Part 1


This is not investment advice.

Good morning and wishing safety to all readers today.
Everyone knows there’s a bubble. It’s more than a bubble now, though. It’s solidified into a giant ‘asset’ that nobody really can understand. Last week, I read two books on this subject cover to cover and hundreds of other articles, and the discoveries have left me both apoplectic and concerned. I covered much of this memo in previous iterations, though I think persistency is the key to success at all times, especially now.
In this memo, I discuss applications from the past and how they may or may not compare. I discuss the bull case and the bear cases from here. Finally, I discuss some common sense to draw strength from during this time. Importantly, by investing today, you are volunteering your capital and because of that, you cannot be considered a victim if things don’t work out in your favor. 
We had a bubble in 2008, and it burst, leaving great destruction in its wake. Likewise, we had bubbles burst in 2000 and in 1930. Importantly though, the policy was such that these bubbles aren’t comparable. The current bubble is something that is new and cannot be compared to past bubbles. Anyone who thinks they know what will happen is mistaken. The common element of all bubbles is debt, but nobody really knows what debt is and I postulate (obscurely) that debt is mostly unknowable.
Debt is an artificial contract that simply disappears if it goes unpaid. Period. Throughout nature and society, very few things disappear completely. Take for instance, gambling. If you lose, the house wins. But in debt, if you can’t pay, nobody wins. This is very important to understanding bubbles, because the asset really was never there to begin with (this is the same argument folks make against Bitcoin, by the way). So, dollars can be created both by debt and the treasury, in a somewhat concerted fashion.
To get my point across better, we can take a very oversimplified local example of an apartment complex. Last year, in 2019, unemployment was very low, occupancy rates were very high, and default was very low. Now the Coronavirus comes.
As a landlord, you own a real asset (outright, for simplicity) and while you expect payment from these occupants, only 50% of your tenants pay rent during the first month of lockdown. So you think to yourself, do I evict them or do I give them a break and allow them to stay, rent free? You are angry at them because they should have made themselves more liquid to pay such an important contract (rent), and you also know that some of your tenants are really bad apples. Because you don’t know how long the nonpayments will last, or if people will fill the vacancies you have piling up, you choose to give them all a break (bailout), and promise to allow them free rent as long as this virus goes on, and so you still technically have the same occupancy as before and you think everything will go back to normal soon and maybe you can increase rent in future years to make up this difference. 
This is the current state we are in, and as the owner of this complex, you need to understand whether the asset will be priced the same as before, more expensive, or less expensive. Here are a few thing to consider as the landlord:
  • What if their employers can’t afford to pay your tenants any more and they lose income for many years? (deflation scenario)
  • What if these tenants have many other people to pay and might go bankrupt, forcing you to evict them anyway? (deflation scenario)
  • What if your tenants continue to borrow from other people throughout the lockdown and can’t pay you back? (deflation scenario)
  • What if the virus goes on longer than you expect? (deflation scenario)
  • From an investment standpoint, what if you can get a better yield from something else during the fallout? (deflation scenario)
  • What could be a scenario where your tenants pay more and you have higher occupancy in the next few years? (inflation scenario)
Two important items resonate – debts not only persist in the example, but they continue to pile up during the lockdown. The low unemployment and default rates were so low due to enormous amounts of promises to pay (i.e. debt) instead of real reserves. Instead of mountains of cash, we have mountains of IOU’s. The second important item is the moral hazard of bailing out your tenants.
Moral hazards are a classic sign of a bubble, and why they have been allowed to pop in the past. The bubble we see today is less prone to moral hazards, and this is a major reason why the bubble will not burst. There is no moral hazard perceived because every industry in every country is affected. 
In past bubbles, the moral hazard has caused the bursts, I believe. In 1930, nobody wanted to bail out the investment trusts, because it was so obvious that they had what was coming to them. In 2008, we saw a harder choice – and eventually the government bailed out the bad actors anyway. They chose to burst the bubble because the public felt, as they did in 1930, that those people had it coming to them. This looking the other way is called ‘austerity’.
Moral hazards are rookie mistakes, in theory.
Bailing everyone out instantly has never been done before, and this is why this bubble has so many unknowns. Most folks talk about inflation from printing so much money to bail everyone out. This is incorrect. The printing is “reflating” the bubble – every dollar printed and brought in from virtually nowhere replaces every dollar of debt that dropped out of the system into thin air. Inflation occurs if demand stays the same and there is simply more money in the economy. Nobody should believe that there is any possibility of inflation right now (unless you consider that as part of the reason why the market has risen from March lows). More money printed does, however, reduce the risk of deflation, or falling asset prices.
Thus, the argument being made lately by the rising market is that real assets, debts, and equities are not impaired, and will continue yielding the same return after the virus, if not a higher return. That apartment complex in the example will not only keep the same occupancy, but it will be able to raise prices, possibly even this year!
This is the same as saying that the cost of a new hire for a business will be the same or higher in the coming months than it was 2 months ago at record lows for unemployment. As a business owner, I don’t see how input costs can rise when millions of people are unemployed and corporations have falling revenues (projected).
These are very risky propositions. If input costs rise, why do we need bailouts? This is a fundamental concern I have with the current policy that I feel must manifest soon.
Let’s look briefly at 2008.
Tim Geithner faced many challenges in his duty as secretary of the Treasury. The largest challenge was the heat he took for proposing bailouts of overextended banks and auto makers during the late stages of 2008 after a year of deflating assets. As economic pain increases (and will increase), populists will call for punishment against those bad actors that exacerbated the pain, and will make it tougher and tougher for them to get bipartisan bills accepted.
During this time, the Fed agreed to backstop $28 Trillion in debts (or 2/3) of the entire US economy. In early 2009, $2 Trillion of money was printed out of thin air, which stimulated market and lending participation again. The debt never left the economy, and the stimulus simply encouraged people to take on more debt. Thus started a massive, 11 year bull market, formed partly by increasing earnings, and mostly from the creation of money in the form of debt.  Markedly, that stimulus bill took around 6 months to pass due to populist disapproval. 
I’d like to take a moment to thank the policy makers today. While it is impossible to agree with everything they did, they worked very hard to maintain their jobs and have heretofore been unwavering. You are all heroes to me. 
Ok, back to the program.
An article was written on September 8th by The New York Times after the nationalization of Fannie Mae and Freddie Mac- “financial stocks led the surge today, propelled by hope that the government’s decision had averted calamity and marked a possible turning point in the credit crisis that has troubled banks for nearly a year.” Boy was that wrong: the next week, Lehman Brothers was allowed to fail. Reflecting on the actions taken up to this point, currency and policy interventions temporarily reversed markets, but didn’t change underlying conditions that necessitated the action. The parallels to today are quite striking in that regard.
The sentiment was turning, but wouldn’t turn completely without that enormous (at the time) stimulus bill. The lesson we can learn here is that austerity hasn’t worked in the past; not in any country at any time. Austerity is always abandoned eventually for bailouts. When bailouts have come, economies flourish.
Here are some more considerations from the 2008 crisis:
  1. At the bottom in February 2009, US Debt was 40% what it is today, while US total stock market values were 30% of today
  2. There were 65,000 bankruptcies in 2008 and 89,000 in 2009.
  3. Unemployment stayed elevated until late 2011, and bailouts continued well into 2012.
  4. The entire drop was caused by one industry in one country, but in 2012, the PIGS (Portugal, Italy, Greece, Spain) mostly went under during the aftermath. It’s hard to know what the PIGS will do this time around.
  5. Real GDP didn’t get back to 2007 levels until late 2011. 
  6. Reforms were set to control those bad actors from doing it all again. So, the bailouts are needed for everyone, and the penalty is mostly a slap on the wrist or laws against bad behavior. 
As a dichotomy, this year we had immediate bailouts – an ‘act first and think later’ campaign. The largest hedge funds are buying and I see it happening, but I have trepidation in following the footsteps. I’m 100% sure that all the prominent investors lived through the recession and know all of the above and feel that we are heading down the same path to a very long bull market, but I’m in the camp that there will be better yielding assets to come about during what will definitely be a very long recession. I’d rather volunteer my capital on my own terms, when I can be mostly certain of a strong return.
More to come in the next iteration.

Part 2


None of the below is investment advice. While much of this is theoretical, I feel it is important for my clients to understand how recent events may affect investing for years to come.

What a difference a month makes. We are now looking at global reopenings, in some countries complete 180 degree reversals from policies only a week ago. Sports franchises seem to be coming back to the table, although watching Tiger Woods dramatic final round at the Masters in 2005 (my favorite round ever) was better than anything Augusta could have delivered this month. We also see new Frankenstien markets that are driven not on their own strength, but on the strength of governments and luckiness.
So this memo discusses a bit more on reflation – the theories playing out, the effects it has on the psychology of investors, the effects it will likely have on markets, and other diversities. A week ago, I discussed what has happened in the past, and why what is happening right now isn’t comparable. As I did last week, I again commend the heroism that policy makers have in doing their job even though at times, policy can be very controversial. Whether you agree or disagree, you must respect them for their dedication. Let’s begin.
The big question on everyone’s mind – are people resilient? How you answer this forms the basis for whether you felt markets would drop or rise. Keep in mind that we haven’t needed to answer this question in over a decade, so it’s O.K. if you are hesitant. This hesitancy, while normal, is dangerous. It can cause us to form opinions from without instead of from within. 
But then governments everywhere answered the question for us. “No”
All of the bubbles created by ‘wretched excesses’ were “reflated” (see my last memo) to guarantee that people keep going and bounce back. The swiftness of the reflation and its effect cannot be underestimated. In future crises, this will be our go-to. Why? Because it’s easy and takes out the question of people’s resilience. It seems more important to have a functioning economy than a productive people. My suspicions lie in the magnitude of the US stimulus and the fact that it was already underway at the end of last year. While this is my perspective, I am probably wrong because I don’t know enough. Anyone claiming they know these things must be incorrect if markets are indeed efficient.
As a conservative person, I believe greatly in free markets – that less government intervention is best for all dependent variables. Somethign to keep in mind is that many other countries are bailing out their economies too. But, despite what many reports say, nearly half the world chose austerity measures (including China, to a large extent), implicitly banking on the resilience of the people. Some countries didn’t have lockdowns, which is extreme austerity, relatively speaking. While this ‘zero tolerance’ ideal sends a firm message, the other half of the world is wondering – when will the stimulus funding end? [Again, my perspective might be lacking experience]. 
This is unknowable.
Cash was basically my only position this month, because I felt there was too much panic in both directions. If you had asked me April 1 where we would likely be at month end, I would have said flat. Why? Unemployment* skyrocketed, oil demand plunged, and there was nothing to do but watch what seemed to be a train wreck. On the other hand, there was the reflation policy that proposed to ‘do whatever it takes to get through the downturn’. After a nearly 20% gain in spite of worse-than-expected earnings results, though, the mind capitulates, in favor of the latter. A wise person follows those in power when there is so much uncertainty.
*What is a furlough, anyway? Seems to me just another way to fire someone so that they can collect unemployment benefits. Will all of those people want to workwhen the economy reopens? O.K., you get it.
Let’s stay with cash for a moment. 
Many hedge funds preach “Cash is Trash” because the money printing inflates stocks and real assets. While I agree, I feel this is not investing, and a true investor should wait for the opportunity to get a great long term return. While discount rates are lower (around 1% now mostly), demand is the real question. If demand doesn’t meet similar levels to before the pandemic, we will see deflation. Keep in mind that these principles can be extrapolated down to specific industries and companies. So for those companies that have higher demand now, you will see massive inflation in their market caps, theoretically. At this point, much of the market moves are guesses, and so luck plays an enormous role in the outcome of these gambles. If deflation does happen, cash is great right now for that opportunity presented.
There will be a time soon when USD, as a control variable, will be an awful investment. Without getting too far into the weeds, the dollar has been bid up lately because of squeezes happening in emerging markets. This will likely continue, but when it ends, the dollar will decline in value, at which point commodities will outperform.
We all know that the USD is a reserve currency, which privileges Americans to avoid high inflation (in theory), even with ‘infinite QE’, so there’s that.
O.K. let’s get to the main points.
Over more than a decade of investing, I have learned fundamental investing. I found strong correlations between rising earnings consistency, revenue growth with stock market prices. I found that the ethics of leadership and the persistent viability of a business model translated to a higher stock market price. I thought the inverses were also true for the downside (if companies have less revenue/become less profitable, their price declines). I took these relationships of logic for granted, like how walking through a doorway brings you to the other side of the door. I also believed (and still do) that this was the only definition of ‘investment’ and any other metric was a gamble.
These things aren’t as correlated in the new environment. They might not be correlated for another 4 years. There will be no historical correlation at any point in the future, without compromising results. So if I hear someone talking about historical comparisons, the conclusions they make are probably false. Thus, fundamental values from the past can no longer be compared to today, because the correlations aren’t similar. The game has changed, and policy now has a stronger correlation to stock performance than fundamentals for the time being. When the government says they expect a V-Shaped recovery, you should believe them, as hard as it seems, even when GDP is projected to drop nearly double digits in the year. 
Why? Because money can be ultimately printed to give everyone in America the same income/capital as they had before the outbreak, which theoretically could stimulate the same demand levels. This is not only my view, but the view of James Grant’s Daily Interest Rate Observer and many others (infinite QE). As my colleagues also posit, in an upmarket, we have free markets, ad in a down market, we become a socialist nation – I won’t go that far, but it’s not completely false…. Howard Marks said last week, “Capitalism without bankruptcy is like Catholicism without Hell.”
For the next four years, you will be able to profit in one of two ways – your ability to sell an idea or luck. Since in public markets, you don’t have the first luxury, the only real chance any of us has to make gain on an ‘investment’ is luck. There are no significant fundamental correlations from here, and so those CEOs that lose more money each year but show growth and sell the growth to investors will be rewarded more than the fiscally responsible. 
While this is frustrating to realize, we must adapt to the situation or die. There will be 4 more years of it (I believe), and I certainly can’t wait that long to reach my personal financial goals, and neither can my clients. It would seem that when brute force overcomes logic, you no longer have a democracy, but these are questions beyond the purposes of my role as portfolio manager.
Rick Rieder of Blackrock captivated me in his April 13 post as he explained he was buying everything the Fed was. Most folks saw that contrarianism as blasphemy – because we wanted to believe those fundamental relationships would win out against government intervention. The smartest investors realized then that policy and our government have more control over the economy than fundamentals do, and this relationship would persist. Markets are dynamic and changes like this happen from time to time, but the subtleties are difficult to discern. The idea now is that there will be a great rebound in demand.
Nonetheless, what if the virus hasn’t been such a train wreck as we are led to believe?
For all the media reports thrown around during the month, how much of them were purposely deceitful, either glorifying the left or right wing? Readership must show gains since the lockdown, though surprisingly no figures are found anywhere. These are all classic symptoms of crises that don’t get put in financial/economic textbooks, but they should be! Media reports exacerbate panic during crises – that’s a correlation I am confident in. 
And yet, we are reopening economies while many areas haven’t peaked (or so we are led to believe). This inconsistency is also frustrating, because while we bailed out struggling companies due to ‘COVID lockdowns’, we are moving forward anyway. Why did we shut down at all if we were just going to put people in danger? Perhaps the reason for the bailouts was not primarily because COVID, but simply because the global economy was already struggling so much. This would be a more consistent explanation given that we are now opening the world back up to the same dangers we were protecting it from.

Then again, Carl Icahn, whom I liken to the Michael Jordan of the investment world, thinks that fundamentals will still play out in the next year or so. He still holds his bets against commercial real estate, saying the bailouts were like “Giving them insurance policies before they go to the electric chair.” 


Further, Michael Burry bet hugely against the proliferation of ETFs, which have been largely bailed out. These guys and thousands of others might feel victimized, which is a harsh reality. Ironically, these guys are getting wiped out by an extraordinarily unlikely event (the bailout) while the corporations they bet against were bailed out due to a different extraordinarily unlikely event (the virus). Where is the bailout for guys like Burry, I wonder?

If these fundamental relationships don’t play out for years, irresponsibility will be encouraged. It might make sense to be irresponsible (from a fundamental vantage) given that we can be fairly assured that the US and many other governments will turn to immediate fixes to replace losses. I hoped that asset markets would become ‘buyer driven’, but alas, we still have seller’s markets. Yet again I come to the hesitant conclusion that there is more correlation between someone’s ability to sell an unsuccessful business rather than his ability to operate a successful business. One wrinkle in this regard is that private companies will benefit asymmetrically from this, while public investors must rely on luck. 
The paradigm has shifted from giving capital to the responsible to giving capital to those that ‘have a good idea at any cost’ . Many folks call this impact investing. I call it charity. When I lay money down, I want a return based on the business operations, and I want those returns to be estimable. Those days are gone for now.
To illustrate this paradigm shift – from cash flow toward “impact investing” (from fundamentals to charity), let’s hear from Chamath Palihapitiya, a successful venture capitalist.. If this is the case and entrepreneurs understand it, there will be many unknowable outcomes. Ideas become more investable than cash flow is, and graduates will come up with fictional ideas rather than trying to produce anything tangible. 
I used to read Chuck Butler’s (Everbank) daily report on the way to my office at Merrill Lynch in 2017. Exasperated, he would say almost daily – “Trees don’t rise to the moon” in regard to stocks. At this point they have, and they are moving toward Mars. So what do you do as an investor?
The term ‘investor’ has morphed into an unknown thing in the historical sense, given that the only return you can have depends on whether you can get capital gains instead of operating returns. In fact, I believe there is a heightened probability that returns from simply holding will become negative, so the only way to gain on an investment is through selling it at a higher price than which you purchased it. For instance, a 5 year AAPL bond pays about 0.7% interest per year right now… That is a nominal (not an inflation-adjusted) return….
I had a nightmare over the weekend, maybe Friday, that I was reading news articles about how buybacks were at the same levels of last year. Before you ask: yes, that was the scariest dream I have had in many years. But those buybacks can be reproduced, which would require even more debt issuance. Since this would require lower credit standards, it is a guess at best. Much of the book value of corporate America has been converted to debt in this crisis, completely devastating any ‘return on capital’ calculation, especially now that equities are back near record highs. And to think that we can ever get back to where we were in terms of returns on capital given current policy is a massive pipe dream. I project a 3% yield on stocks this year, which doesn’t really give you a great risk adjusted return (possibly negative).
Finally, is there really a paradigm shift? I have believed that fundamentals drive returns over the long term. Many other philosophies have come to light recently – stay at home stocks; Rebound stocks; Dividend stocks; managers that follow the Fed money; socially impactful things… The moral is that my vision of value isn’t applicable right now, and though I am confident of this in the long run, I see no bargains today. My investment style encompasses the purpose of the money that I am investing and the care of a diligent value investor. This may be an incorrect approach indefinitely. It would be careless and naive to think fundamentals must consistently have high correlation to market pricing. Thus, because there are different perspectives of value, there will be ever fluctuating prices, perhaps providing value investors an opportunity. After all, one man’s trash is another’s treasure.
If value investing does make a comeback, there will be impossible defaults as investors no longer expect CEO’s to either sell their way out or get bailed out. The chances of another broad drop are basically 0 from what I see. Anyway, it appears we are reopening now, so I struggle to determine what the big deal was anyway. If there was no big threat to public safety, what’s to stop us from creating the same scenario in a few months to provide another massive stimulus? These are questions we NEED to reconcile.
Infinite QE brings infinite questions. While nobody has answers, we need to adapt to the new environment best we can, because 4 years is a long time.
While all this is happening, the psychological effects of the virus continue to demoralize. Having people over, participating in experiences, and even shaking hands have been questioned. Tech companies are gaining from this fallout, which also frightens me. Gone are the days of being neighborly, which I always believed was one of the greatest riches of society – to Part 2
feel comfortable and safe in your own community. Instead of treating people like brothers, we see them as threats. This is a very sad outcome that I hate to see.

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