|Shares Out. (in M):||22||P/E||0||0|
|Market Cap (in $M):||12||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
If you’re like us, you’re still having trouble finding compelling investment opportunities despite the recent correction. Earlier in the year, I posted an idea arguing the virtues of holding cash when stocks reach valuations only seen four or five times a century. Stated simply, the argument was that going 50% into cash or 10-year Treasuries at such times doesn’t really hurt returns but significantly reduces volatility and reduces the risk of a permanent loss of capital for investors with shorter time horizons.
We’ve been doing some more thinking about this and have come up with an idea that we believe improves on simply holding cash or 10-year Treasuries. Specifically we believe that holding a mini-portfolio of long-duration Treasury securities and Fairfax Financial will create for investors a position that yields 1.5-to-2% a year, has limited downside and gives you exposure to a substantial left-tail hedge.
WE’RE ALL KEYNESIANS NOW
Bubble valuations have persisted for so long that they’re beginning to feel normal. You find yourself forgetting to be scared by them. Every major valuation metric—Shiller P/E, Tobin’s Q—shows that the U.S. stock market is at one of the three most expensive times in its history. And we don’t just have a bubble in stocks. We have a bubble in bonds and a bubble in housing. Never before has the bubble been this large in aggregate.
But underneath this arch-bubble, we believe there exists a brave new world unlike any Americans have ever faced in their history. The fact is: the United States and its people have fundamentally changed since the 1960s in ways no one seems to understand. Having sky-high valuations rest on top of this new world creates a deflationary risk which no one really wants to contemplate. It isn’t the right tail that should scare you. It’s the left.
As it often does, the story of our brave new world begins but does not end with debt.
Source: Artemis Capital.
Debt loads as percent of GDP have blown by those last seen before the Great Depression. And it isn’t just our government doing this. It’s the private sector too. The U.S. has been in a debt super-cycle for last 60 years which ended in 2008. Since then, there’s been a lot of self-congratulatory talk about deleveraging. As you can, that didn’t remotely happen. Not only that, it didn’t happen anywhere else either.
Already there’s a large group of commentators explaining to us that debt doesn’t matter. Yes, they say, being in debt up to your ears is bad for an individual, but it’s totally different for companies and governments. Naturally they’re careful to explain away the Great Depression as a “one-time event" and 2008 as a "black swan." But that’s like saying O.J. didn’t kill Nicole Brown or Ron Goldman because, statistically speaking, he spent 99.9999% of his life not murdering them. Frequency is irrelevant here. Bankruptcy, permanent loss of capital, wealth destruction—these are things that only need to happen once to wreck a lot of people’s lives.
But the debt is only the effect, not the cause, of the problem. The real issue is why the U.S. has needed more and more of it.
The chart below shows private nonresidential fixed investment (“PNFI”), net of depreciation, as a percentage of GDP. PNFI represents the most productive capital investments in our economy: equipment, software, etc.
Reinvestment in our economy has never been lower. This trend has been in the making for thirty years. We can’t just blame it on Obamacare.
So if our economy isn’t reinvesting in productive assets, where is the money going? Well, generally where there’s debt, there’s consumption.
We’re eating what we kill, not reinvesting it for the future. But still even this is only the tip of the iceberg.
There’s a saying “demographics is destiny.” In any economy, working-age people are resource-producing, and everyone else, especially the elderly, is resource-consuming. In blunt terms, prosperity is a product of youth, not old age. But since 1970, the U.S. has stopped producing young people in meaningful numbers. In that year, the fertility rate, which is the number of children per woman, collapsed below the replacement rate and never meaningfully recovered. This development has only been even more marked in the rest of the developed world. Now the developed world is caught between the dearth of young workers and a surplus of retirees.
We keep talking about financial crises. The developed world isn’t undergoing a series of financial crises. It’s undergoing one crisis: a crisis of demographics.
The standard narrative about the cause of the financial crisis is that bankers got greedy and used 30:1 leverage to bet on subprime mortgage debt. David Goldman, former head of Debt Research at Bank of America, has a far more concerning theory. He’s argued the banks went into subprime with both feet not because they were greedy but because they were desperate. In the early 2000s, foreign pension funds and foreign banks bought up U.S. mortgage debt en masse, which crushed yields. Suddenly U.S. banks couldn’t find assets that would cover their funding costs.
Why did all this foreign money flood the U.S.? Because these other countries weren’t issuing enough debt to meet the needs of retiree investors. And why not? 90% of finance is the old lending to the young. When young people weren’t brought into the world in sufficient numbers, you have the situation we’re in now: a world drowning in capital and starved for return.
Think, though, about what this says about the financial crisis. It suggests that the nominal cause of the crisis, banks levering housing, was only the pointy end of the real issue. And in fact it was all a symptom of something far, far bigger. In this sense, the financial crisis never ended.
We are facing the greatest retirement wave in human history. That in itself could destroy a weaker economy, but the shocking, sad truth is that most people can’t afford to retire. According to AARP, half of Americans 50 and over have $25,000 or less saved for retirement. And with equities sky-high and yields low, most pension funds will be unable to meet their 8% return assumptions. Think about what that means for a moment. Our economy has never been this leveraged, and never before has the market’s time horizon been shorter.
All of this is deflationary. Older Americans haven’t saved nearly enough, and now they must begin to. Aging populations are the ultimate cause of deflation because (a) old people are lenders, not borrowers, and thus are no longer levering and (b) in order to save up for retirement, old people must trade current consumption for future consumption (in the form of capital assets).
When people speak about demographic decline, which is rare, they mention it as one thing on a list of many other things. But demographics isn’t one thing. It’s everything. That’s why Japan’s stock crashed in the 90s and never recovered. That’s why the EU’s debt negotiations is just Kabuki theatre. Europe, like Germany above, has a burgeoning elderly population, and because it is a welfare state, it also has the Ponzi economics to make sure everyone goes down with them. Europe isn’t solving its problems. It’s just beginning to become acquainted with them.
Meanwhile in the U.S. just as our own elderly population is about to grow to 40% of our working-age population, our labor force is shrinking.
The real story here is men aged 25-64. They are the backbone of the labor force, and their participation rate has fallen off a cliff—from 95% in 1950 to 84% today. An 84% participation rate means 16% of prime-age men not only lack a job but aren’t even looking for one. Considering the unemployment rate is 5% and 10% of working-age Americans work for the government, the "inactivity rate" only grows. Let's be generous and say half of all government employees do something necessary. Then that suggests 26% of prime-age men aren’t engaged in productive work. Keep in mind this doesn't even account for the fact that 18% of workers are only employed part-time. It’s no wonder that welfare spending has gone from less than 5% of GDP in the 1960s to 15% today.
I said earlier that the elderly population is about to grow to 40% of the total working-age population. But of course not all of the working-age population is working, and not all of that work has equal value. 77% of the working-age population, including women, is in the labor force. Of that percentage, 5% are unemployed and 5% do unnecessary make-work for the government. That means a mere 67% of working-age Americans are doing productive work. The rest are either dependents of the state, people who’ve dropped out or homemakers (whose work isn't counted in the offical figures).
Ultimately, in view of this, we see the ratio of elderly to productive workers isn’t even close the 40% figure above. It’s actually closer to 70%, meaning there will soon be 7 retirees drawing Social Security and Medicare for every 10 "producers" paying in. We are reaching the endgame of a problem the world has never faced before. And this isn't something that's pushed out far into the future. The baby boomers are beginning to retire. This is already happening.
But just as our economy desperately needs younger workers, the demands on those workers have soared. For the past few decades, we’ve been living in a world of rising prices, though much of it isn’t captured in CPI. Now our most productive members of society have to labor much harder just to stay in place.
Source: Warren and Tyagi, The Two-Income Trap.
Nothing has improved since the early 2000s. In terms of real discretionary income, dual incomes now often achieve what a single income once did. Never before has a middle-class life had such a high admissions price. College is expensive and a prerequisite. The median home price is once again well over three times median income in the U.S. (It was 2.75x back in the seventies and topped out at 4x in 2007.) Working-age people simply don’t have the wealth subsidize the tens of millions of retirees who didn’t save for retirement.
In the face of all these problems, there is nothing to do except grow our way out of them. But when the problem is demographic, it isn't so simple. As America ages, animal spirits are being drained from the economy. The growth rate of small business income has flattened since 2000:
For the past thirty years, almost all net job creation in this country comes from startups. But the number of new firms has declined rapidly.
It's recently come out that all net job creation since the financial crisis has come from S&P 1000 firms, not startups (hat tip: David Goldman again). Startups are the heart of our economy. They're what make the U.S. a land of opportunity. When they're failing to materialize in the first place and failing to create jobs, something is very, very wrong. And it suggests that we have piled debt on a weakened base. Meanwhile the debt figures presented previously don’t begin to describe this country’s indebtedness. According to the government’s own figures, the unfunded liabilities of Social Security, Medicare and the prescription drug benefit equal $80 trillion. Using those numbers, here’s America’s “net worth” as of two years ago.
So if aliens landed from outer space and offered us book value for everything in our country, we’d get just $4 trillion. $4 trillion measly bucks. It’s like Ray Liotta said at the end of Goodfellas: “Thirty-two hundred dollars he gave me. Thirty-two hundred dollars for a lifetime.”
Unfunded liabilities are a sort of Truman show, except at the end you don’t find out everyone’s watching. You find out that everything you’ve worked for your whole life isn’t actually yours. Why? Because your friends and neighbors secretly took out a mortgage on all of it.
Incidentally the chart above shows why Bernie Sanders, and all socialists, are so brain-dead. (To be clear, there are thousands of reasons, but this is one.) The wealthiest 10% owns 70% of our country’s net worth. That’s $70 trillion. Say we confiscated their stuff and thus ground our economy to a halt. The American people’s consumption expenditure is $12.5 trillion a year. So that $70 trillion could feed them for just 6 years. There is a thin layer of capital financing all productive activity on earth. Destroy it and you turn your nation into Russia where people value life so cheaply that 30% of deaths each year are alcohol-related.
What we’re seeing in the U.S. is only worse in the rest of the developed world. And what we see is a country that’s declining both in terms of demographics and character. Thinkers from Plato and Aristotle to Tocqueville and our founding fathers all had an aversion to, even a hatred of, democracy. They believed that in a democracy, people’s appetites become unleashed, and they will do anything—absolutely anything—to maximize their own personal comfort, whether that entails using the state to confiscate others’ property or conveniently demonizing a minority. To paraphrase Robert Heinlein, the great science fiction writer: democracy fails because the people demand things they can’t afford, and the productive members of society are too few to stop them.
For the past forty-five years, we’ve seen inflation in unproductive assets, in the number of unproductive people, in everything but real earnings power. Meanwhile debt-to-GDP figures do not begin to describe our society’s leverage. How do we know “The Great Leveraging” won’t continue? Because it’s already stopped. Government has tried everything it can think of to get people to borrow and spend, and guess what? The lab rats have stopped consuming the non-nutritive sweetener. All of which leads us to why to why the Fed, despite quantitative easing and ZIRP, can’t produce inflation. And why Treasuries and Fairfax are good investments.
There is a lot of talk about the Fed and whether what it’s doing is harmful. But let’s look at what exactly they’ve done. Starting in 2008, they created $3 trillion in a computer and used it to purchase securities, thus injecting the $3 trillion into the economy. The hope behind this was that the banks would take the money and lend it out, thus increasing the money supply and stimulating the economy. So what happened?
Nothing happened. The growth rate of the money supply didn’t move.
Okay, but seriously, where did the $3 trillion go?
The chart below shows the monetary base and banks’ excess reserves with the Fed. The monetary base is the part of the money supply that the Fed has complete control over. Excess reserves are the reserves banks keep with the Fed when they don’t have anything else to do with the money.
The increase in the monetary base and excess reserves track each other perfectly. Basically when the Fed attempted to inject $3 trillion into the economy, the money didn’t go into the economy. You know that warehouse to nowhere at the end of Indiana Jones. Essentially the Fed filled a warehouse with cash and then changed the name on the door from “Federal Reserve” to “the banks.” The money sits there to this day, idle next to the Ark of the Covenant.
The money sits there because it simply isn’t needed. The banks aren’t growing their loan books.
Loan growth has flat-lined. In a fractional reserve banking system, inflation depends on loan growth or, as James Montier has shown, on supply shocks. We have neither. The simple fact is: the Fed can print all the money it wants, but it won’t cause inflation, it won’t in fact do anything, if the money never gets lent out.
And the reason the money isn’t getting loaned out brings us full-circle, back to demographics. When they were young, the baby-boomers did what young people do. They took on mortgages, car loans, student loans, etc. In a word, they leveraged. Now they need to de-leverage. You might think this is all theoretical, but we have real-world evidence in Japan.
Just look at the U.S., when the baby boomers were hitting the workforce in the 70s, inflation was sky-high. Now as they approach retirement, inflation craters. The same thing happened in Japan, except demographics were even worse. And so was the deflation.
To simplify it down to an equation:
Aging populations + the end of the “Great Levering” + everything’s already expensive = deflationary pressure
Note that by deflation, we refer not just to prices affecting CPI but all assets: stocks, bonds, housing, as well as consumer goods.
The Fed has made it its mission to stop this. And it is failing. It has adorably taken accounting identities, concepts like the velocity of money and spending multipliers, and treated them as though they actually say something about the world. Not many people know this, but Bernie Madoff almost escaped justice because initially he was interviewed and exonerated by a group of high-level Keynesians.
Here’s the transcript:
Bernie Madoff: The money was simply taken from “Investments” on the balance sheet and then moved to “Other Assets”, which is basically all the cars and homes I purchased for myself. So, you see, because the amount that was deducted from “Investments” was then ADDED to “Other Assets,” the total amount of assets never changed. By definition I didn’t steal a thing.
Ben Bernanke [chuckling]: Well, we’ve all been there. You’re free to go.
Janet Yellen: Are you taking new investors?
Bill Clinton: Does this work on women?
People are angry and understandably terrified by what the Fed is doing. We have an alternative view: the Fed is simply irrelevant. It can shape perception and thus markets, but not reality and thus not the underlying economy. And that should concern you, because both people who love the Fed and hate the Fed both think the same thing: that it matters.
The real risk here is in what happens when people realize the Fed is so helpless it lacks the power even to screw things up. As markets come to embrace that, as they stop clapping whenever Janet Yellen puts a sock puppet on her hand and says, “Look here, look here.”, we might ourselves embrace the long-forgotten idea that governments can’t legislate prices, much less prosperity. Many have tried. All have failed. The real minimum wage is zero.
Now does any of this mean deflation HAS to happen? No. And here's the upshot of that. Deflationary pressure tells to not bother hedging the right tail because it is over-priced. (This can be seen in the at times astronomical price of gold.) It also tells us that a levered economy with rich valuations on top of it is RISKY, particularly when you add demographic decline into the mix.The final question is: are we being compensated to take this risk? With asset prices so high, it's difficult to argue that we are. GMO, for one, is forecasting negative real returns for all U.S. stocks. That in turn means the opportunity cost of hedging or holding cash has never been lower. This is the very time to hedge--when hedging becomes itself a value investment. And if you can find a hedge like the one I'm proposing, that pays you 1.5-2% a year to hold it, you're adding to your margin of safety by obeying the golden rule: keep the price you pay down.
Cash is obviously a great thing to hold in the event of deflation. No matter whether that deflation be in stocks, bonds or consumer prices. We think, however, you can do better by converting a cash position into a position that is 50% in 7-10 year Treasuries and 50% in Fairfax Financial. Both offer attractive returns in the event of a left-tail event. But interestingly they offer it in very different, very complimentary ways.
Treasuries will do well if stocks and bonds continue to decline. But Fairfax is a bet on a decline in CPI. They have put $650 million, or 5.6% of the company’s market cap, in CPI-linked derivatives. The contracts have a weighted-average remaining life of 6.6 years.
Source: Fairfax 10-Q.
As you can see, they also have $6 billion in equity return swaps, which hedges all the stocks they currently own. Essentially what you have in Fairfax is an entity that is market-neutral and that gives you some convexity in the event of a major deflationary event.
Other than the $5.3 billion in stocks, Fairfax’s other biggest asset is $12.4 billion in bonds. Two-thirds of the $12 billion is in Treasuries and U.S. state or municipal bonds.
Returning to the CPI hedge, most of the U.S. contracts need CPI to fall 3% to move into the money. The EU contracts need to fall 5% to move into the money.
The notional amount of the contracts is $110 billion. If CPI decreased 5%, Fairfax would stand to make $2 billion, or 16% of its market cap. If CPI decreased 10%, Fairfax would make $8 billion, or 70% of its market cap. Panic by their counter-parties only increases these returns, as was seen with CDS in the Financial Crisis.
The reason Fairfax and long-dated Treasuries should be paired is because together they form the only kind of hedge that’s wise to engage in: one with a low cost in case we’re wrong. Here you can see the returns for the S&P 500, ZROZ (PIMCO 25-year zero-coupon fund), IEF (7-10 year Treasuries fund) and Fairfax.
ZROZ obviously yields more than IEF, and it will likely outperform the most in the event of crisis. The problem is when a crisis never occurs. In 2013, when the S&P 500 soared 30%, ZROZ fell 21%. Its max drawdown over the period was an eye-popping 29%. IEF, on the other hand, is more mild. It’s returned 3% a year since 2012, and it’s done so while only incurring a 7% max drawdown.
When you combine either ZROZ or IEF with Fairfax, you see you get something that’s greater than the sum of the parts. This is captured in the higher Sortino ratios, which measure returns relative to downside volatility. Also if the market ripped another 30%, you wouldn’t lose the skin off your nose. That’s why I like this hedge. The trade is unlikely to become truly punitive. Meanwhile you can protect yourself from the risks that come from stacking bubble valuations on a leveraged economy.
HOW REAL IS THE DEFLATION RISK?
Since World War II, deflation has been non-existent. Before that, however, it was a common occurrence.
Source: Minneapolis Fed.
After a brief period of surging prices, consumer prices fell 60% from 1814 to 1851. Again after another surge in prices, they fell 47% from 1864 to 1898. Finally in the twentieth century, you saw the same thing. Prices surged 50% and then from 1920 to 1935, fell 35%. After that, you see…perfection. A central banker’s dream of prices that are increasing but at a stable rate.
You might be saying to yourself, “We’re off the gold standard. The Fed would never let deflation happen again.” Then I would say you have a lot of faith in an institution which can no longer produce inflation with over $3 trillion.
You might also be saying, “Macro is hard. I don’t think about it.” That’s because for the past 70 years, you haven’t had to. Value investing depends on mean reversion, and mean reversion depends on stability. Look at the Forbes 400 list, and note how many of the people go there by levering the trend. Sam Zell even talks about how returns on his early ventures told him that you could make money simply by being leveraged. On the chart above, note the part of the curve from 1940 to today. That’s the part of the curve where fortunes are made. And the people who make them know only one thing: keep doubling down on what’s worked before. You see the parts where line dips? That’s where a lot of would-be success stories lost everything.
Since 1989, the Japanese stock market has crashed 50%, and even now, 27 years later, the market still hasn’t come even close to recovering. Imagine if the U.S. market didn’t fall 50% but just 30%. Now imagine fifteen years later, it still hasn’t recovered. This is a plausible prospect. Remembering Bruce Kovner’s caution to “always undersize,” even a modest hedge could make a large difference in reducing this risk. And in the event we’re wrong, unlike most everything else out there, the cost is minimal. There's a very real chance that over the next two years, this position is the best in your portfolio.
WHERE THIS ANALYSIS GOES WRONG
Deflation never happens, and the market never corrects much. Instead it stagnates for so long that it grows into its excessive valuation. This is possible. As Vitaliy Katsenelson as shown, most bear markets are in fact sideways markets.
It turns out the risk Fairfax and Treasuries hedge is itself overpriced. Investing life continues to be ordinarily miserable, yet Fairfax and Treasuries decline because people are no longer scared.
Fairfax has a substantial position in Blackberry. It also has a substantial exposure to Greece. If either one turns bad, Fairfax would face losses.
Deflation in CPI or in other assets.
Increased fear in the market.