Living On Borrowed Time
NOTE: Every week or two I wrote a Client Note for my clients. I post most but not all of the notes to my blog but with a time delay usually between 1 day and 1 week. To receive the Client Notes at the same time as my clients, sign up in the box in the right hand corner of the website.
Investing successfully is hard because it is complex. Dictionary.com defines complex as “composed of many interconnected parts”. Another way of saying the same thing is that there are many variables that go into investment outcomes. Or again: the investment world is a complex system.
There are the fundamental factors of any given company. There are the macroeconomic factors involving government policy. There are psychological factors involving crowd psychology. I believe these are the main ones but others could be added. The art of investing involves blending and weighting all of these factors into a balanced and synthesized outlook.
Because investing is complex, many want to simplify it. For example, value investors like Warren Buffett argue that the only thing that matters is company specific fundamentals. It certainly would make things simpler if this were true. However, value investors routinely get destroyed in bear markets because of their failure to take account of macroeconomics.
Indeed, Buffett’s mentor Ben Graham was caught wrongly positioned by the stock market crash of 1929 and the ensuing Great Depression. Similarly, Bill Miller’s reputation was destroyed by the housing bust and ensuing Great Recession. Buffett has been able to weather the storms partly due to luck and partly due to his longevity. He was lucky to start his first investment partnership in 1956 in the midst of the great postwar boom. And his longevity has masked many of his mistakes.
Let’s get concrete. I have said many times on social media that Facebook (FB) is the best stock in the market. They proved this again the other day when they reported first quarter earnings with revenue growth of 52% and EPS growth of 83%. The company is quite simply on fire; it is in the sweet spot of its growth cycle.
Yet I sold Facebook (FB) last year! Why? Because fundamentals are only one part of the equation. My interpretation of the macroeconomics and psychological components of the market have convinced me that we are in a stealth bear market. By “stealth”, I mean that this will only be realized in retrospect by the majority of investors.
Let’s get concrete again. On Wednesday, the Federal Reserve decided to hold interest rates constant at ¼ to ½ percent. Despite massive quantitative easing and low interest rates around the world, governments can’t seem to generate real economic growth. The headlines of today’s Wall Street Journal read “US Growth Starts Year In Familiar Rut” and “Earnings Skid Is Worst Since Crisis”. In this environment, “it’ll be hard to get a whole lot of corporate profit growth. It’s hard to get really bullish”, said Joe LaVorgna, chief US economist at Deutsche Bank.
In other words, Facebook is sailing against the wind. While it produces amazing growth in a stagnant environment, more common are companies like industrial bellwethers 3M (MMM) and United Technologies (UTX) which are each forecasting 1-3% organic sales growth for 2016.
Further, neither of these stocks are cheap for the growth. 3M trades at 20x its 2016 forecast of $8.10-$8.45 EPS. UTX trades at 16x its 2016 forecast of $6.30-$6.60 EPS. I don’t want to pay those kinds of prices for meager growth.
I have recently been reading Henry Hazlitt’s Time Will Run Back. Henry Hazlitt was a great economic popularizer of the 20th century and his works are among the best introductions to economics around. In this novel, Hazlitt imagines that the USSR won the Cold War. All the world went socialist. All the means of production are owned by the State. The government allocates resources to managers and assigns people to jobs. All economic freedom has been extinguished. The works of the great economists, excluding Marx, have been destroyed. As a result, the world is in economic decline.
It is the challenge of the hero, Peter Uldanov, who becomes economic dictator, to solve the economic problem. In a series of Socratic dialogues with his subordinate Adams, Uldanov puzzles over the failures of WonWorld and what reforms he might institute to ignite its economy. Ultimately, he rediscovers the importance of incentives and capital, among other things.
On incentives, he realizes that people need to see some direct relationship between the work they do and the reward they receive. When everybody is working for everybody else, nobody has the motivation to work hard or innovate. That’s because whatever difference he can contribute to overall production is so small that his own reward is proportionately so. Similarly, Uldanov discovers that the quantity and quality of capital that people work with is key to their productivity.
Why do I bring this up? Because we live in a world where the government has gotten everything backwards. They are trying to stimulate economic growth by printing money, rather than stimulating production. As a result, they are enriching those who own financial assets like stocks, bonds and real estate, impoverishing those who do not and creating cascading asset bubbles that inevitably burst. “We’re living on borrowed time”, John Thornton, former President of Goldman Sachs, recently said.
Many sophisticated investors understand the situation. However, most do not. Most simply go along with the crowd, believing that everything is okay as long as everybody else thinks so. This conformity and reflexivity has been firmly embedded into market psychology over the last 30 years, abetted by government policies aimed at keeping things from falling apart rather than addressing the core issues.
This is why I am almost 100% cash. Almost because I still maintain small positions in gold via GLD and GDX. Gold is another one of those things that is fundamentally misunderstood by the majority. In fact, the majority make fun of those who own gold, ridiculing its performance and its adherents as “gold bugs”. What they fail to understand is that the entire economic system is built on the division of labor which depends for its smooth functioning on a stable medium of exchange. Gold has been money for most of history precisely because it suited this purpose. In the current environment, it is insurance against the monetary adventures of the world’s central bankers.
Founder & CEO
Top Gun Financial (www.topgunfp.com)
A Registered Investment Advisor
Bay Area, CA