The World is a Market
Shakespeare gave us this famous line in his play “As You Like It.” “All the world’s a stage, and all men and women merely players. They have their exits and their entrances; and one man in his time plays many parts.” I would like to amend that quote for today to “all the world is a market, and all men and women merely players.” The reason is because no matter what we do, we are making market decisions in our choices of work, the coffee we drink or where we get our news. Our very existence makes us market participants whether we are aware of this fact or not.
We have big financial markets such as the stock, bond, and currency markets. Our markets for necessities are a mix of large and small, ranging from laundry detergent sold through Walmart to the asparagus sold at our local farmer’s market. Likewise, we have players in most markets that enjoy tremendous market power, such as Walmart, and those that lack the market power to make a meaningful impact. We call these people “price takers” as opposed to larger organizations that can be “price setters.”
Understanding the previous paragraph is critical to understanding the current iteration of our financial markets. I use the term iteration because our capital markets have become more of a repetition of a process than the weighted average of market participant’s views on securities prices. Large players with fast connections to the exchanges, the fastest computers with the latest semiconductor chips and the smartest algorithms, dominate the trades of smaller traders/investors while creating trends for investors to follow. This is how the markets were elevated in 2023 by just seven stocks.
The next question is why does the government allow the markets to be dominated by firms with unfair competitive advantages? Governments are subjected to markets as much as individuals and corporations. They are in the market for power and only get to exercise power when voters perceive that government policies are making their lives better. Since just about everyone benefits from a rising stock market and since a rising stock market is an implied vote of confidence in the government’s economic policies, large financial firms that can make the markets rise to the benefit of voters are allowed to exercise those advantages.
Some people may not agree with the above but if you have been watching things with an open mind, the market actions are about as obvious as an electronic billboard on Times Square. How else do you explain the Federal Reserve Chairman Jerome Powell suggesting the Fed is still in a tightening cycle in early December to suggesting that the Fed will start slashing interest rates in 2024 just two weeks later? And he did so during the week of the biggest options expiration of all-time with a LOT of hedge funds betting against the market.
You can see from the chart below where Uncle Jerry helped the market break through upside resistance on the way to new highs! That chart would look nice on a billboard.
Here is an updated version of the chart I provided in the last newsletter where I showed how the biggest companies in the Nasdaq accounted for the majority of the stock market’s gains for 2023. As you can see the trend remained the same into the close of the year.
Just to remind you, the Magnificent Seven, as they were called in 2023, is made up of Apple, Microsoft, Tesla, Meta, Nvidia, Amazon, and Google. By my calculations, all seven stocks are horrendously overvalued. Apple and Tesla offer heavy fundamental risk in the next few years. Here is another chart that runs through the end of November but does a nice job of showing how these seven stocks are responsible for nearly all the gains in 2023.
Twenty-four years ago, it was Cisco Systems that was the darling of the internet bubble. Below is one of my favorite charts that shows how it took Cisco’s stock twenty years to return to the value it hit at the top of the internet bubble despite being an excellent company.
Cisco is a successful company and one of the stalwarts of most large-cap portfolios. I view the above seven as being in a similar place to where Cisco was in 2000. All seven need to generate above average returns on invested capital over the next ten years to justify current valuations. This does not mean they will not continue to rise; the past twenty-five years has taught us that insane valuations are normal course in the markets. It does mean that I view all seven as terrible bets at these valuations.
Besides, as I wrote earlier, stock prices are being set by computer algorithms, not individual fundamental analysis. If enough speculators continue to bet against those seven stocks, the algos are programmed to destroy short sellers and send the stocks higher.
Artificial Intelligence Bubble
2023 was the year of the mini-Y2K bubble where anything tied to artificial intelligence did well even though we have had artificial intelligence for years. The Wall Street hype machine was out in full force and just like 1999, the speculators who bet against the overvaluation of companies such as Nvidia became kindling for the bonfire that propelled these stocks higher. Does this suggest that we are going to experience a crash like 2000? I don’t think so because the stock market still had similarities to true markets in 2000. It is an election year and the leading candidate is an anti-establishment populist. A crash would cement his victory.
A sharp decline in the stock market is still possible but I don’t expect a decline to be led by these overvalued AI stocks. After all, the technology is extremely useful, particularly for the US government in auditing financial transactions but more importantly, AI is an extremely powerful weapon for the US military.
I have read fascinating analyses that suggest that AI can allow our missile defense systems to combat the hypersonic missiles possessed by Russia and China because it allows our missile defense rockets to change trajectory mid-flite to counter changes in the path of enemy missiles, even hypersonic missiles. There have already been six incidences where our Patriot Missile Systems have knocked out Russia’s hypersonic missiles in Ukraine. Re-fitting older systems should be great for our defense stocks!
Nvidia seems to be the main beneficiary of this bubble but you can see from the chart below that it is having trouble breaking through the $500 per share level it established in late August. Such is the nature of bubble dynamics where valuation has little influence on the stock price.
Unlike Y2K, most of the beneficiaries of the AI bubble are profitable companies which makes analog comparisons to the market in 2000 tentative at best. That said, the bloom is off the rose as it pertains to the AI bubble and that is why I do not expect the Magnificent 7 stocks to lead the market in 2024.
War Cycle and Defense Stocks
We have a hit with our War Cycle Thesis from a few years ago and 2023 should have been a great year for our defense stocks solely based on how much equipment we have given to Ukraine, Israel, Taiwan, and others but the stocks were basically flat liners. Such is the nature of a bubble market.
One of our long-term holdings has been Lockheed Martin which makes the F-35 fighter jet as well as the F-16 fighter jet which is presently being shipped to Ukraine and is hugely popular around the globe. With everything going in their favor – including being a beneficiary of retrofitting AI chips into their missile defense systems – the stock was a loser in 2023.
The good news is that the stock is still cheap – it trades at 17X trailing twelve-month earnings and will benefit from new orders for planes, cyber security, and missile defense products. It should also benefit from contracts to upgrade existing deployed systems to adjust for lessons learned in Ukraine and Israel as well as new AI chips. Missile defense seems to be the hottest sector in defense procurement and all our defense holdings are major players in this space.
In conjunction with missile defense, our Space Force is a growing part of national defense and our portfolio companies are all well-positioned for this growth. The threats from space are presently minimal but the Space Force still needs to protect our satellites that are an integral part of modern life. The Chinese Communist Party has invested heavily in space as a means towards levelling the military playing field with the US suggesting that it should remain a good place for investments.
Unfortunately, the War Cycle appears to be getting worse. Iran is doing everything possible to expand violence in the Middle East as a means towards making its oil more valuable. Not only have they bank-rolled violence towards Israel, they are supplying the Houthi rebels in Yemen who are presently shutting down the Red Sea, and thus the Suez Canal, for ocean shipping. Egypt is losing approximately $500,000 per container ship that avoids the canal, which is a significant loss of revenue for the country.
The narrows between Djibouti and Yemen have become dangerous for cargo ships due to Houthi missile attacks. A further risk comes in the form of Ethiopia amassing troops on the Eritrean border as the Ethiopians are desperate to secure a port on the Red Sea to reduce their reliance on Djibouti for imports/exports. Reportedly, the fees to use the port of Djibouti amounts to roughly 25% of Ethiopia’s GDP.
The good news for the world is that the odds of China attempting to take Taiwan by force are declining as Chinese Premier Xi Jinping seems to be experiencing difficultly with his top generals in the People’s Liberation Army. It still can’t be ruled out because Xi has made mistake after mistake since taking power in 2012 but it would be difficult to undertake such aggressive action without the total backing of the military.
Elsewhere, Venezuela is attempting to annex much of Guyana to control Guyana’s energy assets. The Philippines are vying with China over islands in the South China Sea where China has been using its Coast Guard to assert control. The US and Japan have been helping the Philippines which should dissuade China from become more belligerent.
The military lessons of the last few years suggests that nations will need to increase missile defense, electronic warfare, cyber security, and drone spending which should benefit our investments for the next few years.
I love the industry but I do not like where we are in the chip cycle, particularly as the Chinese economy is entering its death throes which we will discuss later. Semiconductor stocks performed well in 2023, in many ways driven by enthusiasm over artificial intelligence. In addition, they benefited from the overall relief in the market that expected a recession by 2023 thanks to higher interest rates.
Earnings have been better even though semiconductor equipment sales are forecast to decline 6% for this year and expected to be largely flat in 2024. 2025 is expected to be a strong year but that is another year out and the global economy is looking increasingly uncertain. Personally, I have a hard time believing in a strong 2025 order book given weak auto sales, weak housing sales, and limited applications for AI.
China represents 31% of global demand for semiconductors by value. I have read estimates that they represent 50% of global demand by volume since they specialize in putting low-end chips into electronic devices and appliances. Regardless, what impact will a rapid decline in China’s economy have on demand for chips? What will appliances demand be in China amidst a housing decline knowing that the correlation between refrigerator and washer demand with housing is extremely high?
How about demand for high-end chips when it is illegal to sell these chips to China? We know that China cannot re-sell intermediate level chips to Russia due to the sanctions placed on Russia for invading Ukraine. How will this affect profitability across the system? It seems to me that these factors and more will make forecasting chip demand far more difficult in the months ahead and volatility in earnings has historically resulted in lower stock prices due to higher risk factors.
The supply chain for semiconductors involves thousands of small companies, many of which are only marginally profitable and located in China. Will these companies remain open? How will the industry replace these companies if China experiences economic dislocation? How quickly can the industry move these companies to more stable parts of the globe?
Lastly, the industry is adding tons of new chip fabrication capacity, ostensibly to secure the supply chain in the event China attempts to invade Taiwan. Will the global economy generate sufficient demand to utilize this new capacity? If demand proves to be insufficient, it does not take much for these companies to go from highly profitable to highly unprofitable.
For semiconductors, this is THE critical point because their profitability models depend on massive economies of scale. When you consider that each new ASML photolithography machine costs over $100 million and requires very expensive maintenance, not to mention the highly skilled people who operate them, payback on the investment requires running the machines continuously. This is only possible with massive demand for the chips.
It is the same for chip designers such as Nvidia and Qualcomm. They spend a fortune on chip design, which is a massive up-front cost. If demand for the chips they design is insufficient, formerly highly profitable companies can report massive losses. This is the reason why China is so important. A sharp reduction in Chinese orders could be enough to destroy profitability in the industry.
It is for these reasons that we require a higher risk premium to purchase the industry aggressively and that is only possible with a significant decline in stock prices and clarity on global economic trends.
Agriculture and food were my biggest disappointment in 2023 because the war in Ukraine, which has shut down thousands of acres of exportable wheat combined with the shipping issues in the Black Sea, should have made US wheat more valuable. In addition, much of the world’s fertilizer comes out of Ukraine, Belarus, and Russia, much of which is sold to Brazilian soy and wheat producers. The soil of the Amazon Basin is extremely poor and requires more fertilizer than comparable US farms. It seems that Brazilian growers were able to get through 2023 without typical levels of soil amendments but I doubt 2024 will yield the same results.
As I see it, the biggest risk to the agriculture/food profit model is the inability of poorer nations to secure sufficient US dollars to pay for global food commodities. As you will see from the Eurodollar section of this piece, the global economy is suffering from weaker trade. As such, 3rd world nations are not receiving enough dollars in trade with which they can purchase food commodities such as wheat for their people.
I would prefer not to contemplate such an eventuality but it is a risk to our investment thesis. It is a bigger risk to people living in places such as Egypt, Pakistan, and China as all three are big importers of food commodities. In Egypt’s case, it is so they can export cotton, a higher value-added commodity than wheat. In Pakistan, recent flooding amidst normally dry weather has destroyed harvests. In the case of China, they have simply destroyed the quality of their topsoil with misguided agricultural policies and incentives.
All three have extensive borrowings in the international banking market but in addition, Egypt and Pakistan have been forced to borrow extensively from the International Monetary Fund or IMF. Countries go to the IMF when they have trouble servicing international bank loans and need help maintaining necessary imports.
Furthermore, the Egyptian pound has fallen 81% versus the US dollar over the past ten years while the Pakistan rupee has fallen 61% over this span. This means that the price of wheat has risen by these amounts relative to local currency over these time spans. The Egyptian government heavily subsidizes bread for this reason.
Currency devaluation is the same as inflation and inflation is running rampant in both nations. Devaluation also makes it MUCH harder to repay foreign denominated debt. How long until it becomes difficult to import wheat without help from richer nations?
Exports to hungry countries is the biggest risk for Archer Daniels Midland and Corteva but the risk is more than offset by both stocks being very cheap. ADM trades at 1.5X book value and 7X cash flow while CTVA trades at 1.3X book value and 10X cash flow. In a bubble market where companies like Nvidia and Tesla trade at extraordinary valuations, we have been able to find excellent companies that sell absolute necessities at bargain prices. It may take a little patience but I expect both companies to prove to be extremely rewarding to clients.
The economic situation in China is moving from bad to worse. This change will not be reflected in Wall Street reports because those economists rely on data reported by the Chinese government which is notoriously bad and getting worse. Fortunately, there are analysts who speak and read Chinese who are supplying updates based on qualitative data and Chinese-language news stories.
In a nutshell, since Covid struck in 2020, global manufacturers have abandoned China for a variety of reasons ranging from a fear of future pandemic lockdowns to geopolitical risk of China invading its neighbors to the harsh and strict controls instituted on foreign companies. Foreign firms have experienced police raids on their premises and a harsher regulatory environment. They have had enough.
Exports to the US are down to the lowest level in 10 years while exports to the European Union are down 10% year-over year. Exports are the lifeblood of China’s financial system because it is where they acquire the dollars they need to purchase commodities in global markets. In total, exports were down 4% in 2023 despite a 50% increase in exports to Russia.
China imports most of its oil/gas and much of its food. A few suppliers will take yuan for small trades but the bulk of their imports require US dollars to settle. As an aside, this is why China wants to dethrone the US dollar as the dominant global reserve currency. Nobody wants a geopolitical competitor to dominate the flow of one’s lifeblood.
The chart below represents Chinese exports to the US over the past 15 years. Our reduced reliance is a cause for optimism for the US and pessimism for China.
The result has been a rapid shuttering of longtime manufacturing businesses. Electronics, semiconductor suppliers, textiles, automotive equipment, and a wide range of other manufacturers have closed their doors, many after more than 30 years in business. In a short span, cities such as Shenzhen, Dongguan, Guangzhou, and Foshan are starting to resemble Detroit. Migrant workers who leave their villages in the countryside and who are responsible for much of the manufacturing labor started heading home for the New Year holidays in October instead of January because they cannot find work.
Retail stores are shuttering, both small and large. Walmart is shutting 400 stores across the country and laying off 20,000 workers. The same can be said for the French giant Carrefour. They are basically telling us that the Chinese growth story is over.
Their stock market tells part of the story. This is a powerful chart. It measures the performance of China’s Shanghai Composite measured in S&P500 units or the Shanghai divided by the S&P500. It reflects a 6% loss in Chinese stocks since 2010 while US stocks have gained 325%.
As bad as this chart looks, Chinese stocks seem to have performed better than the rest of the economy. While the IMF and World Bank are forecasting 5% growth based on guidance from the Chinese government, it appears to me that the Chinese economy is experiencing a secular depression and not just a cyclical recession.
Financial services giant Zhongzhi Enterprise Group, which managed $140 billion in fixed income and real estate, just filed for bankruptcy protection after finding a $36 billion shortfall on its balance sheet. They are missing the equivalent of 26% of the assets they are supposed to manage. That is virtually impossible without widespread graft and malfeasance.
Zhongzhi was the most prominent firm in China’s $3 trillion trust industry. Much like the decline of China’s premier real estate developer Evergrande last year was followed by Country Garden, it is a virtual certainty that more financial services firms will follow the decline of Zhongzhi. It is the cockroach theory; where you find one cockroach, it is certain that there are more. In effect, the Chinese banking system is starting to implode. You may recall that we have been expecting this for at least a decade.
When we consider that regional governments formerly received 25% to 30% of their revenues from selling development rights in their districts, the loss of real estate development has left a massive hole in municipal budgets such that government workers are routinely being forced to take 25% to 40% pay cuts. Furthermore, to attempt to reduce the shortfalls in revenue, many regional and municipal governments have resorted to charging outlandish fees and fines for virtually everything. This is akin to a tapeworm attacking its host – these fees will destroy any remaining economic vitality.
This comes at a time when Chinese households are seriously over-indebted as many Chinese workers had to resort to debt to survive the aggressive lockdowns from Covid. The chart below shows how quickly the Chinese population went from net savers to net borrowers such that they have more household debt relative to income than Americans.
When we consider that the Chinese property market is the largest asset class in the world at the equivalent of $62 trillion and that they have the roughly 7-10 years of excess inventory to clear before there is any chance of market stabilization, it is obvious that there is no way to fix this problem without extraordinary pain. At its peak, property development represented 30% of Chinese Gross Domestic Product, or GDP. It was the main driver of Chinese economic growth over the past ten years. Now it is gone. If you’ve been reading our publications for years, you may remember that we predicted this more than ten years ago!
China’s birth rate is collapsing well below replacement rate and some credible analysts estimate that their population will fall from its current level of 1 billion to 600 million by 2050. If present trends continue, it may get worse because China is suffering through another pandemic. Like Covid, we’ll never know the true number of fatalities but there have been whispers that it is significant.
Add in widespread non-potable drinking water, highly polluted air and waterways, contaminated grains and vegetable from polluted irrigation, and a low-quality healthcare system, the Chinese people are living a nightmare akin to the dark ages of European history. It is impossible to put into words just how much of a mess the Chinese Communist Party has made of China. In 100 years, they have utterly destroyed one of the greatest cultures on Earth. Mao was arguably the worst leader of the 20th century and Xi is set to be the worst leader of the 21st century.
China is the second largest national economy in the world and they are on the cusp of declining as fast as they rose. It is something that most investors are unprepared to face in 2024.
I’m getting tired off all the analysis that suggests that the US dollar is crashing and that nobody wants to hold dollars. There is nothing further from the truth. The world desperately needs US dollars or Eurodollars but they are no longer there. The Federal Reserve filled the bowl to the brim following the GFC or Great Financial Crisis of 2008/2009 but the global banking system has frittered away all those dollars by investing heavily in China and other deadbeat countries. These are strong words but I have been watching the way China has used their massive stash of dollars over the past fifteen years and the result has been criminally stupid.
The Belt & Road Initiative was an infrastructure plan that involved rail lines to Europe and massive port investments in obscure nations like Sri Lanka. I won’t go into details but the CCP (Chinese Communist Party) basically destroyed $2 trillion on projects that will never earn enough dollars to pay back the debt. For all intents, that money has burned – gone. The Chinese official statistics show $3 trillion in foreign exchange reserves held at the People’s Bank of China. This is the money China uses to settle imports in oil and food, among other things. Based on weakening trade and the exodus of foreign companies and investors, I believe the “true” number is closer to just $1 trillion.
Besides the BRI, they also built massive domestic infrastructure that was wholly unnecessary. High-speed rail represents another $1 trillion to build and another $1 trillion per year to operate. The problem is that the quality of the construction is so shoddy that the trains cannot travel very fast destroying the utility of purchasing an expensive high-speed rail ticket in the first place. Nobody is riding these rails and the upkeep and maintenance remains extremely expensive. The rail lines have very expensive stations that are virtually empty and some are empty because they were never opened. The best part is that they are extending the lines further! That’s “Socialism with Chinese Characteristics!!”
It’s not just China. Eqypt built its “New Cairo City” east of Cairo and intended to be a modern city apart from old Cairo. It looks great but it cost $50 billion much of which was borrowed outside Egypt. It is another example of how Eurodollars are destroyed – some banker is going to take a massive write-down on that loan because the investment does not generate returns.
Pakistan borrowed aggressively from China to expand the Belt & Road as well as to buy military equipment. Big mistake and now Pakistan is in economic hell.
Those are just a few of the many examples of investing in the emerging markets and watching those investments get destroyed. As I’ve written on many occasions, when a loan goes bad, its value gets written down to its salvage value. Many of these so-called investments have next to zero value. When they are eventually written down, they will represent a destruction of money and that is the definition of deflation. Even if they are not written down, they aren’t generating cash flow which means those banks lack the liquidity to make new loans.
Again, as I have written in the past, the dollar is effectively two distinct currencies. The dollars inside the US are what we see because they are held in domestic banks and money market funds. They need to be exported abroad as investments in foreign assets or spent on imports in order for that money to become Eurodollars which are dollars held in international banks. These dollars are outside the control of the Federal Reserve Board, our central bank.
People watch the Fed increase the size of their balance sheet and picture wheelbarrows of money exiting the Federal Reserve Bank of New York en route to JP Morgan but that’s not what happens. Instead, the Fed purchases US Treasury bonds or mortgage-backed bonds from big banks and the proceeds are deposited in the bank’s account. For that money to impact the supply/demand dynamics of the US dollar in currency markets, it would need to leave the US as I discussed above. This is why we can have a situation where we have excess domestic dollars while also having a scarcity of Eurodollars. It is the Eurodollar market that determines the value of the dollar in currency markets and because it is unsupervised, nobody knows how many Eurodollars presently exist.
But we do know that bad investments destroy money as I wrote above. We also know that the US has become a net exporter of oil and gas which means that dollars are coming in to the US instead of going into the international banking system. This reduces existing Eurodollars. Finally, we have not increased our trade with China in ten years. Putting these pieces together, we can surmise that the global economy is starved for dollars. And that’s why the dollar is so important to watch.
The long-term chart shows that the US dollar is in a secular bull market. If it breaks above the blue line, it suggests that the global economy is starting to crash due to insufficient amounts of dollars in the system. When borrowers such as China, Egypt, and Pakistan (among others) borrow dollars, they are creating a synthetic short position in the dollar. It is like when a hedge fund sells Tesla stock with the hopes of buying it back at lower prices to complete the trade.
In 2010, in response to the Federal Reserve’s policies that filled the global system with excess dollars, countries all over the world assumed that the value of the dollar would decline so they borrowed dollars to fund all sorts of dumb projects. The opposite occurred and now those countries need to pay back their loans and cannot. This is why Shakespeare once wrote in Hamlet: “neither a borrower nor a lender be, for loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.” Polonius would have made a great central banker.
So why is everyone warning of a dollar collapse? The simple answer is that the people in charge, also known as the global banking elite, don’t want the dollar to spike causing a global “short squeeze in the dollar.” These people include central bankers, private bankers, commerical bankers, representatives of the IMF/World Bank, the Bank for International Settlements, and government Treasury bankers.
If we get a spike in the dollar, countries and their banks around the globe will become insolvent and that will make major banks in developed countries such as the US, Britain, France, Germany, Japan, and Singapore, among many others, go broke because the global banking system is mutually dependent. It will create a deflationary event far worse than the Great Depression.
The global banking elite are very powerful which is why I am not inclined to take positions contrary to their wishes at this time. That said, if the dollar spikes above the blue line shown above, it will indicate that the global bankers are losing control.
Mayer Amschel Rothchild once famously said “give me control of a nation’s money and I care not who makes the laws.” Crypto currencies represent a direct threat to the power of central banks and the entire banking system so why are they being allowed? As a payment system, they circumvent the banking system and the frictional costs associated with banking so it has the potential to be an evolutionary technology. If we are looking for a parallel from history, they most closely represent “bank notes” which allowed holders to redeem the notes for specie, usually gold or silver. The US dollar is a bank note from the Federal Reserve that once allowed holders to redeem the notes at a Federal Reserve bank for specie – gold or silver. It says “Federal Reserve Note” on every bill.
The problem with bank notes before the creation of the Federal Reserve is that bank notes from chartered banks were subject to the credit quality of those banks. If the bank was in bad financial condition, a bank note holder was at risk of not getting full value in return for the note. This represented a substantial frictional cost in US economy which the Fed eliminated by monopolizing the function.
Rothchild’s quote was as relevant in 1800 as it is today. Crypto currencies would eliminate the power of central banks which is why I do not believe they will be permitted to ultimately usurp the power of controlling money supply. Instead, I believe central banks are allowing private enterprises to do all the work and will later attempt to institute their own crypto currencies. Since crypto currencies are not widely owned, it would take little for every government to outlaw them in the future.
Besides, banking is far more than just money. The barriers to exiting a dollar-based world and replacing dollars with bitcoins are enormous and almost insurmountable without an extraordinary crisis. The credit system would need to be completely recalibrated for bitcoin and would need to be massively smaller than today’s banking system which would bring with it a biblical decline in the global economy. This is because the appeal of crypto is that they can’t be devalued by central banks, .
The only benefit that I see is as a store of wealth which remains dependent on acceptance by other holders of crypto currency. Instead of a tangible asset such as an ounce of gold, crypto currencies are somewhere in the spectrum between an intangible asset and a tangible asset.
Money is a social construct as is crypto currency. Under the right set of circumstances, crypto has potential as a store of value but there are innumerable risks to its success.
My working theory on crypto is that it is allowed because it creates a distraction that makes investors feel like they have limited the damage to their wealth from inflationary government policies. Secondly, it takes pressure off true inflation hedges like precious metals and commodities. Thirdly, as I wrote earlier, the private market is providing a framework for instituting central bank digital currencies (CBDC) in the future.
My last point on this topic is that we have no idea how crypto will fare in a crisis. It’s being sold to investors as a panacea for crisis yet there is no history to suggest it will hold its value in a market sell-off.
I have been considering this question for over 20 years because it is obvious that we will get a “re-set” of the system at some point in the future which will come in the form of devaluing global money supply by creating more of it. In effect, this will cut the value of existing debt by the relative amount of new money created.
There is far too much debt in the global financial system and that debt is acting like an anchor holding us back from real economic growth. The problem is that someone must bear the brunt of those costs and this is the underlying motivation for investing in crypto currencies. Crypto currencies can be outlawed but they cannot be devalued.
Precious metals make sense but only if they are held in physical form and in secret because otherwise, criminals can target the owners of gold and silver. If held at a gold bank or in on-line form, it’s easy for the government to appropriate your holdings. This leaves precious metal mining stocks as the best way to invest in this asset class.
Industrial commodities like oil and copper can be useful but are also subject to the supply/demand for their uses which can decline aggressively in an economic downturn. In addition, both are expensive to hold as an inflation hedge. Like precious metals, you can purchase the stocks of the commodity producers but those stocks trade with the underlying commodity and tend to be correlated to the global economy.
Having gone through the analysis of this question hundreds of times, the solution is to own stocks in companies that sell must-have products. Having a little debt on their balance sheets is a sweetener because that debt will presumably get devalued in a re-set. If we look at Germany and Japan, two countries on the losing side of WWII, there are companies such as Mitsubishi (1917) and Siemens (1847) that have survived world wars, hyperinflation, and complete changes in their political systems.
The key is to find the right companies. It is a little more involved than just picking industries. Firstly, the company should sell products that are in demand regardless of the global economy. It is alright if they sell fewer products in a difficult environment if they have sufficient flexibility in their cost structures to adapt to lower levels of demand.
Secondly, the companies need supply chains that are relatively unimpeded by global conflagration or quickly replaceable. An example is that Intel is moving quickly to replace much of the semiconductor supply chain if China tries to invade Taiwan.
Thirdly, the company’s stock must be trading at levels that compensate us for the risk of stock market liquidation. Companies such as Lockheed Martin and Northrup Grumman are very inexpensive relative to their long-term earning power. They may lose some value amidst a chaotic stock market but any losses are likely to be temporary. Tesla and Meta are examples of the opposite as I can imagine both getting cut in half or worse under difficult market conditions.
Fortunately, I do not believe we are in danger of a “re-set” event over the next year. Instead, I expect the Federal Reserve to be accommodating with lower interest rates over 2024. I mentioned the topic because I see people allowing their imaginations to get the best of them in research reports and I know that they are using fear to sell financial products. At GeoVest, we would rather calmly find ways to make money from dramatic change that we anticipated for years than wake up one morning and react to change.
I am not a fan of the way most economists analyze the US economy because much of their work revolves around their econometric models and how the GDP, or gross domestic product, will change given a certain range of inputs. Economics is not a hard science like physics; it is a soft science at best with high variability because people react differently under different circumstances. The Bureau of Economic Analysis releases what is a highly variable estimate of changes in our economy, then spends the next 10 years recalculating it with the final version often being dramatically different than the original release. It is little more than a silly game for traders. The only thing that really matters is what people are doing and why.
Presently, people at the bottom of the income strata are experiencing extreme difficulty. Food shelters continue to do a brisk business while companies that sell low-end food such as Hormel’s Spam point out that consumers are buying fewer canned and packaged products.
The two charts below are for revolving consumer credit and non-revolving consumer credit. Revolving is mostly credit card balances and non-revolving are mostly auto loans, college tuition, recreational vehicles, and boats. What jumps out at me is how revolving loans have jumped over the past year while non-revolving loans have stopped rising. This suggests that people are turning to their high interest rate credit cards to make ends meet. According to Forbes, the average credit card rate is 27.84%.
Think about how desperate people must be to borrow at 28% on their credit cards. These are our neighbors and friends. Economists may tell us that our economy is flat to slightly better but it’s certainly not the case for a young family that needs to borrow at such usurious rates to survive.
You might be tempted to see the revolving credit chart as an aberration but the following chart of the amount being financed for a used car is startling. Normally people at the lower income strata need to borrow to purchase used cars. Yes, the price of used cars has risen dramatically but a jump such as this indicates that life is getting more difficult for a lot of people in our country. Keep in mind that people are not only borrowing more money for a used car, they are also borrowing at a higher interest rate. They are being hurt two ways.
This is why we like companies such as LKQ. They own junk yards around the country so you can buy parts off used cars or parts that LKQ has re-manufactured for dramatically less money than new parts. The stock may have had a rough year but I see a very bright future for them.
Returning to consumer credit, these charts beg the question of how long until these people start to declare bankruptcy? The pain in our economy is moving from the bottom on up. If you are closer to the top of the income strata and you have money in the stock market, you’re not doing badly. The chart below is somewhat elevated by inflation but it still looks stable and strong.
This is where it is so important to know exactly why GDP is changing. GDP continues to expand because the government has put an extraordinary sum of money into consumer’s hands. Pre-Covid, US government transfer payments were $3 trillion per year and after some MASSIVE checks were mailed out, we are now sending out checks at a rate of over $4 trillion per year.
Clearly, the money is being spent at stores such as Walmart, Costco and Target. The giant general merchandise stores sell food and other essentials.
This is the reason why our economy is still in positive territory but every check that goes out without a corresponding unit of labor ADDS to inflation. The charts above are the major reason why inflation has jumped and why the Federal Reserve was forced to raise interest rates. It’s Economics 101, Introductory Macroeconomics. Needless to say, this kind of spending is unsustainable.
Another element that has helped sustain consumer spending is the fact that 40% of people with student loan balances that were required by law to start repaying their loans in October have NOT made any payments. I suspect the 40% who are not paying loans are having trouble making ends meet.
Forgiving student loans seems like a great idea on the surface but viewing the chart below that shows year-over-year percentage changes in the price of education should dissuade even the most ardent supporters of education to give up the idea. If we start to forgive student loans and make the cost of education free, education inflation would explode to the upside and bankrupt the US in short order.
There is a well-known law in economics that says any desired good offered for free will have virtually unlimited demand. Such a move would create an extraordinary misallocation of resources that would destroy our economy because the marginal benefits of education would be driven down to zero – or below.
This means that the country is not in a position to “forgive” student loan balances but given the extraordinary levels of this debt, it may prove to be a motivating factor for a future “re-set.” It’s a political question with negative outcomes in all directions.
Returning to the economy for 2024, we expect it to continue to weaken as the year progresses because people are running out of the free money mailed to them between 2020 and 2022. Apart from the free money, the shocking rise in interest rates is hurting small businesses, commercial real estate, housing, and consumer spending on discretionary items such as cars and appliances. Personally, I believe the Federal Reserve made a terrible mistake by raising interest rates above 5% and this will become more obvious as we get through the year.
Thanks to the changing nature of banking and trade with China, money supply has not correlated with inflation in the same ways as it has in the past. Based on observations over the past 25 years, I believe that the Fed’s balance sheet correlates with inflating asset prices and not the consumer price index. Instead, I attribute the latest bout of inflation to Congress and the massive spending packages since Covid.
Once again, here is my favorite chart for explaining the past 15 years in our economy. I have long suggested that our economy has had zero organic growth since 2006 and that all of the increase in GDP has stemmed from “borrowing growth” from the future by expanding government debt.
This chart screams that the US government has taken over our economy by muscling out business. You can call the last 15 years economic growth if you would like but it does not meet my standard for growth. It is little more than Potemkin growth – all for show but don’t look behind the façade. When I study the economy, I look behind the façade.
The next chart makes the situation clear because it shows “real” retail sales, or retail sales adjusted for inflation. I included the chart of transfer payments again because you can see how those government checks ignited inflation that was formerly under control.
You will notice that the first “batch” of checks pretty much countered the “deflation” of our Covid lockdowns and inflation remained under control. Inflation got out of control only after the subsequent batch of checks went to consumers. In retrospect, it was a mistake.
This is how Congress created inflation, not the Federal Reserve. The Fed is guilty of many economic and financial mistakes but this one was made by the House of Representatives and the Senate. The Fed is simply trying to force Pandora back in the box.
Interest rates are rapidly heading lower in response to the improvement in inflation numbers as well as the growing weakness in the global economy. The US represents a “flight-to-safety” regardless of what anyone says to the contrary. The two charts below are for US Treasury notes with maturities in two years and ten years – both fell by more than 1% or 100 basis points from early November through the end of the year.
As I wrote last quarter, the Federal Reserve will have to engineer interest rates down to 0% again. It’s not just for the weak economy, it’s because the US has added over $10 trillion in new debt since the start of Covid four years ago. 41% of our national debt has been added in the last four years!
This increase in debt, and the spending it allowed, has been obscuring the negative impact of higher interest rates on our economy. The simple truth is that the Fed needs to drive interest rates back down to 0% for interest payments to not bankrupt the Treasury. As of December 31st, US government debt is $34 trillion at an average interest rate of 3.11%. This means that the interest payments made to debt holders is more than $1 trillion per year!
When we consider that annual tax receipts are around $12 trillion, debt service equals 1/12 or 8% of federal tax receipts. This means that one month of tax collection is necessary just to service government debt. Heaven forbid we experience a jump in interest rates to 10% or more because government debt would head into a death spiral where the more they spend on debt, the more taxes or debt they’ll need to feed the monster. Money would leave the US dollar as fast as possible. Fortunately, I see the opposite for 2024; I expect rates to fall back to 0%.
The chart below is perhaps the most important chart in regards to the US economy. For decades, it has been accepted by economists that an inverted yield curve, where short-term rates are higher than long-term rates is a classic sign that a recession is approaching. The rationale is that central banks are keeping short-term interest rates high to slow down an overheated economy and that buyers of long-term bonds believe they will succeed in reducing inflation and economic activity.
The bottom green line shows where interest rates were at the start of 2022 – basically the 0% rates that have been standard for the past 10 years. The two lines at the top represent the start of 2023 and 2024 with the only difference being that the Fed raised short-term interest rates another 100 basis points in 2023 to combat inflation.
This means that we have had an inverted yield curve for more than a year which makes this important signal far more significant than in past economic downturns. As I’ve said repeatedly, the extraordinary expansion of fiscal spending has obscured the negative impact of higher interest rates on the US economy. Buyers of long-term bonds have been telling us for more than a year that the future direction of our economy is negative. The longer that short-term interest rates remain at these elevated levels, the harsher our economic future will be. I don’t view this coming weakness to be a recession because I expect it to be secular in nature.
The GeoVest Approach
Without a new spending bill that inflates debt further, the US economy is going to continue to weaken through the year. The combination of high interest rates, elevated consumer prices, and declining household liquidity will continue to negatively impact household spending.
I’m not sure this will matter to the “Magnificent Seven” stocks in 2024. After all, Apple experienced declining revenue for four straight quarters yet its stock rose 50% in 2023. Such is the expediency of a government faced with a weakening economy to maintain confidence by orchestrating the stock market higher.
This kind of stock market performance represents an outlier, which are rare. China’s failing economy remained stable in 2023 without which, those seven stocks would have performed poorly. Much will depend on whether China can hold it together in 2024.
Our stock and bond selections take China and other risks into consideration. Irrational prices are endemic to modern equity markets but those benefits only accrue to insiders and speculators. Our objective is to make money in both up markets and down markets based on anticipating change as opposed to reacting to change. Our pricing disciplines are built on the existence of a central intrinsic value within a security’s long term trading range.
This is why we are optimistic about 2024, come what may. Unlike the rest of the world, the US has competitive advantages in energy, food, semiconductors, and an educated workforce to thrive even when the rest of the world contracts.
We have some exciting new developments to report. I will be writing a new series of weekly pieces called “the Second Derivative with GeoVest.” Additionally, we are starting to post videos to our Youtube channel. Just go to https:www.youtube.com/@GeoVestAdvisors. Thank you and it is our continued pleasure to serve you.
Philip M. Byrne, CFA