“I think the stock market is fine for now”
-David Tepper - June 17, 2021
The Portfolio Performance
The portfolio is up 3.92% YTD
Our benchmark, the S&P 500 is up +10.93% YTD
The Quote Above
In a June 17th interview on CNBC with Scott Wapner, hedge fund manager David Tepper said,
I think the stock market is fine for now - David Tepper
referring to the Fed's (FOMC) decision to leave rates alone and begin a very slow pace of acknowledging that interest rates will rise. Fed chair Jerome Powell's current projection is one to two raises in 2023. A raise is typically 0.25%. With the current Fed rate at 0%-0.25% and long-term average rates at 4.35%, I think we can all agree that rates are low and it will take a long time to get back to rates above 4%.
I just invented this term, feel free to use it far and wide. By my definition, Faux-Flation is the act of cherry picking anecdotal information from a rise in the price of a specific commodity, product or service, and declaring that your anecdotal data is evidence of inflation.
Faux-Flation comes with any number of risks, such as selling growth stocks and buying so called inflation hedges like commodities, dividend aristocrats and gold. Faux-Flation can make consumers fear ever increasing inflation and accelerate the buying of goods that are already at elevated prices. Think of this as GameStop stock buying but for everyday items. Faux-Flation, when believed and fully accepted by enough people can actually create real, sustained and persistent inflation.
Inflation and Deflation Definitions
In economics, inflation is a general, persistent and sustained rise in the price level of an economy over a prolonged period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money.
The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services.
Why all this attention on inflation? Simple, investors think that during periods of inflation they must sell growth stocks and buy value stocks, particularly commodities, dividend payers, materials, and cyclical stocks in general. If inflation isn't here to stay, and the price increases we've seen are really transitory, then we can get back to investing in growth stocks like technology, the cloud, genomic research, RVs, battery technology, solar, and more.
What's Really Going On?
With respect to the broad economy, I like to do my own research until the data convinces me of one conclusion or another. When the data changes, I have to change too. At the end of this novel, I'll identify the one metric everyone should be focused on because its the one metric that helps keep us sane.
I am more concerned about all the rhetoric around inflation than I am about actual, persistent inflation. - Clay Baker
Inflation is a sustained and persistent increase in prices broadly; that doesn't exist.
Price Pressure or spikes are sudden increases in prices of specific commodities, products, and services; we had that, and in a few place continue to see increases.
First of all, we need to recognize the flaws in measuring inflation and simply acknowledge that it's an imprecise science. The Fed has used every metric imaginable for measuring inflation and changes their preference to suit their own desired outcome. All of these metrics are flawed, have market baskets that are constantly out of date, and most importantly eliminate and simply can't measure the effects of technology. What's the value of a free google search? What's the value of free email? What's the value of cars that get 30-40 miles per gallon instead of 5 mpg? What's the value of flying by jet vs several days on a train? There is a great deal not priced into our inflation metrics.
It's easy to cite specific products or commodities that are elevated, but without the context of long-term average prices and the factors that caused the sudden short-term price increases, those headline numbers are irrelevant.
"Lumber prices have added $36,000 to the price of an average home".
First, that number is old and dates back to late April. Second, that number only affects people building or buying a new home or remodeling, it's not a measure of long-term, sustained inflation by itself. Lumber is now down nearly 50% from peak prices in April and are continuing to fall. In one to two quarters lumber will be back to long-term average prices. If the Biden administration reduces Canadian lumber tariffs the prices will decline even faster. Lumber is currently more expensive because of a pine beetle in British Columbia and tariffs, both solvable. During the first ten months of 2020, US importation of overseas softwood lumber was 39 per cent higher than during the same period in 2019. Despite record-high lumber prices in the US in 2020, Canadian lumber shipments to the US have fallen for the fourth consecutive year. Why? Trump's tariffs on Canadian lumber and a pine beetle in British Columbia dramatically reduced shipments from Canada to the US, enabling US lumber mills to raise their prices. At the same time, demand outstripped supply and more imports from overseas, particularly Europe were required to fill the demand.
Corn is down 11% from peak prices. Taking a look at corn futures, every futures contract is at a lower price, the same for lumber and many other commodities. We are in a state of Backwardation in commodities, not Contango which would indicate persistent inflation. Backwardation, is a state in commodities when future contracts are at lower prices than the current spot price. Contango is when future prices are higher than the current spot price.
In the last inflation read out, 50% of the prices included in the report were for goods that don't normally appear in the report, like used cars and air fares. Used cars alone made up 30% of the increase.
Manufacturing Inventories are at a 20 year low, which means the base effect exaggerates any reported increases. Low inventories supports transitory inflation (short-term price spikes). Lacking confidence in my economic theories, or Fed Chair Powell, I would suggest looking at the bond market. The bond market is NOT confirming that inflation is a threat to markets. The 10-year Treasury is at 1.49 going into the Latest Fed press conference. Today the US 10-Year is at 1.45% and appears to be headed down. When compared to traditional comparison metrics for the broad economy, the US 10-year treasury should be at 5%.
Purchases of treasuries by pension funds and others that are required to own U.S treasuries are driving the yield down, it's really that simple. The more it goes down, the more they have to buy. If we get back to zero-ish levels I'll put on an interest rate hedge to capture any upside in something like the ProShare Ultra Short (TBT).
The dollar is hovering around 92, its been below 90 this year and as high as 93.3, not exactly a strong dollar year. The dollar is at a 3 year low and is more likely to head to the low 80's than to rise back to 100 to 102; why, because the U.S needs dozens of little countries to pay their bills and service their debts. A low dollar accelerates international trade which enables other countries to service their debts which are denominated in dollars. Commodities do well in a low dollar environment so you might see some spikes in commodities prices. A low dollar combined with tariffs, and supply disruptions explain the price increases we've seen. But these price increases will only last a few quarters. One exception might be oil and gasoline prices.
During the pandemic consumer delinquencies declined significantly, new bankruptcies are near zero, cash accounts are at astronomical levels with $5-$6 trillion sitting in individual cash accounts. This suggests that now, more than ever is the best time for banks to make loans because the consumers balance sheet is looking great.
Nobody should care if rates move from 0%-0.25% to 0.25%-0.50%. Long term averages for 10-year treasury rates are 4.35% and significant gains in equities have been earned at every interest rate level between 0% and 4%. Rates below 1% are irrelevant.
When I measure inflation hedge trades, none, not a single inflation investment trade has outperformed stocks.
Inflation trades may work for a short period of time, but they don't persist. Innovation never stops and will always beat inflation.
Looking at the average annual return of gold and other assets worldwide between January 1971 and December 2019, gold had average annual returns of 10.61 percent, which was only slightly behind commodities with 10.69 percent average annual returns. Stocks average about the same. And depending on which 5 year time frame you choose to look at, stocks dramatically outperform gold and commodities; why would anyone sell stocks to buy dubious inflation hedges when interest rates are this low.
Gold is considered (I disagree) one of the best inflation hedges. But if inflation is a threat and gold is the hedge against inflation, why is Gold down over 9% YTD? Over the past 12 months gold is only up 2.27%, while the S&P gained over 33%, NASDAQ over 41%, and the DOW over 27%. Even if stocks had only achieved a long term average of about 10%, stocks still outperformed Gold. Stocks have always been the best inflation hedge, especially when money is so cheap, but also when money was much more expensive to borrow.
Milton Friedman was a brilliant economist, but he got inflation wrong. In fact he was so wrong that it's now a typical case study. I think Friedman's mistake was trusting the inflation measurements more than he should have. I'm oversimplifying, but basically he proposed that the printing of money was "causing" inflation. The existence of money can't cause inflation, only the speed at which money is used causes inflation. When supply is low and demand high, consumers (70% of the economy) will pay up with their excess dollars, driving prices up. That increased velocity creates the inflation that we worry about.
In the 1970's we had no control over the overriding source of inflation, oil prices. The US simply imported way too much oil and wasn't drilling for and pumping enough of our own oil. New technology has since exposed the existence of massive oil fields here at home. At the same time we were trying to pay for a war, left the gold standard which devalued the dollar and sent all commodities higher. I'll skip all the other factors; the point is in the 1970's we lacked control over supply disruptions, whereas today we have more control. There are 'levers' for politicians to pull that would bring prices down, and I suspect in time they will act. Inflation is one of the biggest reasons politicians loose their jobs; so I'm not expecting runaway inflation anytime soon. Reduce tariffs, prices come down. Increase funding to the semiconductor industry, prices come down. More chips, cheaper aluminum and steel will cause auto production to increase and prices will come down. New equipment purchases made during the pandemic in agriculture will increase yields and lower prices (technology is deflationary). If we keep connecting all the dots its easy to see that the price increases we're seeing is 'transitory', short-term spikes, not persistent inflation.
So, what's the one metric worth watching for signs of inflation, the VELOCITY OF MONEY. The velocity of money measures how many times a dollar changes hands in the course of a year. During the financial crisis the velocity of money was averaging 8-10 times, that's fast and we got inflation. Velocity spiked to as high as 17-18 times, that's super fast. Every quarter since December 2008 velocity has decreased. Velocity currently runs around 1 to 1.2 times, that's slow, in fact too slow. That's a March reading when we were all so impressed by consumer spending.
Printing money in and of itself is not inflationary, if it were we would already be living in a Weimar Republic level of inflation. By the way, the inflation in Germany lasted only from 1921-1923 and was the result of the allies demands for war reparations. How could Germany produce the needed exports and pay reparations at the same time? The resulting inflation and ever expanding money printing to pay reparations was inevitable and foreseeable because both created a velocity of money that were unsustainable.
The bottom line is consumer spending creates inflation by increasing the velocity of money. As individuals, we are most responsible for inflation, not politicians, not greedy corporations, it's all on us.
If you choose to build a home when lumber and copper are at peak prices, you caused inflation.
When you insist on buying a new car when supply is short and plants are idle; you caused inflation.
When you buy imported goods during a massive container shortage; you caused inflation.
Sitting on cash and investing in technology are deflationary and those are the biggest forces at work right now. An article from recent history by Alan Greenspan was a seminal moment in understanding productivity and measurements of inflation. Greenspan was one of the first to say aloud the nasty secret, our metrics for measuring inflation are wrong. Alan was ignored on this subject and still is https://www.bis.org/review/r010327a.pdf.
My view, and my analysis of the data is that prices will rise and fall over a short period of time, maybe through the end of this year, but there is no sign of persistent, sustained inflation or the ingredients necessary to bake up hyperinflation. I'm ready to invest in growth again.
"Markets don't go to zero, Portfolio's do.
Buy quality, be patient...and look twice for motorcycles."
- Clay Baker