Remember last week when I showed you how financial markets have been nothing but a giant zero interest rate simulation for years now? Well, the simulation continues this week! The US Federal Reserve announced last week it would ‘taper’ its monthly bond purchases over the next eight months, eventually getting down to zero in June 2022.
But what about interest rates? Will those go up? The Fed, unlike the Reserve Bank of Australia, doesn’t practice yield curve control. And the RBA, bowing to market expectations for higher inflation AND interest rates, doesn’t practice curve control anymore either. So what’s next: inflation or deflation?
The truth is, nobody knows. In the current simulation, central banks have engineered a synchronised global bubble in just about everything (except gold and silver). For example, Yale Economist Robert Schiller’s Cyclically-Adjusted Price-to-Earnings Ratio (CAPE) hit 40 after US markets closed. Its all-time high is 44.19, reached in December of 1999.
It’s not far away from a new high then. That’s what you get when money is easy and cheap. You get broad-based inflation in financial assets, including houses. But what will the world look like in 18 months? And if you had, say, $150 billion in cash, what would you do with it right now?
Those two questions come from two investment greats, Stanley Druckenmiller and Warren Buffett. They remember the old world and the old gods before this simulation began. Druckenmiller points out that the challenge for macro or value investors — or any investor really — is not to figure out what’s happening right now. It’s to try and imagine what the world will be like in 18 months. Why?
Markets are supposed to be forward-looking. They’re mechanisms for discounting the price of future cash flows (assuming a business generates cash). If you want to know what to buy now, you have to figure out what’s going to be throwing huge wads of cash 18 months from now — but isn’t ‘priced’ for that right now.
Easier said than done. It’s hard enough to figure out what next week is going to look like, much less 18 months from now. What will interest rates be? What will the price of oil be? Will the pandemic even be over by then? These are all questions the ‘macro’ investor thinks about and the acts upon. Hold those thoughts.
Now, imagine you’re Warren Buffett. Your holding company, Berkshire Hathaway, has US$149 billion in cash. But you don’t know what to do with it. You’ve said in the past that cash is a lousy position — the world’s ‘worst investment’. You’ve spent over US$51 billion buying back shares in your own company over the last three years.
But because you’ve amassed a portfolio of businesses run by owner/operators, and because those businesses tend to generate high returns on capital and lots of cash, you keep piling up the cash. Even after turning a US$36 billion investment in Apple into over US$120 billion, you still can’t find investments big enough for your cash pile. What do you do?
Of course, most of us don’t have the problem of investing hundreds of billions of other people’s money in the market. You don’t have a lot of choices when you’re moving around that much money. Vern Gowdie and I discussed this last week on a Zoom call. Institutional money managers HAVE to be in the market whether they like or not. Money managers don’t tend to get paid to leave money in cash.
But that might be just where you want to be 18 months from now. Aside from niche opportunities in hard assets — commodity producers that might benefit from both inflation and problems in the global supply chain — there’s not much that’s cheap. And parking lots of money in bonds as interest rates rise — not to mention with a huge global debt bubble — doesn’t seem attractive either.
It’s a dilemma. In the last two monthly editions of The Bonner-Denning Letter, I’m looking at what to do with cash right now. We have a fairly large allocation to cash as an asset class in our model. That model, as you might guess, is defensive — based on the observation that a mean-reverting crash would wipe out at least 50% from major stock market indices at this level.
It’s possible that in this simulation, when central banks are the buyers of last resort in credit and equity markets, there will never be a 50% crash again. It’s possible. But in our view, not likely. Why?
Because the coming 18 months will show that in this simulation, with record-low interest rates and asset purchases by global central banks, you get a toxic financial, social, and political mix. Asset prices to the Moon. You get huge gaps between the 1% and the middle class. And then?
And then you get real inflation in food, fuel, housing, and costs that hit everyday people. That kind of inflation, historically, is the precursor to political and social instability. And in THAT world, you want to own real assets and have a large cash buffer. It won’t look stupid then.
Until next week,