“We always overestimate the change that will occur in the next two years

and underestimate the change that will occur in the next 10.”

Bill Gates

 

Last year impacted everyone but in several different ways and to different degrees. Sure we all went a bit stir crazy and a few of us snacked too much and watched far too much CNN for their own mental health. I am not downplaying any of those developments but I am going to focus my observations on the financial matters.

There was a huge disparity in how Covid19 financially impacted different parts of society and the overall economy. Many came out way ahead financially speaking while many suffered greatly. While governments moved quickly to ease the suffering with income replacement programs and mortgage and rent “holidays” it didn’t prevent food lines that stretched for hours in many places on many days. It really highlights that a huge part of society lives day to day with no safety net.

It seems almost perverted that stock and bond markets did as well as they did in 2020. I was certainly in the camp that markets were a tad delusional for many parts of last year. I kept rationalizing that “liquidity was winning” but I honestly expected and kept preparing for a reality check that was just around every corner. Unemployment went to depression levels. Economic contraction due to mandatory global shutdown was truly unprecedented. And markets kept chugging along, backstopped by government guarantees of “whatever it takes”. Uncertainty around the US election (will he even leave if he loses?) was largely a non-event. Ample liquidity along with a new generation of smartphone day traders helped fill the void. It is as if we are living in the twilight zone with so many companies more valuable today than before the pandemic even though their businesses are operating in first gear. Global companies like Marriott with real land and real properties are worth a fraction of what a software company like AirBnB is worth in this modern world. I get it, liquidity is winning but how much is too much?

Almost 25% of all the US dollars currently in circulation came into existence after Covid19. These newly minted dollars actually add up to more than what the entire US money supply was in 2002! It took the US Federal Reserve 94 years to amass a balance sheet of $1 Trillion, and just 7 years to take it to $7 Trillion (up 100% from the $3.5 Trillion balance before Covid19). When I say liquidity is winning, it is hard to comprehend the scale and even harder to comprehend the unforeseen and unintended consequences.

Please don’t interpret these comments as being negative or calling for a doomsday. Quite the contrary actually. Most of this liquidity is going to slosh around for a long time and cheap money inflates the values of all assets. So maybe stock market valuations can go much higher and we just have to orient the sails correctly. We have already seen that monetary authorities don’t like to upset markets by pulling away the punchbowl. Remember the taper tantrum of 2013 and then again at the end of 2018 when the US Federal Reserve indicated they were going to let the punchbowl run low? They learned their lessons both times.

The Federal Reserve has said dozens of times over the last 6 months that the overnight lending rate will remain anchored at close to 0% for at least 2 years. They have also said they will be very tolerant of inflation above the 2% target and would prefer to see 3% handle before touching the punchbowl. The die is cast.

Investors have a very unique challenge in this environment. After a 30 year epic bull market in bonds that have seen interest rates go from middle teen yields to around 1%, government bonds offer a return-free risk except for in times of market panic. So investors can hold government bonds just in case the stock market stubs its toe but most of the time they will provide little diversification benefit and a negative real return after inflation. Of course cash pays practically nothing but does provide the fire power when the market panics. This usually plays out over several months but as 2020 showed, not necessarily! This leaves the stock market, real estate and exotic structures like private equity and hedge funds as our set of investment options. Or if you like, you can now invest in the original 1963 Marvel Avengers Issue #1 comic as a company sold shares on the market at $54 each! They are not making any more of those so it must be valuable! Oh and Bitcoin! Let’s not forget crypto currencies!

I am not making a value judgement call on Bitcoin. Many smart investors have very publically allocated a tiny percentage of their funds or personal wealth to Bitcoin just in case it pays off (a bit like a lottery ticket!). Other true believers think it will revolutionize financial markets and ascend to its rightful place as a new global digital currency that is not backed or regulated by any sovereign government. I have spent some time on the subject and like many, I have a hard time truly understanding the paradigm or more importantly, why governments would ever cede that kind of control.

That said, I think Bitcoin has the potential to be the modern day equivalent of Tulip Mania. Most don’t understand it but know that it has a finite supply of just 21 million coins so it must be valuable. And as the expression goes, watching others get rich quickly is one of the hardest things an investor can do! Remember, at the height of Tulip Mania, just one tulip bulb would pay for a very nice house on a Dutch canal. And then suddenly, one day in 1637, not so much.

I will stick with good quality businesses! Ones that make money and have great moats around their franchises.

As always, feel free to call anytime!

Derrick