The End of the Free Lunch
In our last letter we warned that there are major changes happening in the world economy: “The Times Are Changing”. In this letter we would like to reiterate what we are seeing and lay out how we are adapting to the new realities in greater detail.
We are seeing the first significant inflationary pressure in forty years, cold wars erupting on two fronts and the first extended land war in Europe since WWII, an America more polarized than any time since the Civil War, the end of the nearly thirty-year trend toward globalization and a rush to protectionism, the need to unwind the excessive speculation demonstrated by bitcoin and big tech mania, and a world awash in debt.
In sum, the end of THE FREE LUNCH.
No More Free Money
For almost a decade now, money was free. Not just in the US but all around the world, reaching its peak with negative interest rates in some countries. When short term interest rates are lower than inflation, money is not just free, they are paying you to take it. Free money sends a clear signal to markets from central banks; “do not keep your money in the bank, take risk with it, borrow some more, and juice the economy.” We will never know if the current inflation was caused by an accumulation of debt for Covid relief or the contributing factors from an energy price shock, labor shortages or supply disruptions, but central banks had no choice but to raise interest rates and put at least a small price on money.
Central banks really have only one tool to fight inflation and regardless of what happens in the short run, in the long run tight money will slow down the economy enough to bring prices down. How high interest rates must go and how long they’ll have to stay there is anybody’s guess but we would argue that even after the economy slows, the great free money experiment has seen its day and the reliance on free money to stimulate economic growth won’t return for some time.
No More Free Labor
The average worker at Foxconn assembles iPhones for less than $10 an hour. With benefits, the equivalent US worker would make about $50 an hour and be eligible for disability, unemployment and possibly union benefits. Apple’s labor has been almost free but that is coming to an end as it is for every industry that got used to outsourcing labor.
China has accounted for a huge percentage of the deflation we have seen in manufacturing costs for the past several decades. Unfortunately, it’s not just that corporations can’t trust them because of Covid lockdowns and national securities issues. More concerning is that they are becoming an untrustworthy supplier of labor due to their shift from soft capitalism to state control and that threat will become a shockwave if they continue to threaten Taiwan. Much of the low skill jobs will go to other countries but that takes time and money. It won’t be free.
No More Free Energy
The world cut a deal with oil producing countries. We stay out of your politics, you keep pumping cheap oil and gas. We broke the deal with Iraq and it cost us dearly in the recession following the Gulf War. The Russians thought they could invade a country and the West would look the other way as long as they kept pumping, but they were wrong. The world is learning to not put its faith in dictators with imperial urges like Russia and China. So, we must change suppliers and go to alternative fuels. It will be costly.
No More Free Democracy
A world that cares about democracy and wants to avoid war will have to pay at the pump, in its defense budget and its politics. The deals we cut with Russia, China, Saudi Arabia, Venezuela and you name it are being tested and democracy has to be defended with missiles, ships and trade embargoes. Really expensive stuff that will test Western resolve.
Then there is our own political mess which is challenging the orderly transitions of power. The very basis of our democracy. Resolving what some have called a civil war could be incredibly costly if we go down the road of defaults, government shutdowns and general dysfunction that we often flirt with but have steered clear of in the past. Going there could come at a cost we can’t begin to calculate.
No More Worry-Free Investing
Investing for the past few decades was easy. Pick gigantic tech companies like Apple, Google or Amazon and watch them grow year after year as they expanded horizontally adding more services and vertically by crushing smaller competition. No worries…until there are! Now the big guys are so big that they can’t grow meaningfully by buying small companies with free money or crushing ones that don’t submit. They are also increasingly finding themselves in competition with each other. Witness the races to own the cloud, produce entertainment content and the land grab for the metaverse. The winners are far from guaranteed and the losers are cause for worry with investors.
For real growth, investors will have to turn to smaller companies and that requires research and diversification, the exact opposite of what investors are accustomed to with concentrated portfolios of big tech.
If that wasn’t enough to worry about, we now have VOLATILITY which used to be normal but became unusual when everything was risk free. In a world with wars, spiking interest rates and earnings uncertainty, pricing things becomes much more challenging.
You would expect it in the highly speculative part of the market like bitcoin, the crypto exchanges, SPACs, and commodity futures but when interest rates move 300 basis points in a few months and big cap stocks suffer 50-60% losses, the world has changed. Fear, as they say, is a bad investment philosophy but who can be worry free in this environment? Volatility is the price paid in the new environment but as we will see, it can also be a blessing.
WHAT TO DO
When Money isn’t Free, Lend Some
It has been so long since lenders got a reasonable return for their unlevered capital that we have almost forgotten that buying bonds can be profitable. This year witnessed the biggest increase in bond yields in recent history and the Fed promised more to come. Fixed income investing, done right, doesn’t require you to pick the top in yields to make money, just be prudent and disciplined.
We don’t buy long bonds or bond funds that have seen 15 to 25% losses this year. We build laddered portfolios of short to intermediate term bonds to avoid that kind of volatility. We also typically don’t sell because we can take the cash or roll them over at a higher yield at maturity.
Until this year that was a defensive but not particularly profitable exercise, but now we have safety and a decent return on our investment. Today we can put together a bond portfolio in solidly investment grade bonds laddered in maturity from one to seven years at better than 5% yield. Municipal bonds in a similar portfolio will get you about 3% but that is a taxable equivalent of 4.6% for people in a 35% federal income tax bracket.
Avoid Companies that Depend on Free Money, Free Labor or Free Energy. Own Some that Benefit
It’s easy to see what benefited from free everything, just look at what got punished the most this year when things changed. At the top of the list is so called high risk, long duration, speculative assets. Those things without much in the way of earnings or real assets that got priced when risk was something someone else worried about.
Cryptocurrencies meet those criteria perfectly. Trusting your money to a thirty-year-old in the Bahamas who claimed to amass a fifteen billion dollar fortune in few years seems obviously foolish, at least in retrospect. The SPACs, special purpose acquisition companies, attracted billions based solely on hope, instead of earnings or assets and got destroyed as soon as investors began to think about risk, and the cost of money. If there is anything left after all the scams are shut down, it will most likely flow into less exciting investments like stocks with earnings and bonds with yields.
Many companies benefited from free labor, mostly in China, and while Apple and Tesla are obvious there is a long list of firms that must change their supply chains as China becomes more challenged.
The beneficiaries of the end of the free lunch are the companies with consistent earnings, even when there are oil shocks and higher debt expenses. There are plenty of companies like Pepsi, Comcast and Adobe that have pricing power to cover their added costs and have minimal exposure to more expensive inputs.
The direct beneficiaries of price increases are commodity producers, but you need some caution here because a big recession could see their recent gains evaporate if demand falls. The same could be said of banks that will charge more for loans but could have to raise reserves in a full-blown recession. Yet both banks and commodity producers are necessary hedges against inflation in our portfolios. We balance these against companies with some exposure to inflation but ones that are generally more defensive in a recessionary environment.
Don’t Panic, Take Advantage of the Volatility
Most investors over the long run hideously underperform the market averages for a lot of reasons, but the number one reason is that they buy when prices are high and sell when prices are low. They get euphoric when making money and panic when losing money. We have no idea how much more this market will go down, but we know it is down, so we don’t plan on selling. We are not panicking! Instead, we are taking advantage of this bear market the way we have in every bear market we have been in for the past forty years. Here is how:
Slowly spend cash: We are not market timers so we never have very large cash positions, but we almost always have some and as stocks get cheaper and our shopping list gets longer we use cash to buy bargains.
Use tax loss selling to our advantage: In taxable accounts we will take tax losses this year and let the government subsidize us for years to come when capital gains will be unavoidable. But guess what, we aren’t the only manager who has to sell for tax reasons an asset they thought was a bargain at a much higher price. We think this year will be the mother of all tax loss selling opportunities because there were so many gains taken earlier in the year that need to be offset. Index funds that dominate the market don’t differentiate the good from the bad, they just sell everything. We’ll keep our eyes out for the good.
Rotate from cheap to dirt cheap because the market doesn’t: As hard as it is to not sell everything that is down it is twice as hard to sell what is up in order to buy the losers. It’s what we have done successfully in every bear market for the past forty years
Rebalance: Balanced portfolios suffered through miserable relative performance over the past few years as the fixed income portion of the portfolio yielded little compared to the fabulous returns of all equity portfolios. Now is the time to start to get even. We try to keep asset allocations stable so when stocks go down more than bonds, we need to reallocate. Even though this has been one of the rare times when stocks and bonds had negative returns, our short-term bond portfolios are generally down less than the stock market giving us a chance to reallocate. We will be doing it slowly, knowing we will never pick the bottom, but it gives us some cash to buy bargains.
NO MORE FREE LUNCHES BUT GREAT OPPORTUNITIES FOR INVESTORS
What makes us nervous is when the market is going up day after day, when a handful of companies are anointed as guaranteed winners and when risk is being priced at zero. We probably aren’t to the point that we can feel at ease, but we are getting there. The greatest investments are made in the worst of times. We’d be happy to settle for just good investments in uncertain times.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.