“The master-economist must possess a rare combination of gifts …. He must be mathematician, historian, statesman, philosopher—in some degree. He must understand symbols and speak in words. He must contemplate the particular, in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must be entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood, as aloof and incorruptible as an artist, yet sometimes as near to earth as a politician.”
― John Maynard Keynes
Successful investors intuitively understand that the traits of Math, History, Statesmanship (politics), and Philosophy are where the future is being shaped. In these quarterly efforts I attempt to throw these various elements into a nutritious smoothie so that we can consume the current noise and remain confident that our investments have the potential to grow. Please stay patient my readers, as I zig and zag through some of the items that I have been thinking about recently.
“Keynesian Economics” has infused the discipline of Economics beginning with the publication of The Economic Consequences of The Peace in 1919, and for decades thereafter. Keynesian economics encourages active government policy to manage aggregate demand in order to address or prevent economic recessions. Keynes argued that governments should attempt to shape the economic cycle in the short term, rather than wait for market forces to fix things over the long term. Famously Keynes was quoted, “In the long run, we are all dead.”
It’s likely he would have agreed with the Federal Reserve’s action that sought to prevent the pandemic from wreaking havoc on the broad economy. It’s notable that Keynes was known for policy positions and philosophical views. The technical and math of Keynesian economic study was robust, yet the drama of the time leaves us to remember more of where Keynes led governments in their search for better economic outcomes than in the world of technical economic theory.
The difference between economics and biotech is akin to the divide between art and science. This distinction emanates from the fact that there is only one Iraq War or 2008 housing crisis. Since economists cannot take 100 or 1000 trials of an economic event, the math and science of growth, markets and investor behavior is not something that can be modeled.
For over 100 years, our central bankers have been developing techniques to promote monetary stability and higher employment. US banks acting to stem financial crisis in the modern era dates to an event referred to as “The Panic of 1907”. This was 6 years before the passage of the Federal Reserve Act in 1913. In 1907 it was up to independent banks to gather and add money to the US financial system. This was in effort to restore the ability of banks to lend and keep depositors confident.
JP Morgan played a legendary role marshaling banks together and injecting liquidity into the lending system. This ensured the economy would not suffer due to lack of credit prior to a government sanctioned central institution. This informally organized action was crucial to allow the banks to continue to function and lend to one another. After 1913, The Federal Reserve then began to define what a “Central Bank” could offer in its designated dual mandate, price stability and maximum sustainable employment.
Price stability has historically seen endless challenges. Inflation expectations have experienced upheaval when the perception of the Fed drifted into the realm of monetary expansion. A scarier term for this is money printing.
Economies have consistently overcome inflation fears after the 1970s experience of commodities shortage and double-digit interest rates. That time in history also saw the peak of the OPEC “embargo”, gasoline shortages, and the aftermath of Vietnam.
2021 does not entail physical “printing” but rather Fed actions to buy bonds in the open market. The theory here is that this additional demand will serve to maintain interest rates at a level that would otherwise be higher without the actions of the bank.
While these techniques were initiated in 2008 by Federal Reserve Chairman Bernanke, it was current Fed Chair Powell in 2020 that expanded the money supply (just like financial steroids). This action kept the economy breathing during the initial freak out of COVID 19 in early 2020.
The market and economy of 2021 are moving forward as the momentum of 2020 rolls forward like a boulder down a mountain. The obsession of market watchers and pundits is – when will the $120B per month of Fed bond buying be “tapered”? “Tapering” is the idea that the central bank will slowly back off the assistance and allow the market to slowly return to normal and avoid a letdown.
COVID-19 was perceived as an existential threat to our economy. A “do whatever it takes” mentality in our monetary policy allowed the pandemic to result in numerous benefits to investors. The downswing turned out to be a historic bear market, yet within a month a massive upswing had begun. In the recent words of The Economist, “During most of the pandemic, exceptional uncertainty about the future of America’s economy has been met with exceptional certainty that monetary policy would stay very loose.”
The US residential real estate markets have gone from “foreclosure crisis” to bidding competitions and housing “shortages” in a 13-year span. The panics during this stretch are looked back upon as buying opportunities in denial of how difficult it was to muster confidence at many of these junctures.
We are now over a decade into a money creation super cycle. In 13 years, the Federal Reserve has reacted in two very different situations with essentially the same policy response: Easing of interest rates enhanced with historic money creation, referred to as QE or quantitative easing. This has allowed the financial system to function counter to the expectation of what would occur during a pandemic and its economic consequences.
This QE era has many risks of bubbles and inflationary factors. The consequences may be revealed over the next economic cycle. The range of outcomes is wide: Inflationary bubble? US Debt Ceiling crisis? Smooth rising asset values? Going into the next phase investors need to remember that invest = make money is not standard. The Fed has begun giving notice to the markets that in 2023 it will begin raising rates. The long lead time reflects the concern that the banking system, markets, and the general economy has become dependent on cheap money.
The low interest rates have created significant support for a broad spectrum of activities globally. The side effect is that easy money is creating dislocations. From “Meme Stocks” and crypto currency trading, to residential real estate, money is flowing in and forming intense price spikes. Bubbles inflate with the fuel of cheap money. The Fed is now embarking on an historic experiment to attempt to wean the economy and markets by slowly raising rates.
We are a long way from rates that would be even considered average by historical standards. The current US 10-year note is hovering around 1.5%. The historic average is somewhere between 4 and 5%. It is probable that the economy can grow significantly from here as the Fed proceeds gently with the withdrawal of monetary stimulus. The residential real estate bidding wars are being fueled by 3% mortgage rates. Mortgage interest rate average is in the range of 5-7% over the last 40 years.
For those of you vaccinated for COVID, is there a chance to inoculate your portfolio against future downswings? The short answer is no. The most frequent conversation that I have had in my 29 years speaking with people about investing is regarding loss aversion. The human brain is theorized to be two-three times more sensitive to loss than appreciative of gain. This sensitivity towards loss drives all sorts of financial behavior in seeking protection against financial upheavals.
The Financial industry is continuously inventing concepts that play upon these natural human instincts. These commentaries are constructed to point out these innate vulnerabilities so we can be better than our misinformed instincts.
There is no roadmap that could provide post pandemic instructions, we are subject to a sequence of events that are without precedent. The was no roadmap after WWII, The late 1960’s riots or any other events of history. When pundits are barking that, “things are very uncertain now”, that is always the case.
Trust in institutions is crucial for the Fed to be able to attempt to find a glidepath that can slowly lead to a world of “normalization”. The messy and “polarized” political environment stands as a serious impediment to fiscal policy as our two parties jockey for position in an endless joust.
Hopes have recently been raised in anticipation for an “infrastructure deal”. There is anticipation that our two-party system could move on from cycles of recrimination and actually legislate. Optimism in this regard is likely misplaced as the left pushes the Biden admin to govern in a fantasy world were government stands with solutions for all issues.
The “polarization” and systemic breakdown of our two-party system may be getting significant fuel from other countries. There is much to be gained by autocrats in the effort to diminish western capitalism and rule of law.
This geopolitical malaise is referred to as the “democracy recession”.
Why should the United States care about the state of democracy around the world? Free nations are more economically successful, stable, and reliable. Democratic societies are less likely to produce terrorists, create incentives for mass emigration, proliferate weapons of mass destruction, or engage in aggression and war. This means that the advance of democracy benefits not just the United States, but bolsters stability and peace around the globe.
The destabilizing of political systems is not a welcome dynamic for investors. Rule of law and transparency are crucial elements that allow investors to retain confidence. Ownership of assets must represent clear title and liquidity that can be managed in an orderly fashion. Investors in Russia have no such assurance.
…investors revise their beliefs, not according to the objective methods set forth by Bayes, but by overweighting the new information and underweighting prior and longer-term information. That is, they weight the probabilities of outcomes on the “distribution of impressions” rather than on an objective calculation based on historical probability distributions. As a consequence, stock prices systematically overshoot so far in either direction that their reversal is predictable regardless of what happens to earnings or dividends or any other objective factor.
Bernstein, Peter L.. Against the Gods (pp. 334-335). Wiley. Kindle Edition.
Against the Gods is a chronicle of mankind’s gradual effort to understand probability, risk and the effect of variance on human progress. The notion that the human mind overreacts to new information may remind you of personal experiences. We are often held to the drama of recent events while events like 9/11, the Iraq war and 2008 are rarely mentioned. The instinct to overweight recent events must be resisted for a long term buy and hold strategy to be effective.
Recency bias is a term that I have discussed in these commentaries previously. Humans are evolved to take our current circumstances and react so as not to get eaten by predators. The threats to our investment portfolios are much different than what our instincts are built to recognize. We must stay constantly vigilant against the deep evolutional constructs that can mislead our investment decisions through intuition and instinct.
The threats of today are unlikely to be extrapolated from recent events. If only it were so that we could make current observations and then apply course corrections. Yet it is obvious, that is not the way the world works. Vast complex and unpredictable elements in human behavior create catastrophic events like the Korean and Vietnam Wars or the continuing battle that is now migrating to the digital realm.
In study of these historic events, we can see that the elements riveted US public attention, yet long term investors who held through the drama were often rewarded. The tragic consequences for all who served in the military or were harmed in conflicts in Indochina and Korea is heartbreaking. The Cold War shaped so much of recent human history, that it is impossible to think of the world without some sort of binary framework pitting freedom and democracy vs Evil societies bent on world domination.
In The Brothers: John Foster Dulles, Allen Dulles, and Their Secret World War; Author Stephen Kinzer documents two individuals who shaped so much of the post WWII era into a struggle between “good” and “evil”. The actual experience of the collapse of the USSR and the kleptocracy that followed reflects quite poorly on the strategies that were deployed.
The Dulles brothers are a fascinating illustration of how personalities come along and formulate US policy in ways that are looked back on with significant regret. They helped create an era in which the cold war positioned the USA as a bulwark against evil and tyranny. The global reality was much more complex. The brothers chose enemies in Iran, Vietnam, and Cuba and constructed espionage and all types of covert attack. The outcomes were uneven and often far from democratic.
There has been a troubling instability in the post WWII order. The average citizen has a hard time understanding the value of troops in S Korea or Germany. The value of NATO has been aggressively questioned.
Yet, there recently are signs in Europe that the trend of nationalist autocrats may be ebbing. As noted in The New York Times Populist Leaders in Eastern Europe Run Into a Little Problem: Unpopularity; the article notes how the nationalists that have gotten into power in Hungary, Poland and Slovenia have seen their popularity decline significantly. This would bolster that narrative that populists and nationalists have great trouble in the real work of governing. Provocative slogans, denigrating immigrants and other techniques of demagoguery do little once these demagogues are elected and have no clue as to how to improve the lives of citizens.
If the CIA had developed a bigger picture of life inside the Soviet Union, it would have learned that the Soviets were putting little money into the resources that truly made a nation strong. They were a weak enemy. If the CIA’s leaders had been able to run effective intelligence operations inside the Soviet Union, they might have seen that Russians were unable to produce the necessities of life. The idea that the final battles of the cold war would be economic instead of military was beyond their imagination.
The reformer Gorbachev famously stated in an interview on 4-23-2001; “It was a shame, and I continue to say that it was a shame, that during the final years under Brezhnev, we were planning to create a commission headed by the secretary of the Central Committee, [Ivan V.] Kapitonov to solve the problem of women’s pantyhose. Imagine a country that flies into space, launches Sputniks, creates such a defense system, and it can’t resolve the problem of women’s pantyhose. There’s no toothpaste, no soap powder, not the basic necessities of life. It was incredible and humiliating to work in such a government. And so, our people were already worked up, and that is why the dissident movement occurred.”
It is tragic that the post USSR reform movement was not successful and instead of joining the global rules-based system, Russia has seemingly become a Mafia like entity. We must now grapple with the president for life, Putin, as the exploiter of the post-communist era. This was a roll of the dice that western society lost out on. As the hope of the Gorbachev era ended and yielded power to a drunkard named Yeltsin, who was then overrun by KGB operative Putin.
In that world, Putin was a figure of extraordinary menace, the leader of an authoritarian renaissance whose tentacles extended everywhere, from Brexit to the N.R.A. He had hacked American democracy, placed a Manchurian candidate in the White House, sowed the internet with misinformation, placed bounties on our soldiers in Afghanistan, extended Russian power across the Middle East and threatened Eastern Europe with invasion or subversion. In this atmosphere every rumor about Russian perfidy was pre-emptively believed, and the defense of liberal democracy required recognizing that we had been thrust into Cold War 2.0.
The post-Cold War world has evolved into a struggle between Kleptocracy VS Capitalist Western Democracy. In The Folly and the Glory esteemed author Tim Weiner documents the pollical conflict between the CIA and KGB since 1945. The era spawned by the internet and social media has evolved into a battle between propaganda of autocracy and lawless realms headed by Russia and the worn notions of Democracy and western “rule of law” based society.
As Kennan had written in The Long Telegram back in February 1946: “The very disrespect of Russians for objective truth—indeed, their disbelief in its existence—leads them to view all stated facts as instruments for furtherance of one ulterior purpose or another.” Now the internet could magnify their clandestine ambitions a millionfold.
Weiner, Tim. The Folly and the Glory (pp. 229-230). Henry Holt and Co. Kindle Edition.
The Kremlin was “a political force committed fanatically to the belief … that it is desirable and necessary that the internal harmony of our society be disrupted,” Kennan wrote, in a passage foreshadowing the political warfare waged by Putin against American democracy. The Kremlin would seek through covert means “to disrupt national self-confidence, to hamstring measures of national defense, to increase social and industrial unrest, to stimulate all forms of disunity.… Poor will be set against rich, black against white, young against old, newcomers against established residents”—all of which presaged the Russian attack that lay seventy years ahead.
Weiner, Tim. The Folly and the Glory (p. 14). Henry Holt and Co. Kindle Edition.
Mr. Weiner has mined a trove of incredible history with his books on the CIA and FBI. In The Folly and the Glory, he builds a compelling argument that we are engaged in a political war that has been escalated via hacking, aggressive cyber-attack, and our homegrown social media. The noisy proclamations of how “polarized” we as Americans seems mask the underlying fuel that is being produced through cyber espionage.
It is important for investors to see that there are shape-shifting forces actively working to create turbulence. It is possible much of this noise could be squelched through technological innovation. Large financial, commercial, and industrial entities will likely be compelled to migrate from the wild gauntlet that the web has become, to a more secure version. The next stage presents a massive economic opportunity for providers to put forth offerings that allow users to have a greater sense of security. This could create digital aspects crucial to future economic growth based on a more secure and transparent cyber environment.
Economic and political systems progress in a connected manner. The relative quiet that has arrived with the Biden Presidency will be challenged by the slovenly undercurrent that seeks to undermine the very idea of democracy. Current progressive ideas of massive infrastructure spending and taxing the rich seem naïve in the face of such slim margins in the House and Senate. The Grandfather image in the American Presidency does not seem to be building a compelling narrative that may be required after what we have witnessed in season one of The Apprentice.
A transcendent personality like FDR or someone with a higher heroic standing like Eisenhower may be lurking. Such a personality would come along and shake up our two-party system so we can address the big challenges like an aging population, outdated infrastructure, and funding solutions for Medicare and Social Security. The shortage of inspiring leadership and threats from abroad may cause investors to underestimate the potential for growth and economic prosperity. This has been known to market commentators as the “Wall of Worry”.
In addition to the perpetual patience, courage, discipline that successful investing demands. We need strong personal practices; these include maintaining strong up-to-date computers. Deployment of active security hygiene like freezing credit and monthly reconciliation of all financial accounts. Making a external backup of important files daily is not difficult. Please contact and I would be happy to explain so you can never be held hostage to lost files. These activities must be incorporated in our financial lives as our regimen that we maintain.
These practices are not complicated and simply require consistent attention along with common sense. As our world becomes ever more complex, we need to fortify defense, digitally and against all the disruption to be faced going forward.
Forecast remains pointless. We must recognize that little that we will face can be modeled, predicted, or anticipated in any meaningful way. Quality investments, courage and patience is what is demanded. This is not simple or easy, that is why so many are on the wrong side of wealth. Quality, Courage Patience. Q.C.P. That is what we shall strive for.