Investors took a beating in the first half of 2022 and are now hoping, dare I say praying, that the worst is over. This newsletter assesses today’s risks to stock and bond markets and decision making in the context of the Margin of Safety principle.
Year to Date Review
For the first six months of 2022 (if MCS clients’ assets were treated as one large portfolio), on average clients lost 3.3%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) lost 20%, and the Bloomberg Barclays Aggregate Bond Index lost 10.4%. The range of MCS individual client returns was from a gain of 0.6% to a loss of 12%.1
The clients with the lowest returns had large legacy tech stock exposure. Clients with the highest returns owned legacy positions in oil stocks that outperformed after Russia’s invasion of Ukraine. Overall, MCS client returns were shielded from the bond and stock market losses by the focus on safer short-term bonds, which did not materially decline in price.
2022 Marks the Beginning of the End of an Investment Era
It is the Era that saw central banks destroy bonds as safe, reliable investments worldwide.
The destruction of bond yields started after the Japanese stock and real estate meltdown in 1989, with the Bank of Japan eventually pushing rates to near zero to support their economy. Later financial crises would encourage central banks in Europe and the US to do the same. (Central banks control the cost of money by setting or influencing key interest rates and by adding or removing money from the financial system.)
By depriving investors of interest on safe bonds, central banks enabled Wall Street to sell investors on increasing their allocations to riskier investments like stocks, real estate, alternatives, all manner of leveraged investments, and exotica like cryptocurrencies.
Fiduciaries worldwide, people whose legal obligation is to exercise prudence on behalf of the clients whose money they manage, should have known better.
Now, with inflation raging, bond yields are starting to perk up again after a long drought, handing steep losses to many investors. (Higher yields mean lower prices.) True, there are inflation plays like commodities and, if you are nimble enough, the ‘rotation trade’ to commodities, dividend stocks, or value stocks can work, but it is not easy to pull off – even for experts.
None-the-less, it is the early days of what is likely to be an increasingly painful episode for most investors.
The world has shifted to a higher-friction / higher-cost environment due to the pandemic, de-globalization, geo- political realignments (NATO, China/Russia), US political polarization, intentional destruction of public trust in media and experts, war, demographics (higher dependency ratio = higher inflation2), energy transition away from fossil fuels, and climate change, to name a few.
Still, hope abounds for a soft landing or shallow recession, characterized by decreasing inflation and modest- but-soon-to-end interest rate increases going forward. Such an outcome would be good news, but I’m not going to bet your money on it.
The Limitations of Expert Knowledge
An important thing to know is that those who are addressing inflation do not have a full understanding of it. Really, no one does3. With that in mind, some beliefs in economics should be carefully examined.
One of those beliefs is called ‘R-star’ or the interest rate which keeps the economy at full employment while keeping inflation constant or benign. It seems logical that there could be a ‘Goldilocks’, not-too-hot-not-too-cold, interest rate, right?
Another example is NAIRU, or the Non-Accelerating Inflation Rate of Unemployment. NAIRU is a goldilocks level of unemployment, not-too-hot-not-too-cold, that represents the lowest rate of unemployment the economy can bear before undesirable wage inflation is triggered, forcing businesses to raise prices at an accelerating rate.
The problem with these beliefs is that, even if these rates exist, their properties are poorly understood. Under what conditions do they hold true, and how do they vary over time? Do we even have enough data (large enough sample) to evaluate their properties? How does one target a rate that can’t be observed and thus confirmed?
Another belief is that surveys which ask people to estimate future inflation somehow offer meaningful guidance about what inflation will be years from now. It’s the self-fulling prophecy idea.
The Federal Reserve Bank of Cleveland released Economic Commentary #2021-19, Oct 18, 2021, titled, “Whose inflation Expectations Best Predict inflation?”4 From that commentary is this excerpt (italics and paragraph breaks added for emphasis and clarity):
“Considerable attention has turned to the question of whether this surge in inflation will persist into 2022 and beyond.
An answer could come from developments in inflation expectations. People’s expectations about future inflation influence their behavior, and thus their expectations are thought to play a role in shaping inflation. Inflation expectations should be able to give us an idea of where inflation is headed.
However, there are several measures of inflation expectations, and they don’t always agree.
For example, one-year-ahead inflation expectations from three different surveys—the University of Michigan Surveys of Consumers, Blue Chip Economic Indicators, and the Federal Reserve Bank of Atlanta’s business inflation expectations—have all risen sharply since January and have been around the 2.5 percent to 4.7 percent range since June.
By contrast, one-year-ahead inflation expectations from the Federal Reserve Bank of Cleveland’s inflation expectations model, which is based on financial-market data, has averaged 2.2 percent since June (and currently stands at just 1.8 percent).
Given these mixed signals, whose inflation expectations provide the best signal about the inflation outlook?”
To reiterate, the 2021 forecasts for 2022 inflation, from 4 different surveys, was between 2.2 and 4.7%.
And what was inflation a year later? 9.1%!!
You see where I’m going. That 2021 survey of inflation expectations had negative value when it really mattered. Yet, that doesn’t stop market commentators from blowing smoke about the results or the financial market reacting to it!
For example, I’m working on this newsletter at 8:21 am on July 15th. The Dow Jones Industrial Average is up 640 points after the release of the Michigan Consumer Sentiment Index. Bloomberg reports5:
“Consumers may believe gas prices have crested,” according to the report, which helps explain the small improvement in inflation expectations. The median expectation for 1-year-ahead inflation fell to 5.2% from 5.3% prior, while the expectation for inflation 5-10 years ahead fell to 2.8% from 3.1% prior.”
“That removes the urgency for the Fed to go for a 100-basis-point (1%) hike, as a 75-bp (0.75%) move remains the most likely outcome for the late-July meeting.”
Bearing in mind how badly wrong one-year expectations surveys can be, this survey includes inflation expectations for 5-10 years ahead!
Yet, confirmation that the Fed did in fact base its 75-bp rate hike on the survey appears in a Bloomberg article on July 22, quoting Powell (emphasis added).
“One of the factors in our deciding to move ahead with 75 basis points today was what we saw in inflation expectations,” Powell said in June. “We’re absolutely determined to keep them anchored at 2%. That was one of the reasons — the other was just the CPI reading.”6
The article even provides us with a table of economists’ assessment of Fed Chairman Powell’s favorite indicators, in other words, the indicators that economists think shape his decision-making.
The Fed believes that keeping consumer’s future inflation expectations anchored at 2% will keep long term inflation down.
I find this application of the self-fulfilling prophesy to be total rubbish. Consumers aren’t analytically planful, (Gee, I think inflation will be 3.3% not 2.3% and therefore I should do x, y and z’), they’re reactive. If consumers, as a group, thought about the future at that level of detail they would fully fund their retirement plans, which they don’t. In the Fed’s world, obesity, currently affecting 41% of Americans, would not exist because consumers would anticipate their health problems five and ten years from now and change their behavior to avoid those problems.
Given a choice between taking expert vs non-expert advice, I would take the expert, of course. Yet, it’s critical to appreciate the limitations of expert knowledge. Consideration of which leads to what follows.
Margin of Safety
The margin of safety principle is well known to professional investors. It is a central concept of investing introduced by Benjamin Graham in his now classic book, The Intelligent Investor (1949). Professor Benjamin Graham was Warren Buffet’s instructor and mentor at Columbia University, where Buffett got his master’s degree in economics. You can watch Warren Buffett discuss his relationship with Ben Graham here7.
The Margin of Safety is essentially a disciplined set of rules to guide the investor when buying stocks or bonds. It involves analyzing a security based the market level and the price you are paying compared to the income it earns and the certainty those earnings will materialize.
“If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them assurance of an adequate margin of safety. The danger to investors lies in concentrating their purchase in the upper levels of the market, or in buying non-representative common stocks that carry more than average risk of diminished earning power.”8 (emphasis added)
Unfortunately, Graham’s work never contemplated a world in which central banks (Japan, Europe, US) manipulated interest rates over a few decades to zero (or near-zero) to coerce investors into taking more and more risk.
Nevertheless, we can observe that these policies pushed prices to the upper levels of the market and beyond.
The graph below plots the relationship between value of the S&P 500 index vs the total sales of companies in that index.
The figure above tracks a common metric for valuing stocks, the Price-to-Sales ratio (P/S). If a company has $5 billion in Sales (revenue) and that company’s total stock value is $10 billion, the P/S ratio is 2x.
As you can see, despite the recent downturn in stocks, the price-to-sales ratio remains at historically high levels. It is even more dramatic if we pull away from the last 30 years in which central banks manipulated interest rates to next to nothing.
The graph below shows a longer-term view of the P/S ratio, using the total US stock market not including foreign stocks traded in the US.
Today’s P/S ratio is stratospheric when compared to the past 70 years. Remember, this graph does not show the stock market’s value; it shows the price-to-sales ratio which helps investors compare market valuation (bargain v overpriced) over long time periods. The other observation is that, during every recession shaded area, the price to sales ratio drops significantly and pulls stock prices down with it.
Now, if you want to get a little dizzy, compare today’s price to sales (P/S) to the last big inflationary period; the late 1960’s to the early 1980’s. If you assumed that the P/S ratio reverted overnight from 2.4x to 1x , the stock market would be 58% lower based on current sales. That equates to an S&P 500 Index valuation closer to 1,700 instead of today’s 3,900 value. (This is not a forecast.)
It’s important to note that stock prices were rising after 1983, even though the graph shows sideways movement. Sales were growing so stock prices grew, too. Huge ‘bonus appreciation’ occurred in the mid-90s as the P/S ratio also increased. Here’s an example of how the price-to-sales ratio and different levels of sales per share affect a company’s stock price (assuming company profit margins remain the same).
The point is that the sales per share ratio expansion dramatically increases stock market returns. This means that a reversion of the ratio from 2.4x to something more normal, say 1.0x, implies big stock declines even if a company’s sales are doing well.
Many investors believe that if company grows, then it follows that the company stock price will increase. This isn’t necessarily true! You can lose money even if the company is growing as expected if the P/S ratio reverts from its highs to a more ‘normal’ level. Assume you buy the stock at 2.4x P/S, sales grow but the ratio reverts to from 2.4x to 1x. The stock you paid $240 per share for is worth $146 per share after four years of the company doing well!
This isn’t even the ugliest scenario. It’s far worse if both sales don’t grow as expected and the P/S ratio declines. Assume you pay $240/share or 2.4x sales and the sales grow meagerly to 116 over 4 years and it’s then priced at 1x sales. The stock you paid $240 for is now worth $116. Ouch.
So, what causes price to sales ratios to expand or contract?
Answer: Interest rates and inflation10:
- Low inflation / low interest rates = higher price to sales
- High inflation / high interest rates = lower price to sales
What do we have now?
- High inflation / low interest rates = modestly declining (20%) price to sales thus far, that is still way, way above previous P/S in the last high inflation environment.
Am I implying that the stock market could drop 79% from here if the ratio goes from its current 2.4x to the roughly .5x ratio of the inflationary 1970’s and 1980’s.? Well, that’s just arithmetic, and I’m not going to make that call.
I conclude that current conditions provide ‘NO MARGIN of SAFETY for STOCK INVESTORS.’ For some, when the market is down 20%, it is a ‘buy the dip’ signal. That ignores a very important historical perspective.
The prudent thing to do under these conditions is minimize your exposure to this game for now.
And, it will come as no surprise, minimizing downside risk is what I am doing. You probably noticed that I’ve been selling your stock positions. I sold companies like AT&T, even though they were paying good dividends, doing the right things, and meeting my expectations. Why? Look to the examples of how a potential P/S ratio contraction overwhelms the effect of a company performing well. It would look like this:
A company does the right things, but the stock price gets pounded anyway because the P/S ratio collapses toward ‘normalcy’, or worse. The statistical term for this adventure is ‘mean reversion’ or going back to average values. And it feels pretty mean, too. (That’s a little joke for you math aficionados out there.) But it’s not funny when it’s happening to your portfolio.
Aren’t Bonds Safe?
Good News and Bad News.
The good news is that you can now get 2.8% yield on short term, US T-bills. These yields have been climbing quickly since the beginning of the year. My strategy is to keep maturities very short as yields climb.
The bad news is longer term bonds do not yield much more than short term bonds. This makes long term bonds unattractive because no one knows how high interest rates need to go to bring down inflation. The market thinks a recession is coming and inflation and thus interest rates will decline. I’m not in this camp. A ‘technical recession’ is likely because we’ve had 2 quarters of negative GDP but, if this is a recession, it’s a very strange one.
Consumers, while very unhappy about most everything, are in good financial shape and are still spending. Jobs are in high demand. Housing has slowed due to higher interest rates and breakneck price increases have eased or even given way to some price cuts. It looks like normalization of a too hot market.
How Long and How High Will Interest Rates Need to Be to Bring Inflation Down?
Many investors currently think that rates will not need to go much higher; stopping out at 3.5% to 4% on the Fed funds rate (overnight lending rate that banks pay). There is a strong belief that we’re on the verge of, or currently in, a recession, and there is hope that moderating economic growth will cool off the economy and inflation and thus limit the rise in interest rates. I’m skeptical that this is how things will play out; it looks like wishful thinking.
The popularity of this viewpoint tells me that many believe / are promoting the transitory inflation story from 2021; that inflation will be self-correcting after a mild recession.
It is difficult for me to imagine that the pandemic / supply chain / China’s covid response / war in Ukraine with nuclear threat /record stimulus side-effects will somehow give way to a normalized pre-covid environment over the next 2 years. Perhaps I’m too pessimistic?
Except for Larry Summers and a few others11, most forecasters never saw high inflation persisting, instead opting to explain it away as transitory.
My view is that bond yields are not yet high enough to reduce inflation to the target of 2% to 2.5%. (Note the Fed’s inflation target keeps getting pushed further out in time as forecast after forecast has been drubbed by persistent inflation.)
It is possible to have a recession and have inflation remain at unacceptably high levels, a situation called stagflation. Therefore, the most prudent strategy is to invest in short term securities with the intent of investing longer term when rates are higher.
How High Might Interest Rates Go?
The orange line is inflation, and the green line is interest rates. To match inflation with the corresponding interest rate, draw a vertical line from the orange line to the green line.
The chart indicates that when inflation exceeded 5%, the corresponding 10 yr. US Treasury bond rate was 6% or higher. Today, the Treasury bond rate is just under 3% and inflation is over 9%. This means that the market believes that the Fed is doing enough to rein in inflation.
However, if the market decides the Fed is not doing enough, bond yields could double from today’s still- historically-low rates, driving down long-term bond prices. In turn, this could drive down the markets P/S ratio and be disastrous for stock prices.
Margin of Safety means there is room to be wrong and still have a successful outcome. It is non-existent today. An example of margin of safety is when bad news comes out and markets don’t react negatively. This means that bad news is already reflected in prices.
Could things turn out better? Could inflation surprise and decline deeply and quickly enough to stabilize the economy? Yes, it’s possible, but I do not think it is probable. My job as a fiduciary, managing your money, is to weigh the probabilities and make an allocation decision. While I don’t like the odds for long term investments right now, I am pleased to see short term interest rates finally offering some yield. That’s a good start.
- MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary Income/Growth accounts under management for at least one full month in 2022. These accounts represent 99.6% of MCS’s discretionary assets under management as of 06/30/2022 and were invested primarily in US stocks and bonds (7.8% of client assets on 06/30/2022 were invested in tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Bloomberg Barclays US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results
- See https://www.brookings.edu/research/monetary-policy-without-a-working-theory-of-inflation/ or https://www.vox.com/22996474/inflation-federal-reserve-nairu-ngdp-powell
- https://www.clevelandfed.org/en/newsroom-and-events/publications/economic-commentary/2021-economic- commentaries/ec-202119-whose-inflation-expectations-best-predict-inflation.aspx
- Bloomberg: US REACT: Sentiment Still at Doom-and-Gloom Level Over Inflation; 2022-07-15 14:47:46.423 GMT
- Bloomberg News, Here Are Powell’s Key Indicators Shaping the Fed’s Rate Path, 7/22/2022
- Warren Buffett on The Intelligent Investor by Ben Graham
- Page 2 Graham’s Central Concept of Margin of Safety http://csinvesting.org/wp-content/uploads/2012/07/chapter-20_margin-of-safety-concept.pdf
- Profit margin expansion and contraction is also an important determinate of price to sales ratios. Higher profit margins = higher P/S and vice versa.
- https://wolfstreet.com/2021/07/24/bond-market-has-been-clueless-about-inflation-for-decades-now-more-so- than-ever-the-meme-the-drop-in-yields-end-of-inflation-is-a-fantasy/