Here Comes the Future

Good riddance to 2020.  It was a year where we faced an existential threat that the world was entirely unprepared to combat.  Every one of us has a Covid-19 story.  We all know people who contracted the virus.  Some experienced little more than an inconvenience while others paid a hefty price.  All of us dealt with things outside our expectations and experience.

In the markets, we experienced lows similar to 2008 yet ended the year with highs much like 1999.  It was a year where making logical decisions based on the economy and company fundamentals produced middling results while embracing extreme risk in securities that make little sense returned spectacular gains.  Such is our present reality.

In the past, situations like the present were guaranteed to end in pain but I don’t see storm clouds on the horizon thanks to market intervention.  Instead, I see a need to adapt our strategies to present realities where we look to profit from anticipating the interventionists’ next move while keeping our choices within our disciplines.  In this way, investing becomes more like chess.

Intervention

Since the 2008 crash, it seems that the only time the equity markets decline is when the people in charge of intervening in the markets are caught by surprise.  Covid-19 was just such a surprise which is why the markets were down over 25% in the first quarter.  Preventing the equity markets from falling seems like a beneficial policy but there are drawbacks.

Specifically, the more the government intervenes in the market, the more it has to intervene in the future.  The reason is simple; every time they intervene, they create an imbalance in our economy which necessitates ever greater intervention.

In 2006, the Fed had $800 billion dollars in the banking system from its own account.  By the end of 2009, this figure had risen to $2 trillion for a gain of $1.2 trillion.  Since the third quarter of 2019, the Fed has gone from $3.7 trillion to $7.4 trillion today.  That’s a gain of $3.7 trillion in a year and more than 3X the bailout during the Great Financial Crisis. 

The best example of the unintended consequences from this policy is the sharp increase in corporate debt which allowed corporations to buy back their stocks, making those companies much riskier for shareholders and bondholders alike.  Corporate debt has doubled since 2008 even as corporate earnings have been flat for much of this time.

The chart below is a bit difficult to read but it shows non-financial corporate debt rising from $3.3 trillion in 2008 to $7.2 trillion presently.

The next chart shows US corporate earnings from 2006 to the present.  Total corporate earnings have risen from $1.9 trillion to roughly $2.2 trillion and flat since 2011.

In 2006, we had $1.9 trillion in corporate earnings to cover $3 trillion in corporate debt.  In general, it took 1.5 years of corporate earnings to pay off corporate debt in the US.  We all remember how corporate debt that was almost twice the level of corporate earnings coverage was almost too much to keep the financial system from imploding in 2008.

Today we have $2.2 trillion in corporate earnings accompanied by $7.2 trillion in corporate debt, or 3.25 times corporate earnings. Given that corporations have doubled their debt outstanding since 2008 and earnings have been largely flat since that time, corporate bonds are highly susceptible to business disruptions and Covid brought us the mother of all disruptions.  This is why the Fed had to double the amount of money injected into the banking system over the past year.

The chart below shows that the Fed had $3.7 trillion injected into the banking system at the end of 2019 and thanks to Covid, they’ve injected cash into the system equal to $7.4 trillion.  Does anyone else see the size of the Fed’s injection as being aimed at keeping the $7.2 trillion of corporate debt from imploding?

If we go back to just before 2008 Financial Crash, the Federal Reserve has increased money supply by a shocking 900%!!!  Each time the Fed bails out Corporate America, the problems get bigger resulting in what has become an exponential increase in printing money.  It’s no wonder so many people have turned to Bitcoin.

This is where it gets interesting.  By creating an implicit promise that they won’t allow companies to go bankrupt en masse, the Federal Reserve has changed our perception of risk such that the age old trade-off between debt and risk has been nullified.  Now, stock buybacks have effectively created a scarcity of equity shares that drives the market higher irrespective of risk.

The correct term for what the Fed is doing is Financial Repression.  It’s when a central bank holds rates below the rate of inflation in order to transfer value from savers to borrowers.  In this case, the Fed has been able to limit inflation to the asset markets.  They’re giving us stellar stock market returns to compensate for the financial repression in the debt markets.

Bitcoin

As a means towards circumventing the ongoing devaluation of currencies in the world, some people have turned to Bitcoin and other digital currencies.  The idea is that the Fed may devalue the dollar but the algorithm that created each unit of digital currency is impossible to devalue.  This fact should make it more appealing to merchants than national currencies.

Bitcoin has been a great speculation and it remains a very interesting SPECULATION.  When the country ultimately turns to digital dollars, I have little doubt that Bitcoin will be devalued along with existing dollars.  That’s the positive case.  In the negative case, Bitcoins can become worthless.

Why you ask?  Governments will NEVER allow an alternative currency because it negates all of their power.  In its truest form, devaluation of the currency is a HIDDEN TAX on savings and the government does not abide tax cheats.

For the moment, the strength in Bitcoin is taking upward pressure off the precious metals like gold and silver but Bitcoin doesn’t have any intrinsic value whereas gold and silver have been used as money for 2,500 years.  But what happens to the value of Bitcoin if/when the government outlaws its use in commercial transactions? 

Investors are buying Bitcoin instead of gold and silver but I expect gold and silver to be the long term winner of central bank devaluation.  For now, I’m cautiously optimistic about Bitcoin as a speculation for people with a short term time horizon that can accept potential losses.

 The Economy

Our economy has been stuck in a largely no-growth cycle since 2006.  As you can see from the chart below, our domestic economy has been nurtured on government spending in order to produce positive GDP or gross domestic product since 2008.  The chart is Gross Domestic Product minus Total Federal Debt.

Since 2008, this represents an $11 trillion swing from positive $5 trillion to negative $6 trillion.  I’ve shown this chart many times because it represents a clear illustration of what passes for economic growth in today’s world – deficit spending.

This chart only shows the first two quarters of 2020.  If updated for real time data, the line on the chart would be down to minus $8 trillion.

When I consider the impact of Covid on the economy, I realize that Covid caused some long term trend lines to expand exponentially.  Government debt and the amount of dollars the Fed has injected into the banking system have both grown exponentially.

I can also see the irony where Covid has caused job losses predominantly in the areas of the economy that have been responsible for much of our job growth since the tech crash of 2000.  It’s almost as if we’ve come full circle following the tech crash. 

This is why this piece is entitled “Here Comes the Future”.  Our nation has been creating vast economic and financial imbalances for decades.  It’s gone on for so long that people have come to believe that these imbalances can continue forever.  Covid has resulted in an exponential growth rate of those imbalances and will likely bring us to the end of the cycle before 2021 has ended.

Stocks

We’ve been preparing for this cycle end for more than a decade.  Our stock selections have given our clients strong growth in our portfolios while simultaneously representing “real value” by which I mean that we own stock in businesses that will transcend long term cycles. 

The most disappointing part of 2020 is that the fundamentals of our companies have been much better than the broader economy.  Our companies retained pricing power and revenue growth even as the fundamentals of the companies in the broader stock exchanges have faltered. 

In retrospect, I forgot the lessons of 1999.

1999

It was a special year in the stock market because it combined society changing technology at the same time the Federal Reserve was keeping excess liquidity in the financial system to prevent problems arising from computer issues when the calendar rolled over to the year 2000.  It was a dream year for speculators.

Companies like AOL, Yahoo, and EBay promised years of unimpeded growth in earnings arising from market acceptance of their products.  Investors lost their sense of perspective and bid up the values of these stocks to levels where future fundamentals could never justify. 

Much the same thing happened in 2020.  We don’t have the same level of technological innovation as 1999 but the Fed has added dramatically more liquidity to the financial system than it did in 1999.  The result is a stock chart like the one for Tesla.

As of today, Tesla is worth $817 billion, which is more than Toyota, Honda, Volkswagen, BMW, Daimler, GM, Ford, and Fiat-Chrysler combined.  Tesla is priced to control the entire global automotive business as a monopoly despite having just 0.7% global market share.  Yes, that’s right, Tesla doesn’t even sell 1% of total auto sales in the world yet it is valued higher than all the major producers combined.  Such is the power of excess liquidity in the markets combined with a good sale pitch.

Worse yet, total vehicle miles driven in the US is dramatically lower.  The fewer miles people put on their cars, the less they need to replace their cars.

The GeoVest Approach

The biggest difference between 1999 and today is that the Fed will likely continue to maintain excess liquidity in the financial system as people realize that vaccines won’t allow us to get back to normal.  Whereas the year 2000 was a rough year in the markets, something big will need to happen for the equity markets to produce negative returns for 2021. 

As such, we will adapt our strategies to take advantage of this new reality.  While we will always focus on selecting securities to provide both growth and capital protection, we’ll do so acknowledging the growing impact of Fed policies on winners/losers in the capital markets.

On behalf of the staff at GeoVest, I wish you all a safe, healthy and prosperous 2021.  Thank you and it is our continued pleasure to serve you.

Philip M. Byrne, CFA
Chief Investment Officer