The Crosscurrents of In/De-flation Part 2
Extraordinary times call for extraordinary measures.
Extraordinary times and extraordinary measures do not usually lead to ordinary outcomes.
In the first part of this article, The Crosscurrents of In/De-Flation, we raise the specter that inflation may result from the synchronized combination of a variety of factors, including surging money supply, fractured supply chains, and in time, economic resurgence.
The current environment is deflationary, but what matters for investors is what will happen to prices tomorrow. Because monetary stimulus and economic activity are dynamic, answering the question is akin to solving an enormous jigsaw puzzle. Adding to the complexity and frustration, the image of this puzzle is changing as we work through it.

The Fed Enters Monetary Light Speed
Ben Kenobi: How long before you make the jump to lightspeed?
Han Solo: It’ll take a few moments to get the coordinates from the navicomputer.
Luke Skywalker: Are you kidding??! At the rate they’re gaining—
Han Solo: Traveling through hyperspace ain’t like dusting crops, boy! – Star Wars, Episode IV
Light Speed
In the early Star Wars movies, Han Solo was the captain of the rusting Millennium Falcon spaceship. When making a daring escape, Solo would command the ship to jump to light speed. The surrounding stars would blur in streaks as they left their pursuers in stardust and suddenly ended up somewhere across the galaxy far, far away.
On April 9, 2020, the Fed made the jump to light speed with their announcements of even more remarkable stimulus packages.

Putting a Price on the S&P 500
Honey, I bought a new set of golf clubs for 40% off. What a deal!
Dearest, I also found a bargain. I bought XYZ stock at $30, and it was trading at $50 two weeks ago.
Our happy couple seems to have found some great bargains. Their purchases may be cheap in their minds, but are they? To answer the question, we need an understanding of what the right price is, not what the price was yesterday.
Why Do We Invest Our Hard-Earned Money?
There is no way to value a set golf clubs conclusively. Those that play three times a week value the latest and greatest set of clubs much higher than hacks like ourselves.
Stocks and other financial assets, on the other hand, are a little easier. Various forms of quantitative valuation methods allow a calculation of “fair value.”

On April 29, 2020, Jerome Powell said: “both the depth and duration of the economic downturn are extraordinarily uncertain.”
We are often critical of Federal Reserve policy and contradictory economic jargon coming from Fed presidents and governors.  However, to our amazement, Fed Chairman Jerome Powell surprised us with a moment of clarity.
No truer words were ever spoken.
His statement is so obvious, it is profound. Yet, if you only follow the financial media or much of social media, you might think his statement hyperbolic. The future, according to so many “experts”, is certain.
In case you haven’t heard, the economy will gradually re-open, and, in time, everyone will go back to work and resume the same lives and consumption patterns they were leading in 2019.
This reassuring picture of

The Crosscurrents of In/De-flation
The remarkable deflationary and inflationary crosscurrents swirling through the economy are grossly underappreciated and misunderstood. Need proof? Watch CNBC or read Wall Street research and consider the likelihood of the smooth path back to “normal” they tout.
It is comforting to think about “normal” and what that may entail for our lives and portfolios. However, given the global economic tsunami and extraordinary monetary and fiscal stimulus, we would be remiss if we did not raise awareness that economic and market recovery may be far different from “normal.”
One of our deepest concerns is a highly inflationary outcome, an experience not seen in fifty years, and one for which we are least prepared. Markets always have a strange way of finding investors

U.S. Treasury bonds of all maturities have recently flirted with zero percent yields and, in the case of some Treasury Bills, have at times traded at negative yields. As a result, these bonds are closing in on the same “greater fool” status, which plagues sovereign and corporate bond investors throughout Europe and Japan.
We use the term greater fool to describe a market circumstance in which overvalued conditions are so extreme that foolish participants must rely on an even greater fool to whom they may sell their holdings to profit.
In the case of the U.S. Treasury market, the fool is the buyer of bonds at meager yields. The greater fool is an “investor” that he or she thinks will buy it at an even lower yield in the future.
Since the yield is minimal and the risk extensive, the fools

Prelude: This article was largely written before the emergence of the Coronavirus. Recent developments as a result of the pandemic only add emphasis and gravity to the points made here.
 “…many people living in the West are dissatisfied with their own society. They despise it or accuse it of no longer being up to the level of maturity by mankind. And this causes many to sway toward socialism, which is a false and dangerous current.”  – Aleksandr Solzhenitsyn, Harvard University, June 8, 1978
In the political primaries leading up to the 2016 and 2020 Presidential elections, the United States experienced something never before witnessed in its history; a major Presidential candidate who did not espouse democratic, free-market principles. Bernie Sanders, a self-avowed “democratic socialist”,

It seems the entirety of the financial media and many on Wall Street believe a “V” shaped economic recovery is in our future. While we hope they are right, we would be foolish to take such analysis and, quite frankly, unwarranted optimism, at face value.
If history teaches us one thing, it is that significant, life-altering events are rarely if ever followed by a quick return to normality. In this article, we raise a few considerations that may make you reconsider popular economic narratives. Today, the importance for investors to think outside of the box cannot be overstated. Or to put it another way, the parameters of “the box” have likely changed and, if so, we should be cognizant of those changes in our decision making.
If the future economic recovery does not resemble the “V” shape

“You better tuck that in. You’re gonna’ get that caught on a tripwire.” – Lieutenant Dan, Forrest Gump
There is a popular game called Jenga in which a tower of rectangular blocks is arranged to form a sturdy tower. The objective of the game is to take turns removing blocks without causing the tower to fall. At first, the task is as easy as the structure is stable. However, as more blocks are removed, the structure weakens. At some point, a key block is pulled, and the tower collapses. Yes, the collapse is a direct cause of the last block being removed, but piece by piece the structure became increasingly unstable. The last block was the catalyst, but the turns played leading up to that point had just as much to do with the collapse. It was bound to happen; the only question was, which

“The process by which money is created is so simple that the mind is repelled.” – JK Galbraith
By formally announcing quantitative easing (QE) infinity on March 23, 2020, the Federal Reserve (Fed) is using its entire arsenal of monetary stimulus. Unlimited purchases of Treasury securities and mortgage-backed securities for an indefinite period is far more dramatic than anything they did in 2008. The Fed also revived other financial crisis programs like the Term Asset-Backed Securities Loan Facility (TALF) and created a new special purpose vehicle (SPV), allowing them to buy investment-grade corporate bonds and related ETF’s. The purpose of these unprecedented actions is to unfreeze the credit markets, stem financial market losses, and provide some ballast to the economy.
Most investors

Pragmatism is seeking immediate solutions with little to no consideration for the longer-term benefits and consequences. An excellent example of this is the Social Security system in the United States. In the Depression-era, a government-sponsored savings plan was established to “solve” for lack of retirement savings by requiring contributions to a government-sponsored savings plan.  At the time, the idea made sense as the population was greatly skewed towards younger people.  No one seriously considered whether there would always be enough workers to support benefits for retired people in the future. Now, long after those policies were enacted and those that pushed the legislation are long gone, the time is fast approaching when Social Security will be unable to pay out what the

“A good person is as rare as a black swan”- Decimus Juvenal

In 2007, Nassim Taleb wrote a
bestselling and highly impactful book titled The Black Swan: The Impact of the Highly Improbable. The book uses
the analogy of a black swan to describe negative events that appear to be very
rare and occur without warning.  Since
the book was published, the term black swan has been overused to describe all
kinds of events that were predictable to some degree. 

Last April, we wrote A Fly in the Ointment, which was one of a few articles that pointed out the risk of higher inflation to the markets and economy. Thinking about inflation in the context of the Corona Virus and the Fed’s aggressive monetary policy, might our fly be a black swan.

Corona Virus

The economic impact of the Corona

“I got my toes in the water, ass in the sandNot a worry in the world, a cold beer in my handLife is good today, life is good today” – Toes, Zac Brown Band

The economic
and social instabilities in the U.S. are numerous and growing despite the fact
that many of these factors have been in place and observable for years.   

Overvaluation of equity marketsWeak GDP GrowthHigh Debt to GDP levelsBBB Corporate Debt at Record LevelsHigh Leverage and Margin DebtWeak ProductivityGrowing Fiscal DeficitsGeopolitical uncertaintyAcute Domestic Political DivisivenessRising PopulismTrade WarsCorona VirusAs we know, this list could be extended for pages, however, the one thing that will never show up on this list is…? 

Inflation.

Inflation

As reported
by the Bureau of Labor Statistics (BLS)

A special thank you to Brett Freeze of Global Technical Analysis for his analytical rigor and technical expertise.

There is an
old story about a little boy who was such an extreme optimist that his worried
parents took him to a psychiatrist. The doctor decided to try to temper the
young boy’s optimism by ushering him into a room full of horse manure. Promptly
the boy waded enthusiastically into the middle of the room saying, “I know
there’s a pony in here somewhere!”

Such as it
is with markets these days.

Finding
Opportunity

These days,
we often hear that the financial markets are caught up in the “Everything
Bubble.” Stocks are overvalued, trillions in sovereign debt trade with negative
interest rates, corporate credit, both investment grade, and high yield seem to
trade

“I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.”  – Alan Greenspan

Imagine if Federal Reserve (Fed)
Chairman Jerome Powell told the American people they must pay more for the goods
and services they consume.

How long would it take for mobs with pitchforks
to surround the Mariner Eccles building? 
However, Jerome Powell and every other member of the Fed routinely and consistently
convey pro-inflationary ideals, and there is nary a protest, which seems odd.
The reason for the American public’s complacency is that the Fed is not that direct
and relies on carefully crafted language and euphemisms to describe the desire
for higher inflation.

To wit, the following statements from past
and present Fed officials make it

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”John Maynard Keynes – The Economic Consequences of Peace 1920

“And when we see that we’ve reached that level we’ll begin to gradually reduce our asset purchases to the level of the underlying trend growth of demand for our liabilities.” –Jerome Powell January 29, 2020.

With that one seemingly innocuous statement, Chairman Powell revealed an alarming admission about the supply of money and your wealth. The current state of monetary policy explains why so many people are falling behind

“Stock prices have reached what looks like a permanently high plateau” – Irving Fisher, New York Times September 3, 1929

One of the more infamous quotes from
the roaring ‘20s came within two months of a market peak, which would not be
surpassed again until the 1950s. Between 1920 and September 1929, the Dow Jones
Industrial Average rose over 18% on an annualized basis.  Economist Irving Fisher essentially declared that
such outsized gains were the norm. As he discovered a couple of months later,
that time was not different.

Today, with valuations as stretched as
they were in 1929 and 1999, the calls for a lengthy continuation of the current
bull market are growing to a crescendo. The sentiment is so extreme that some
outlandish predictions on individual stocks and indexes are

“Oh, a storm is threat’ning my very life todayIf I don’t get some shelter oh yeah I’m gonna fade away” – Rolling Stones

The graph below plots 15 years’ worth of quarterly earnings per share for a large, well known publicly traded company. Within the graph’s time horizon is the 2008 financial crisis and recession. Can you spot where it occurred? Hint- it is not the big dip on the right side of the graph or the outsized increase in the middle.

The purpose of
asking the question is to point out that this company has very steady earnings
growth with few instances of marked variation. The recession of 2008 had no
discernable effect on their earnings. It is not a stretch to say the company’s
earnings are recession-proof.

The company
was formed in 1886 and is the parent of an

Yeah… Barry
Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his
career. What sets him apart from other players is that he got better in the later
years of his career, a time when most players see their production rapidly
decline.

Before the age
of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30th
birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an
astounding .351, well above his lifetime .298 batting average. Of all Major League
baseball players over the age of 35, Bonds leads in home runs, slugging
percentage, runs created, extra-base hits, and home runs per at bat. We would
be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns
in his MLB career and he also holds the MLB record

Value investing is an active management strategy that
considers company fundamentals and the valuation of securities to acquire that
which is undervalued. The time-proven investment style is most clearly defined
by Ben Graham and David Dodd in their book, Security
Analysis. In the book they state, “An
investment operation is one which, upon thorough analysis promises safety of
principal and an adequate return. Operations not meeting these requirements are
speculative.”

There are countless articles and textbooks written about, and
accolades showered upon, the Mount Rushmore of value investors (Graham, Dodd,
Berkowitz, Klarman, Buffett, et al.). Yet, present-day “investors” have shifted
away from the value proposition these greats profess as the time-tested secret to
successful investing

Unlike most
trade deals where the terms are readily available, the details of the Phase One
trade agreement between China and the U.S. will not be announced nor signed in
public. Accordingly, investors are left to cobble together official comments,
anonymous statements from officials, and rumors to ascertain how it might
affect their portfolios.

Based on official
and unofficial sources, existing tariffs will remain in place, new tariff hikes
will be delayed, and China will purchase $40-50 billion in agricultural goods
annually. At first blush, the “deal” appears to be a hostage situation- China
will buy more goods in exchange for tariff relief.

The chart
below, courtesy of Bloomberg, provides reasons for skepticism. The rumored $40-50
billion in goods is nearly double what China

Occasionally,
problems reveal themselves gradually. A water stain on the ceiling is potentially
evidence of a much larger problem. Painting over the stain will temporarily
relieve the unsightly condition, but in time, the water stain will return. This
is analogous to a situation occurring within the banking system. Almost three
months after water stains first appeared in the overnight funding markets, the
Fed has stepped in on a daily basis to “re-paint the ceiling” and the problem has
appeared to vanish. Yet, every day the stain reappears and the Fed’s work
begins anew. One is left to wonder why the leak hasn’t been fixed. 

In
mid-September, evidence of issues in the U.S. banking system began to appear.
The problem occurred in the overnight funding markets which serve as one of the

“3. And they said to one another, ‘Come, let us make bricks, and burn them thoroughly.’ And they had brick for stone, and bitumen for mortar. 4. Then they said, ‘Come, let us build ourselves a city, and a tower with its top in the heavens, and let us make a name for ourselves; otherwise we shall be scattered abroad upon the face of the whole earth.’” Genesis 11:3-4 (NRSV)

Technology

Technology can
be thought of as the development of new tools. New tools enhance productivity
and profits, and productivity improvements afford a rising standard of living
for the people of a nation. Put to proper uses, technological advancement is a
good thing; indeed, it is a necessary thing. Like the invention of bricks and
mortar as documented in the book of Genesis, the term technology has

A recent
article by James Deporre at thestreet.com
asked Will
Powell’s Remarks Push the Algos to Make a Move?

Deporre’s article
is a recap of a day’s market events beginning with Jerome Powell’s recent
testimony to Congress. He suggests that what matters are not Powell’s words,
but whether computerized trading programs, known as “algos,” would buy stocks
as a result of Powell’s testimony. Summarizing what ended up being an
uneventful day of trading activity, Deporre made the following absurd comment
which caught our attention:

“On the other hand, the mighty Apple
(AAPL) is holding up and seems to function as a de facto money market account
these days. It is a great place for some to park cash and that helps to keep
the indices hovering near highs.” 

While we currently hold

Over the last 30 years, the popularity of impact investing and a
desire to ‘do good’ with investment portfolios has blossomed. In April 2019, The Global Impact Investing Network
estimated the global impact investing market was $502 billion. While impressive,
it represents less than 1% of the investing universe.

Impact investors, looking to have a positive social and environmental influence,
tend to analyze factors not typically on the radar of traditional investors. In
particular, ESG, an acronym for environmental, social, and corporate governance,
is a framework for investors to assess investments within three broad
factors.  

We all
want to make the world a better place, but are investment portfolios the right
tool to do that?

To answer the question it is important to step

“I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019

The recent quote above from Federal Reserve Chairman Jerome Powell is
powerful, to say the least. We cannot remember a time in the last 30 years when
a Fed Chairman has so clearly articulated such a strong desire for more
inflation.

In particular, let’s dissect the bolded words in the quote for further
clarification. 

“Really Significant”– Powell is not only saying that the Fed will allow a substantial boost to inflation but does one better by adding the word “really.” “Persistent”– Unlike the prior few Fed Chairman who claimed to be vigilant towards inflation, Powell is clearly telling us that

In a poll administered by the CFA Institute of America {Link},
readers, many of whom are professional investors, were asked which behavioral
biases most affect investment decisions. The results are shown in the chart
below.

We are not surprised by the results, but we believe a rational investor
would put these in reverse order.

Compounding wealth, which should be the primary objective of every investor, depends first and foremost on avoiding large losses. Based on the poll, loss aversion was the lowest ranked bias. Warren Buffett has commented frequently on the importance of limiting losses. His two most important rules are: “Rule #1 of investing is don’t lose money. Rule #2 is never forget rule #1.”

At Real Investment Advice, we have covered a lot of ground on investor

Opening day is a glorious time for
baseball fans. Warmer temperatures and blooming shrubbery are on their way, and
more importantly, their favorite teams will begin a stretch of 162 games that
culminates with a best-of-seven battle between the American and National League
champions.

With leaves falling and colder
temperatures upon us, most baseball fans are left out in the cold. However, here
in Washington D.C., and no doubt in Houston, everyone is a diehard fan cheering
their team on to a World Series crown.

Curly W’s, the logo of the Washington
Nationals (Nats) baseball team, litter the streets, schools, and even office
buildings of D.C. Everyone is on board the Nationals train, yet in August you
could have spent a paltry $20 for a decent seat and shown up to a half-empty

Part one of this article can be found HERE.

President
Trump recently nominated Judy Shelton to fill an open seat on the Federal
Reserve Board. She was recently quoted by the Washington Post as follows: “(I) would lower rates as fast, as efficiently,
and as expeditiously as possible.” From a political perspective there is no
doubting that Shelton is conservative.

Janet
Yellen, a Ph.D. economist from Brooklyn, New York, appointed by President
Barack Obama, was the most liberal Fed Chairman in the last thirty years.

Despite what
appears to be polar opposite political views, Mrs. Shelton and Mrs. Yellen have
nearly identical approaches regarding their philosophy in prescribing monetary
policy. Simply put, they are uber-liberal when it comes to monetary policy,
making them

“Those who cannot remember the past are condemned to repeat it.” – George Santayana

Current
investors must be at least 60 years old to have been of working age during a
sustained bond bear market. The vast majority of investment professionals have
only worked in an environment where yields generally decline and bond prices increase.
For those with this perspective, the bond market has been very rewarding and seemingly
risk-free and easy to trade.

Investors in
Europe are buying bonds with negative yields, guaranteeing some loss of
principal unless bond yields become even more negative. The U.S. Treasury 30-year
bond carries a current yield to maturity of 2.00%, which implies negative real
returns when adjusted for expected inflation unless yields continue to fall. From
the