous impact on what the analyst thinks the stock is worth. This is basic math – when averaging numbers, a zero has an enormous impact. When zero was taken off the table, the projected value of the stock market skyrocketed, and in this case so did the market in real life. The little things make the big things happen.
Just a little while after that, the price of oil flew higher. There were several causes for this, as is always the case. We wishfully try to explain everything that happens in this world with simple cause and effect, but that isn’t reality. When something gets as out-of-whack as oil selling for $140 per barrel, there are multiple reasons. One of those reasons was the Obama administration restricting drilling on government lands. I am not commenting on whether this is good overall policy; reasonable people can have different opinions on that. However, there is no doubt that doing this reduces the supply of available oil and therefore raises the price.
I explained this to one of my friends who agreed with the policy, and he reasoned that even if the administration allowed drilling, it would take a decade before oil was actually found, extracted, and brought to market. All true, but that is not how markets work; markets look at the future. The mere possibility of future sources being available impacts today’s price by more than most would believe. Little things make big things happen, but some details are more important. To the market, the mere idea of oil in the future made a difference, while the detail on timing did not.
We have seen this is reverse when the Biden administration stopped construction on pipelines. These pipelines were not finished and therefore not in operation, but that is a detail that does not matter to markets. The idea that less expensive, more environmentally friendly ways of transporting oil and natural gas were on their way was enough to lower prices. When this was reversed, we have seen firsthand what has happened at the pump.
As we began to exit the first wave of the Pandemic last year, our economy took off. The market saw economic growth, interest rates rose, and the stocks of companies that only do well when everyone is doing well led the way. These are signs that investors believed the economy was off to the races, therefore they demanded a higher return on bonds and saw opportunity in companies that are sensitive to the overall economy.
Yet today, Employment has not come back as expected, economic growth missed expectations by two full percentage points, and inflation has gone up to 5.4 percent and shows no sign of slowing no matter how many times the Fed uses the word transitory. There are lots of economic data details, but there are only two that matter right now: employment and inflation. These are the details that are driving the market today. As long as the employment situation disappoints, we will see interest rates stay low and the stock market favor companies whose business is less sensitive to overall economic activity. As long as inflation continues to rise, we will see investors go into areas that have historically been good inflation hedges, like real estate.
This trend will continue until these details change or the market decides to focus on different details, like the still-solid growth numbers or the potential for hybrid work models destroying the demand for real estate. Little things make the big things happen, but all details are not created equal. Knowing which details matter is the art of investing.
Chuck Osborne, CFA
~The Details That Matter
I don’t know about you, but I’m a once-every-four-years (or in this case five years) fan of sports like gymnastics and swimming. My heart goes out to Simone Biles and the USA women’s gymnastics team. I will admit that my first reaction was, “She just quit?” Yet, when we heard from Simone it was clear that she truly believed in that moment that her team was better off with someone else taking her place, and that actually is a brave decision.
I do not believe we can even begin to understand the pressure she is under; in fact I don’t believe gymnasts of the past can understand the pressure she is under. It is one thing to be the best on your team and the team leader; it is another to be told constantly that you are the greatest of all time while still competing. If Simone had done the impossible and gotten perfect scores in every event it would have been, “Oh well, that’s why she is the greatest.” Anything less is treated as a disappointment. Unrealistic expectations are an enormous burden.
It isn’t just Simone Biles who feels that pressure: Second quarter GDP was reported on Thursday this week. The expectation was for 8.5 percent, and that had already come down from more than 9 percent. The economy actually grew at 6.5 percent according to the first reading of GDP; that is a full two-point deduction, which is a little more than simply “not sticking the landing” – this is a huge disappointment.
Or is it? The market has been telling us that people who live in the real world have been lowering their expectations much faster than economists. The interest rate on the 10-year Treasury bill is now yielding 1.25 percent, down from the 1.75 percent range. What is that telling us?
It tells me that bond investors are pessimistic about future growth. They believe that we have seen all the economic growth that we are going to see. This is a sea change from just a few months ago when rates were rising rapidly, and it is not just the bond market.
I have said it a thousand times if I have said it once, but the real indicator of how the market feels is not the headline index return, but what is happening under the surface. While the broad indices have held up, underneath the surface we have had a closet correction. Small company stocks, as measured by the Russell 2000, have had a full 10 percent selloff. Value stocks, which had been leading the way in the optimism of economic growth, have sold off. Just about every type of stock there is has been negative over the last several weeks except for big tech, which had been trailing earlier.
Investors now go toward these large technology firms, when they believe there is no growth to be had anywhere else. These high-fliers have somewhat ironically become today’s defensive stocks. The market has gone from telling us that we are going to grow exponentially to saying we are headed for a recession. The market exaggerates.
In reality we are seeing good economic growth; less than the hyperbolic expectations, but still good. We live in a time, however, when missing even unrealistic expectations is treated like the end of the world; it is not, and right as the market was teetering on heading down, corporate earnings have come out and said, “We are doing well.”
Markets overreact on both sides. What was overly optimistic just a few months ago has become overly pessimistic. Small companies are fine, value stocks are fine; we are growing at 6.5 percent. That is a good number. There are never any guarantees in the market, but I suspect that before too long we will get back to rates rising and value and small company stocks leading the way.
We live in a world of constant hyperbole and the market is not immune. It would be great if the exaggeration would stop, but that is a subject for a future Perspective. In the meantime, we have Olympic Games to watch. USA! USA! USA!
Chuck Osborne, CFA
~That’s a Two-Point Deduction
Inflation is a stranger to many. In 2011 I wrote a Quarterly Report article about how hard it was to actually have inflation. Yet here we are. The Consumer Price Index (CPI) was up 5 percent in May and the Producer Price Index (PPI – wholesale prices) was up 6.2 percent in April. Anecdotally, things like lumber are up 252 percent.
Why has inflation suddenly returned, and what can we, as investors, do about it? The answer to the first question is interesting. For years we have believed that inflation was caused by loose monetary policy, including very low interest rates and the printing of dollars. The idea is simply that inflation is really a loss of value in the dollar as opposed to an increase in value of goods and services purchased with dollars. In 1995 a gallon of milk cost $2.52, according to research from the University of Wisconsin. According to the USDA the average price of a gallon of milk in May 2021 was $3.60. The idea of inflation being a monetary policy issue means that a gallon of milk is a gallon of milk. The actual value of milk has not changed; what changed was the value of the dollar. Today a dollar is worth less than it was in 1995.
This is how we have long understood inflation. For three decades now we have had loose monetary policy and while this brought us such wonderful events as the dot-com bubble and the financial crisis, it has not actually caused overall inflation as so many have feared. Perhaps there is something we missed?
That 30-year period was marked by the victory of so-called “supply-side economics.” Another way of looking at prices is through the economic law of supply and demand: the price of a product is determined by the supply of that product relative to the demand for the product. If the supply is high and demand low, the product will cost next to nothing. If the supply is low and demand high, then the price will be very high.
In the 1960s and 1970s economic policy was dominated by the thoughts of John Maynard Keynes, who believed that government could stimulate aggregate demand, and that the increase in demand would in turn lead to an increase is supply and overall economic growth. In practice it led to low growth, high inflation, and high unemployment. In fairness to Keynes the man, what politicians did in his name was not exactly what he intended; having studied Keynes I personally believe he would have changed his mind (which, like all truly great thinkers, he often did) had he lived to see the results of policies that bared his name. Unfortunately, we will never know.
In the 1980s the Austrian school of economic thought overtook Keynes, believing government should largely get out of the way. In doing so it would make it easier for businesses to make their products, therefore stimulating supply directly. It was coined supply-side economics. Like with Keynes before, what some politicians proposed in the name of supply-side economics would not exactly hold up under scrutiny, but still as a whole this theory had served us well.
As the supply side of our economy grew, prices naturally would level out if not even drop. We have seen this especially in the technology sector over the last few decades. This phenomenon helped to keep overall inflation at bay even as we experienced loose monetary policy and solid economic growth.
This year we have made a dramatic shift towards demand-side economics and large fiscal stimulus, most notably by paying people bonuses not to work, and of course direct stimulus checks. Simultaneously, we are not just ignoring supply but attacking it. It is hard to increase the supply of products when one cannot find people willing to work to make said products. While much of the remaining attack is in the discussion phase, even threats of increased regulation and taxes has an impact on those who provide the supply of goods and services.
With supply remaining low, demand has been increased and right on cue, inflation is back. The Fed continues to say it is transitory. What they mean is that they believe the increase in demand will stimulate growth in supply and all will be good. I hope they are correct, but the folks who believed this in the past never were. Inflation may be here to stay until we re-learn our basic economic lessons.
In the meantime, what is an investor to do? In the shorter term the market is likely to go sideways as it figures all this out. For long-term inflation protection, nothing beats stocks; as prices rise, so do nominal profits and therefore stock prices. The place to avoid is fixed income, where yields below 2 percent mean that an investor is actually losing purchasing power as inflation rises at twice that rate. We remain cautious and will keep looking at inflation. Will it be transitory or is it here to stay? The Fed says one thing and history tells us another. We hope the Fed is right, but we are not counting on it.
Chuck Osborne, CFA
Wednesday the Consumer Price Index (CPI) came out +4.2 percent over the past year. Thursday morning the Producer Price Index (PPI), which measures wholesale inflation, was announced to be 6.2 percent. More concerning is the reaction of Richard Clarida, the Federal Reserve vice-chair, who said he was, “surprised.” The Fed, a leading contributor to this explosion of inflation, continues to believe this is just “transitory.” It feels like a scene from “The Princess Bride” when Vizzini keeps using the word “inconceivable,” and finally Inigo Montoya says, “You keep using that word. I do not think it means what you think it means.”
The problem at the Fed is the same problem they have had for a long time: There is no voice in the room that has real-world experience. We, along with many others, have written about inflation; Warren Buffett has warned about inflation; and the financial media outlets have been beating the inflation drums, yet the Fed is still “surprised” and still insists that it is only “transitory.”
As we mentioned in a recent Insight, we are set up for disappointment on the economic data front and for inflation. Since then, GDP came out at 6.4 percent growth, which in absolute terms is fantastic. The market was expecting more and thus up only slightly that day. and down significantly the next day. Then we received the employment report: The economy created 266,000 jobs compared to an expectation of 974,000 jobs. The unemployment rate rose even as we are still recovering from the reaction to the pandemic.
The initial response that day from President Biden was, “The recovery is going faster than expected.” Really? Expectations were missed by more than 700,000 jobs. This is precisely what happens when government policy is to pay people not to work. We know this and we have known it for a long time, which is why Bill Clinton reformed our welfare system.
However, we live in a world where facts no longer seem to matter. This is a symptom of the criminal enterprise that is our higher education system, which we will discuss further in our next Perspective. In the meantime, the Administration and the Fed are suffering from a very human condition that John Meynard Keynes described when he said, “The difficulty lies not so much in developing new ideas as in escaping old ones.”
To add insult to injury, we have a self-induced energy crisis, which in fairness actually is transitory. Within a five-minute window on Wednesday I received a text from my sister saying she had to wait in line for an hour to get gas, but fortunately was able to get some; then a text from my cousin, who said she had to go to several gas stations before finding one that still had gas. I then read in The New York Times that there were no gas lines. That is disappointing.
The old ideas that previously gave us the economic malaise of the 1970s are doing the same thing now, and thanks to a lack of cyber security a pipeline shutdown really put us back in the mood for some disco. At least when my sister waited for an hour for gas this time, her legs weren’t burning on the vinyl seats of the pea-green Pontiac Ventura we had to sit in back in the days of the original energy crisis.
How is this trip down memory lane going to impact the stock market? As of now it has simply stalled; down one day and up the next, but caution is certainly in order, at least until the economic data – and reactions from policy-makers – stop disappointing.
Chuck Osborne, CFA