1-10-22

None of the following is investment advice. This memo describes US investments and is a continuation of our memo published two weeks ago. However, we feel the topics discussed below will flood headlines for months and years into the future.

“Check your ego at the door.”

In 1985, these words were posted in the studio where “We are the World” was created with 45 of the greatest vocal talents of the time. The underlying message – do it for the music and humanity; not for yourselves.

36 years later, we have put these same words in our office to remind everyone how lucky we have been. For several consecutive years, life has gotten better for us all. New technologies have improved qualities of life and quantitative easing has enabled more people to afford those technologies. Improving standards of living over the next several years promises to be difficult, as those same technologies have gotten increasingly expensive at a time when governments will provide less economic liquidity. All standards of living changes have been and will continue to be primarily the result of monetary policy and not the result of individual decision making. Humility must replace the ego.

While we know the Federal Reserve (“The Fed”) will rein in liquidity and also that virtually everything we use in day-to-day life has become more expensive, we do not know the challenges these things could pose to our society. As we have been for over a decade, we are at the mercy of our governments, leading us to assert that governance risk is at once the only risk a rational investor should be concerned with and virtually impossible to predict. Many irrational people will try to be heroes and predict what the Fed will do and they will probably fail. Even more people will continue to speculate in the same ways they did profitably last year (i.e. cryptocurrencies) and they too will probably fail.

Check your Ego at the Door.

To preface our investment narrative, we are in favor of The Fed. Human nature is such that many of us want to govern and many of us need to be governed. Nonetheless, below are figures from three important years. Source: St. Louis FRED

2000 – $580 B in cash, $5.8 Trillion in debt, $10.3 Trillion in GDP

2008 – $800 B in Cash, $9.5 Trillion in debt, $14.8 Trillion GDP

2022 – $2.2 Trillion is held in cash, $28.6 trillion in debt, $23.2 Trillion GDP

2022 takes the crown for the most debt ladled onto each unit of currency. $13 for every $1 of cash, whereas the figures in 2000 and 2008 were $10:$1 and $11.88:1, respectively. Debt has grown steadily more in proportion to both cash and GDP almost every year, and of course interest rates have come down throughout that time to near zero. Importantly, the US has increased debt by a factor of 3 during the last 13 years, meaning that volatility could be around three times higher for changes in collateral values.

Moreover, cryptocurrencies also stand as collateral for a portion of the total public debt, meaning that $2 trillion of cryptocurrencies back trillions more in real public debt. As Bitcoin drops in price, those debts don’t change in principal. All of those debts still exist if Bitcoin goes to $0, until they default. Suffice it to say, we are more levered today than we were at any point in recent history, by a long shot.

We also have a higher GDP (Source: Macrotrends.com) to balance out the higher debt. However, Much of the debt in the economy is based on GDP improvement, if not GDP stability. A drop in GDP would result in a similar result as Bitcoin: lower collateral value, but the same amount of debt. This is the ‘inflection point’ – we must discourage speculative (junk) debt in the face of inflationary pressures.

Business earnings are equivalent to what a business takes in minus what it pays out. Businesses took in more than ever last year as people spent more money than ever (for various reasons). Those businesses are now paying more out and we are yet to know if they took in that much more. If they did and they continue to pass off higher costs, every year ’til kingdom come, inflation will never be a problem. This would require higher demand on increasingly higher prices.

If businesses don’t take in enough, earnings will drop, debtors will have less earnings to pay back debt, and many debts will lose value, especially junk. Junk debt has no tangible collateral: it is backed by faith in the underlying business. Junk was issued at a record rate near $500 Billion in 2021, and probably would continue to see records in 2022 without rate hikes.

Inflationary pressures will occur whether or not new debt is issued. It remains to be seen whether those pressures will be enough to negatively affect business earnings and then the bond market. The ‘inflection point’ is this: will inflation negatively affect earnings enough to cause bonds to lose significant value? And if so, what magnitude of a rate rise is needed immediately to choke off new debt issuance?

We view current Fed decisions as difficult to determine, but essentially all important. Investors cannot make any moves until the Fed acts on these, and even when they do, our view is then that political/governance pressure may discourage them from doing what is needed.

As “ESG Investing” has caught fire over the past couple of years, our view is that we have a “G” risk (Governance) at the very top of the food chain: The Fed. The Fed’s mandate is twofold: reach full employment and limit inflation. In December, The Fed discovered a problem – that the US was very near full employment and that inflation would remain high longer than they like. Let’s consider options the Fed has from here:

1. An immediate, significant rise in rates causes jobs to be lost and debts to fail. Inflation drops very quickly as the economy goes into a very severe recession. Real rates rise significantly to the positive. The wealth divide becomes narrower.
2. No change in rates, inflation continues marching even higher, businesses continue issuing speculative debt, real rates drop further and earnings come under pressure. Wealth divide grows.
3. Rates rise slowly, we see a yearslong recession take place, inflation stays elevated, but the wealth divide stays very wide.

Naturally, if you are a billionaire family with myriad business interests, you would love rates to stay low or if nothing else have very slow rate rises to try and sell the positions you have. If you can barely afford to feed your family of four, you would love rates to rise quickly and significantly. It will be interesting to see which family gets fed.

Investors must prepare for one of these events to occur. A 27% rise in the S&P likely gave middle income (and higher income) Americans more money passively than they made working. Since the stock market has gained about 14% on average for the last 13 years, most of us have come to believe, like Pavlov’s Dogs, at the opening bell, you get food.

When that food doesn’t arrive, many investors will try to force the gains to happen. If you try to force it to happen, you should stop and check your ego. We are entering a very dangerous time to fear missing out (FOMO). The only FOMO our firm has is on normal goods, which will continue to remain elevated in price while other assets drop in value.

Let’s address the ultimate FOMO trade that minted millionaires and billionaires all over the world. We find significant evidence that there is no use case at all for any cryptocurrencies as they exist today. We apologize for bluntness.

Since 2016, we have watched Bitcoin (and other cryptocurrencies) grow in value on speculation. The largest use cases over that time were threefold

• Better stores of value than USD
• Improved governance versus the USD
• Bitcoin: A currency replacement for all global currencies (one world currency)

All of these have been nullified. Recently, as The Fed is signaling longer lasting inflation, Bitcoin has dropped about 40% to the USD, and most other cryptocurrencies have been lucky to do that well. A store of value should rise if the USD gets weaker.

Millions are spent weekly on digital properties and digital art. The sellers are coders. Unlike a real house, the replacement value of a million dollar digital home is the time spent coding. And of course that property has no practical use as of late and in the case it does, there is no government to protect the property in the ‘decentralized metaverse’.

Crypto proselytizers believe currencies should not be governed by one central government. However, that is exactly what is needed in the Crypto space. Among many other examples, former Twitter and current Block CEO Jack Dorsey argued with Marc Andreessen about ownership of a ‘decentralized internet akin to cryptocurrencies.

Dorsey: “You don’t own web3, the VCs and their LPs do. It will never escape their incentives. It’s ultimately a centralized entity with a different label.”

Dorsey is right – Marc Andreessen’s firm seems to be making a run at taking over web3, and it very well could work. It’s human nature that many of us want to govern and many of us need to be governed so they don’t lose everything. If cryptos do have a Minsky Moment, those who lose their life savings will wonder why there weren’t more safeguards while governments will promise it will never happen again. Bitcoin will no longer be decentralized.

We do not comment on the prospects of Bitcoin becoming a global currency because we do not have a clue what that would look like and why it might happen. We figure such a change would be extremely costly and open mountains of fraud, theft, and money laundering issues. Those are all the very reasons we have currencies.

To conclude, this is not a time to speculate. For 13 years, we have been conditioned to believe that any risk we take will not result in a total loss, but a slight drop and then money will flood in to buy the dip. We are completely over crypto as it’s known today. We believe (and hope) that crypto in the future will have a definite government and be highly controlled with more safeguards than any other global asset. We see no problems in society today that cryptos solve, but many they create.

Everyone has an opinion on inflation, including our firm. A couple weeks ago, we detailed the risks inflation could bring. We have not and will not forecast, but one thing is for sure – nobody is giving direction. Many prominent economists are declaring crisis as the Fed says the economy is doing fine and can withstand gradual rate rises. But as in everything else, change is the only constant, and we are watching those changes closely. We are confident that a time will come in the next two years when we can trust business fundamentals without worrying about governance risks. Current fundamentals mean nothing if the Fed raises rates to 3% from 0% currently and because of that, the US markets are more akin to casinos than vehicles to generate positive returns.

Check your Ego at the Door