AM Brew, Jun 14th, 2022

Wow, in four days the market dropped from over 4150 to 3750 - that is a cool 10% drop in just 4 days. What changed? Not much but perceptions certainly changed. In some respects, things actually have improved, as oil's rate of increase has slowed materially as it hit $120.

Instead of reviewing the daily events, we figure that after a big downdraft, you probably reviewed the events for yourself. Instead, we wanted to do some original thinking for you during this time of turmoil.

We were doing some research on investing in the 1970s, trying to learn more about investing during inflationary times. This research uncovered something extremely interesting, almost shocking really. Paul Volcker was credited with "doing the hard thing by raising rates in the late 70s/early 80s" and he has been lauded for his fiscal discipline for the last 40 years. Boy were we shocked to find out how wrong all of that was. It turns out that Volcker was the primary architect behind Nixon's decision to abandon the gold standard, thus creating the era of fiat money! Wow, Volcker was the bad guy who fired the first shot. It turns out that he DID raise the rates, but he started in 1970, NOT 1980 - he started by basically inventing money printing of the US Dollar. In the bull markets, you can throw darts and do well, but in the bear markets, you better get your research right. Does this look like a financial genius or someone who acts with restraint?

Volcker was the main architect in creating the backdrop for the inflation that he got credit for curing. Wow. History always looks at the last dance, which in Volcker's case was a good one, but maybe it was the Reagan optimism that brought the economy out of the doldrums - think about it - Volcker just kept raising & raising the rates - maybe, just maybe the economy turned around despite tall Paul. If you look at past recessions & recoveries, the US probably would have recovered and tamed inflation without rates going to 20%. The 70s brought 2 oil shocks, which usually brings more supply which then leads to inflation dropping. Taming inflation takes time. The main message here is that: even the well known consensus accepted for 40 straight years can be wrong - do your research - the WSJ might be wrong ! Just because something is accepted as an economic fact, that doesn't make it true. Back in the early 1980s, every economics course taught students that we would never return to the 2% interest rates of the 1950s: once again, economic facts are not always facts - do your own research.

The recent US Dollar strength is foretelling a nasty July & August. The large multi-national companies are going to be complaining about the dollar strength - this is almost a mathematical certainty at this point. That is a headwind that is upcoming, and the market is now realizing this.

Unfortunately, the Fed is between a rock & a hard place. There are no good policy solutions. If they raise the rates another 3% to curb aggregate demand, there will be a crash and a depression. What we mean is that if market rates go up another 3%, so the 10-year goes above 6% YTM, there will almost certainly be a major crash followed by a depression. Crashes themselves don't create depressions and higher rates don't create depressions but the combination of a joint stock/bond crash combined with higher rates will almost certainly create a depression. It seems like things are spiraling out of control now, but they are not. Energy prices are one of the main drivers of this inflation, and eventually we can employ enough renewables that over a 15 year period, starting today, energy prices will be in long term decline (energy deflation is almost guaranteed over the super long term ). Our second message is that its doubtful the Fed can go on much longer with the hawkishness because the starting debt/GDP was too high this time. If market rates go up 3%, then the interest costs on the Federal debt go up another trillion or two, per year. Thus the math is simple: if rates go up too much, we go into a guaranteed debt/gdp death spiral, and taxes or inflation will be necessary to get out of that trap. Long story shorrt, we think the Fed knows this is the big variable and they won't hike too much - they can't without starting a true death spiral that can't be stopped. When Debt/GDP was 0.3X, Volcker could raise rates 600 bps but today that is not possible today. As stated earlier, leaving the gold standard was Volcker's idea and his other big idea was telling Nixon about wage price controls - the Volcker solutions are bad solutions - they were bad then, and they are bad now.

Aren't you glad you exchanged $300,000 of Bitcoin to buy a single $300,000 bored ape NFT :-). We think Bitcoin will survive and bored apes may actually do ok, but second & third tier crypto coins & NFTs will almost certainly be going to zero. In 1905 there were probably 300 auto companies but how many do you think there were 20 years later?

We get emails of residential listings from Redfin and yesterday's crop of emails was one of the weakest we have ever seen. In November, everything was selling right away and maybe 10% of houses were raising their prices after listing. In May, maybe 20% of the houses were being marked down. Yesterday, over 50% of the emails were mark-down emails. In commercial real estate, we are hearing that there is nothing happening, as there is a huge bid-ask spread buyers are thinking rates will keep rising and sellers are still in last years state of mind. Our conclusion: keep REITs on your radar, there should be some good deals coming up but its a bit too early right now.

The NYT had an interesting graphic:

Bear markets last about 18 months on average - this is a well publicized figure. What we found interesting is that the last 2 real bear markets, 2000 & 2008 were influenced by tight liquidity intersecting with bubble prices. Note that this is what we are experiencing now. Given that the current bear has only lasted about 6 months, it is logical that we have another year to go. That year is required to get energy prices to weaken, aggregate demand to soften, and inflation to moderate. Then markets can start rising again. We don't see a lot of "beat & raises" in the upcoming quarter, with volumes for everything decelerating in the face of high input prices and high financing rates.

Bank stocks got cheap fast. Goldman is now selling at a teeny discount to tangible book value. BofA's stock dropped from $42 to $32 and they are sending out both their CEO & CFO out to conferences to tell investors they watch the daily numbers and see no pullback in consumer spending. Banks do like higher rates, but flat yield curves are the worst - don't bet on the yield curve staying so flat. Eventually banks will be a buy. We are hearing that property-casualty insurers are a better buy than banks, as they do well in a high yield environment and are less inflation sensitive.