The reset of 2022 was a painful reminder that investment fads and cycles can shift direction with little warning. Diversification helps mitigate risk, but it isn’t perfect. Bonds typically are a reliable and stable diversifier when stocks decline, but the spike in inflation created the worst bond market in 100 years. Domestic and global political tensions remain high. The war in Ukraine continues. In Crypto land, many Ponzi schemes and MEMEs crashed and left many burned. However, there are some silver linings after the reset that give us a more normal investment environment. Though it’s too early to say if this down cycle is over.
Stock Values, Interest Rates, and Inflation
The Price investors are willing to pay for $1 of Earnings (profits) is called the PE Ratio. This chart shows that the PE ratio typically declines when rates increase. An extreme case was during the 1980’s: inflation ranged between 13-20%; mortgage rates ranged between 12-18%! The PE ratio fell to 7, or 60% below its long-term average due to double digit interest rates and inflation.
In 2022, stock prices fell as rates and inflation increased; the S&P 500 PE Ratio declined from 23 to 20. Interest rates rose to stop inflation and are nearing their long-term average. Prices declined, but earnings did not as corporations were able to pass on higher costs to customers. The concern for 2023 is that higher interest rates will create a recession; earnings will decline, and prices could go lower again.
Bond Values, Interest Rates, and Income
Bond prices go down when interest rates go up as depicted below in the chart. In early 2022, an intermediate bond fund costing $100 paid 1.5% in interest income. The bond fund lost 12% in value as the market rate increased to 3.7%. The price adjustment hurt. However, if principal isn’t sold, capital is preserved. Income rises as old bonds mature and new bonds come into the fund paying market rates. The greater income provides more cash flow (from $1.50 to $3.26) and will eventually offset the price decline.
For the past thirty years, the default US economic policy has been that when markets are in trouble, the Federal Reserve lowered interest rates to stimulate economic activity. This so-called “Greenspan Put” began with Alan Greenspan, the central banker who began this trend in the late 1980’s. COVID brought on the most aggressive fiscal and monetary support in history. With massive cheap money flowing into the economy speculation raged and voila! Other asset bubbles emerged.
“The best time to join a Ponzi scheme is on the ground floor!” Dave Portnoy
Magic Internet Money
Truly a great time to be a hustler and a conman! Like in the dot.com era, investment due diligence went out of fashion. Even savvy institutions got lost in the bubble amidst the prospect of easy profits. History shows when money and credit flood the system, financial discipline gives way to greed. Markets get aided, abetted, and distorted by cheap credit.
1. Cryptocurrency: In crypto land, the economist Nouriel Roubini noted that there have been over 20,000 Initial Coin Offerings (ICOs), 80% were a scam; another 17% went to 0. The top 10 currencies have lost about 80% of value over the past 12 months. The bubble went bust for most investors.
2. The SPAC Market: (aka “blank check companies) is on life support. SPACs were an alternative way to take a company public via a simplified process. The market peaked at over $150 billion in deal value in Q1 2021. And has rapidly declined since. The game was rigged such that the sponsors frontloaded the deal with a small amount of money and then sold to retail investors who got much less favorable terms. SPACs have underperformed the S&P 500 by 80%-90%.
3. MEMES: are more like mummies at this point. Meme’s emerged in mid-2020 via the Reddit forum Wallstreetbets. It was quite a spectacle during a short time period in late 2020-early 2021. GameStop (went from $5 to $325); AMC and KOSS were also big winners. However, unless you caught the short-term window when prices spiked you would have underperformed the S&P 500 by a wide margin. Most investors were late to this party. In 2022, a group of 8 Meme stocks were all down more than the S&P 500 (AMC -81%; BBBY -75%; BBIG -59%; BB -65%).
The law and regulators are always running behind the hucksters. In 2022, justice caught up with several shameless fraudsters, crooks, and con men. The list below includes some entertainment value, though it’s a sad indictment of human nature. Many unsuspecting investors lost a lot of money.
The Internet sleuth (Coffeezilla) does an awesome job of interviewing many crypto/NFT scammers and “gurus” calling out big funny money power brokers. His due diligence, integrity, and humor are worth a listen and a good way to better educate yourself on the risks in this speculative space. Below are a few links.
Portnoy Pump and Dump Scam (this is somewhat funny, but it’s a stupid way to invest)
Gurus, Influencers, Cons and Crooks (I report you decide which😎)
Below is a partial list of supposed gurus and visionaries who got hosed or who did the hosing. Turns out they are mere mortals, scam artists, or in some cases pure scumbags:
• Sam Bankman Fried: (aka SBF) whose net worth went from $32B to $0. Cramer the clown called him the “J.P. Morgan of crypto.” Others, the “Warren Buffet of the digital money.” Fact is, he violated the Terms of Service agreement with users by taking their deposits on his FTX Exchange and commingling them with a hedge fund sister company. And all in the name of “effective altruism!” For Sam, that meant ‘give me your money and I will give it away to good causes!’ He generously funded stadiums, bribed politicians to mold regulations in his favor, paid high profile celebrities to hype FTX and crytpo, and lived like a rock star while driving a Corolla. A true philanthropist.
• Kevin O’Leary: (paid spokesperson for FTX), whose due diligence on FTX was MIA. He’s a Shark Tanker and is supposed to know better. He may see fines and jail time. He wasn’t alone. Numerous high profile venture capitalists (Sequoia, Tiger Global, BlackRock among many others ) lost all their money in the FTX deal. We won’t mention the numerous celebrities named in class action lawsuits at this point. Some of who I am sure had no clue what they were promoting.
• Mark Cuban: Dallas Mav’s owner and a Shark Tanker. Cuban’s Mavericks formed a partnership with Voyager to promote its crypto platform: “it’s as risk-free as you will find in Crypto,” said Cuban. Soon after the promo, Voyager declared bankruptcy and froze client money. Voyager had a prior lawsuit that Cuban allegedly knew about but didn’t tell his fans. I guess he forgot, right? Further, Voyager mislead people while touting its “transparency.” The suit alleges this was all a Ponzi scheme. In a separate deal, Cuban lost all his investment in Titan (it went from $4 to $60 to $0, all in one week!).
• Kim Kardashian: fined $1.3M by SEC for unlawfully touting crypto.
• Elizabeth Holmes: CEO Theranos sentenced to 11 years for defrauding investors on fraudulent claims and omitting information about the limits of its technologies.
There are scores more who either naively or greedily or knowingly lent their name and influence to bad ideas.
The Economy and Interest Rates
US stock markets historically rise about 70% of the time, and we expect price volatility. With bonds we expect price stability, but the rapid rise in interest rates caused the worst bond market decline in over 100 years. Investment strategists offer different opinions on where rates are headed:
• Globalization and technology will reassert itself as supply chains come back online and inflated price pressures will subside. The muted rates on long-term bonds partially supports this view.
• Anti-globalization and onshoring will either mean higher prices, low-middle class workers will need to take pay cuts, or corporations will need to eat the cost and lose profits.
• The economy will weaken, and the Fed will “pivot” to lower rates to stimulate the economy.
Allies, Enemies, and Competing Priorities
Internal and external alliances play key roles where public and social needs meet economic interest. Lessening external dependence with political rhetoric is simple. But it’s a complex proposition. Future uncertainties are many. A couple examples illustrate why it’s important to avoid hasty, unforced errors.
External: Saudi Arabia, a supposed US ally, cut oil production after Biden asked them for an increase, thereby aiding Russia’s cause. When Pelosi went to Taiwan, the Chinese demonstrated the military capability to create a trade blockade around the country. Taiwan manufactures 50% of global semiconductors; 90% of leading edge components. Semiconductors are vital components in cars, phones, computers, TVs, dishwashers, refrigerators, washers, dryers, etc. etc. Apple produces iPhones in China; Tesla is betting big on EV growth in China. Countless companies source goods and make markets in China. An economic blockade could trigger disastrous global shortages, slower growth, and higher inflation.
Internal: compromise between left and right is a sorry spectacle. Republicans even forgot they are on the same team! Both sides distort opposing views instead of looking for common sensical, common ground. Prudent energy policy would lessen the need for foreign oil, as the transition to carbon neutral occurs. The posturing over raising the debt limit is pure idiocy. The debt limit is for funds already committed and has nothing to do with future spending priorities. If the US were to default on its debt, it would wreak havoc across markets. Rates would rise. The economy would slow. With deficit spending at record levels, debt payments would rise. Tax hikes and/or spending cuts would be needed and not popular.
Silver Linings for 2023
The Federal Reserve is aware of the mistakes made in the 1960’s and 1970’s. Inconsistent monetary policy allowed inflation to get out of control. It took aggressive and consistent interest rate increases in the 1980’s to kill the inflation beast. For this reason, the Fed has indicated it will keep raising rates. The risk is that this will tip the economy into recession. Most analysts think it will be mild given the continued strength in the job market.
International markets have underperformed US markets by a wide margin for the past 10 years. Has the tide finally turned? In spite of the war and less favorable economics, Europe has outperformed the US for the past 6 months by almost 15%. With a PE ratio of only 11, it represents better value than the S&P at 20. China has abandoned its Zero-COVID policy, which could kickstart global growth.
Commodities have outperformed, aided by the Ukraine war. But they are volatile and unreliable diversifiers that tend to decline during recessions when portfolios need them most. Oil is especially hard to predict because its supply and demand dynamics are often driven by geopolitical factors. The transition to carbon neutral is uneven across the globe, hence making oil even more difficult to forecast.
Public REIT markets have declined substantially. US housing has held up thus far but is due for a fall after the huge spikes of 2020 to mid-2022. Some argue that lack of housing supply will help keep prices stable. The jury is out.
In the right situation, private assets can add value to a portfolio. But buyer beware.
Private REITs invest in the same assets as public REITs, yet their respective returns can vary by wide margins. You do well to ask why the divergence. One explanation is public REITs are subject to the vagaries of short-term market sentiment. It is often noted that “the market has predicted 7 of the last 4 recessions!” Another explanation is that because private REITs are illiquid and accounting requirements less restrictive, its reported NAV may not reflect current reality.
To compensate for a lack of liquidity, more of private REITs total return comes from income. Current dividend yields range between 6%-8% vs. 3-4% in public markets. All things being equal, over time it is common economic sense that their total returns will be similar. Alas, all things are not equal. Private REITs require additional due diligence to mitigate financial and operational risks that are less prevalent in public markets. Still, a well-structured private REIT can provide tax-advantaged yield by using the underlying properties depreciation to shield income from taxation.
Private Credit (direct lending) offers yields today about 10%. Publicly traded counterparts are about 7%. Loans in this segment target small-medium firms with below investment grade ratings. The loans are typically short duration variable rates that adjust every 30-90 days with rate changes. This reduces interest rate risk. However, in an economic downturn small firms are more likely to become insolvent; ensuing defaults would diminish the yield advantage. Additional due diligence is prudent. To mitigate credit risk, ensure the portfolio holds senior-secured loans with strong covenant and collateral protections.
Caution: There are no free lunches in capital markets. When you seek higher return, there will be more risk – regardless of what a salesperson may represent.
Inflation may have peaked. Stock valuations have declined. Still not cheap, but closer to long-term averages. Long-term market driven interest rates have declined, while short-term rates continue to move up. Today, short-term safe rates are yielding 4.0% or more. In early 2022, they were paying close to 0.0%. Assuming inflation stabilizes and continues lower, high quality bonds should provide more stability, higher income, and less reliance on stock appreciation.
That is welcome news for savers and investors.
Jerry Matecun – Founder, President
Expert guidance to plan your future, preserve your lifestyle, and retire with confidence. For a confidential consult, contact me at firstname.lastname@example.org.
PLEASE NOTE: You can’t invest directly in an index. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.