2022
Jan 12
Pick Your Poison
by Casey Clarke |

We typically operate day to day within the guardrails of precedent, making decisions and evaluating outcomes based on what we’ve observed and those things that have played out in the past. Certain rhythms repeat for certain reasons which is why more times than not, this modus operandi not only makes sense, but is wise. There’s a reason we should respect and learn from our elders. There’s also a reason why as we age, we tend to become a little jaded about certain things – we often see the same mistakes being made over and over again. The boom/bust cycle is a tale as old as time and is a good example of this. Five years ago, we warned clients that the boom part of the current cycle was getting very long in the tooth, was very extreme, and based on historical precedent, was creating a very dangerous situation for investors when the “bust” eventually shows up. Well, since then we’ve learned that there are almost no lengths to which policy-makers (humans) aren’t willing to go to extend the natural rhythm of the boom/bust cycle, and so far, those actions have worked in keeping what is now the biggest bubble in history not only from deflating, but inflating ever further. There is no precedent for what we’ve witnessed in recent years. That doesn’t mean however that we’ve discovered a new happy equilibrium where everybody wins indefinitely. Quite the contrary actually. The situation we find ourselves in now is more binary than had we let markets sort themselves out more naturally along the way. Every day that goes by, our options are a more extreme choice between a cost of living that is increasingly unaffordable to most, or a massive deflation of asset prices that brings the world back into a more sustainable balance.

Most are aware that prices for things, whether home appliances or food at the supermarket, have gone up measurably over the last 18-24 months. What’s interesting about how we’ve gotten to this point though is that many are attributing these price increases almost entirely to Covid, rather than the combination of monetary stimulus from the Federal Reserve and government spending out of Washington. Although Covid (mostly the world’s reaction to it) has certainly played a role in supply disruption, which in turn has played a role in price increases, chalking inflation up to Covid alone misses the bigger picture. Over time, supply disruptions are normal and will happen. Our ability to take natural resources from the Earth, turn them into finished goods, and sell them on demand to whomever wants them actually does have limits. When the demand side of the equation via monetary policy and government spending is constantly and relentlessly being throttled, eventually you get what we’ve gotten over the last few quarters: rapid and broad price increases. For those who’ve been paying attention, this “Covid inflation” is nothing new, but more a confirmation of what’s been happening for years underneath the veneer of the carefully curated government inflation numbers. Food prices have gone up little by little while packaging has gotten smaller and smaller. Like watching a child grow day by day; it’s hard to notice, but it’s happening. Paying a reasonably steady price for an appliance, but having to replace it twice as quickly because the quality isn’t what it used to be. Health care costs rising by more than 10% each year. All of these things represent higher costs of living that existed prior to Covid but weren’t as broad-based and obvious as the acute rises we’ve seen recently. Nonetheless, they are persistent, real, and the result of manipulating the demand side of the economic equation in order to perpetuate the status quo. A question to ponder: If prices fell by half, would it be the end of the world if 401ks fell by half? A pure hypothetical of course; situations are never this tidy and neat, but we’d venture to say that the vast majority of planet Earth’s population would benefit greatly by this. It’s really only those relative few with the bulk of the money in financial assets such as 401k plans that seem to have a problem with it – those whose lives aren’t as greatly impacted by inflation. Of course we don’t want 401k plans to fall by half, but we raise the question to illustrate the rock and the hard place we find ourselves between.

And so, we’re in a situation where the pernicious effects of inflation are undeniable and can no longer be massaged, obfuscated, or discounted. This seems a reasonable crossroads for our policy-makers to arrive at where the decision to perpetuate the cycle now has real and obvious consequences – the end of the line if you will. Do they continue to inflate markets and keep money in people’s pockets while letting inflation rise further? Or, do they recognize that inflation hurts far more people over time than falling asset markets do? It’s a classic pick your poison scenario and it seems we’re very close to finding out which poison our trusted and partially-elected financial wizards choose. One point we want to make is this: it’s the actions of the Federal Reserve and government over many years that have led to this extreme binary scenario, not Covid 19. Don’t think for a minute that this situation would have been avoided had Covid not arrived on our shores. Delayed maybe, but not avoided. The biggest bubble of all time doesn’t get puffed routinely bigger without a reckoning at some point.

Rather than being happily ignorant to all of this in recent years, we’ve chosen to embrace it as reality, shun the notion that acknowledgment is cynicism, and focus on making the best of it. So, how does one prepare for either of the potential outcomes? Well, if our best and brightest in and around Washington decide to let inflation fully out of the bottle in fear of falling asset markets, then we need to own those things that will inflate in price as well or at least benefit from inflation. We currently have a good allocation to these categories within our managed client accounts. On the other hand, if they decide to battle inflation at the expense of asset markets, then we need to own the things that are least egregiously priced. If markets deflate, it’s most likely going to be the things that are most expensive (usually the things that were most speculative – see our next piece on Tesla for more on this) that fall the furthest while those things that are viewed as relatively cheap or fairly priced tend to perform the best. Ironically, the asset classes that seem the most fairly priced right now are also some of the same ones that would perform well in the inflationary outcome. This simplifies things immensely. In the end, the investing principle that is most instructive here is “The long-term return you get is all about the price you pay”. This is the worst time in history to overpay for anything.

So, in the spirit of living with our heads up and full of awareness, it’s important to recognize the crossroads we’re fast approaching, if not already upon as a society. We either continue to marginalize the masses who aren’t fortunate enough to have large nest eggs by allowing inflation to run freely, or begin to move back toward greater balance and equilibrium and accept the financial market events that come with that. We can’t have it both ways, so if this is the reality we’re facing, the question becomes “what do we do about it?” A piece of wisdom that’s always resonated with me is “10% of life is what happens to you, 90% is how you react to it”. It’s possible that this saying has never been more relevant than it is today.

Editor’s Note: This article was originally published in the December 2021 edition of our “Cadence Clips” newsletter.

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