May 3, 2021: Inflation, Sub Zero Interest Rate … | Better Financial Future -- MyPlanIQ

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Inflation, Sub Zero Interest Rate …

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness”.

What was said in Charles Dickens’ ‘A Tale of Two Cities’ 150 years ago describes very well our current situation and dilemma: our economy is roaring back and there has been a recognition that government stimulus can work regardless of the debts incurred. On the other hand, inflation is coming, valuations of stocks and bonds and other financial assets are at some nose bleeding levels. Speculation abound in crypto, SPAC, …

Or just like what Warren Buffett said in this weekend’s Berkshire Hathaway’s annual meeting, ‘Charlie and I consider it the most interesting movie by far we’ve ever seen in terms of economics,’.

In this newsletter, we discuss several important topics in the context of the Buffett’s thinkings from the latest Berkshire’s meeting.

Economy recovery

The US economy has experienced an extremely strong recovery. The US GDP growth in the first quarter of 2021 was 1.6 percent, or 6.4% on an annualized basis. Between goods and services, consumer spending on goods has shot up way above the last quarter of 2019, before the pandemic:

This is understandable as people are spending more on purchasing goods since they are confined to home or have limited mobility. On the other hand, it also tells us where most of government’s stimulus checks went.

The GDP is still yet back to the level prior to the pandemic but it’s very likely that we might be able to grow back at that level by the end of this quarter.

Many economic indicators are on fire. The following charts show that both the housing units started and real personal income have exceeded their levels a year ago:

Again, real personal income was way above prior levels before the pandemic mostly because of the government stimulus payments.

Nose bleeding valuation & sub zero interest rates

Meanwhile, interest rates are at historically low: the 3 month Treasury Bill rate is practically 0:

Furthermore, the long term interest rate (^TNX in the above chart represents 10 year Treasury note’s interest rate), often used as the discount rate to estimate the present value of a financial asset such as a stock, is also at a historically low.

The ultra low long term interest rate has an important implication as Buffett pointed out that “interest rates, basically, are to the value of assets, what gravity is to matter, essentially.”.

Intuitively, if you try to value a company’s stock, the simplest way is to compare its future value (say 10 years from now), discounted with the 10 year ultra safe interest rate. Basically, you just want to see how much the company earns in this 10-year period, compared with what you would get if you put the money to Treasury notes (10 year maturity).

So if the discount rate is ultra low, you don’t need a company to make much to justify to hold its stock. For example, currently, the forward 12-month P/E ratio for the S&P 500 is 22 (see the latest Factset report), that would mean the S&P 500 ‘conglomerate’ earns 1/22 or 4.5% per year (so called earnings yield). Compared this with the current 1.6% 10-year Treasury note’s interest rate, it doesn’t seem that the S&P 500 is expensive.

The above is a very simple quick back-of-the-envelope calculation. It’s based on the assumption that the long term interest rate will stay at this level for the coming years. Buffett used the above argument to indicate that stocks are very, very cheap. But he quickly followed up with ‘Now, the question is what interest rates do over time.’ This ‘stocks are very very cheap if the interest rates stay this low for a long time’ argument is based on the big if — if interest rates stay low indefinitely. Buffett further said, ‘there are consequences to everything’. They just don’t know what they are and when that will occur. Of course, we have no clue either.

When you use other famous long term stock metrics, the current valuation is indeed nose bleeding. For example, the following shows Dr. Hussman’s estimated 12-year annual nominal return will be -2.29% for a 60/30/10 mix of S&P 500, Treasury bonds and T-bills:

Notice that his chart even shows the valuations in 1920s and 1930s, the great depression period. In fact, however many people claimed that the current interest rate is at a historically low in an uncharted territory, the 3 month Treasury bill was indeed at the zero levels in 1930s:

To be fair, the sub zero interest rate part happened before. History does not repeat itself, but it rhymes.

That’s why this is a fascinating time. On the other hand, it’s also probably the most dangerous time as we are in an uncharted territory with many strong and bold fiscal and monetary policies.

Inflation is coming

Unfortunately, the inflation has begun to rise rapidly. Buffett stated:

We’re seeing very substantial inflation. It’s very interesting. We’re raising prices. People are raising prices to us, and it’s being accepted. Take home building. We’ve got nine home builders in addition to our manufactured housing operation, which is the largest in the country. So we really do a lot of housing. The costs are just up, up, up. Steel costs, just every day they’re they’re going up. And there hasn’t yet been because the wage stuff follows. The UAW writes a three-year contract, we got a three-year contract, but if you’re buying steel at General motors or someplace, you’re paying more every day. So it’s an economy really, it’s red hot. And we weren’t expecting it.

Bear in mind that Berkshire Hathaway is the largest diverse conglomerate in the US. Their operations span over consumers, utilities, energies and infrastructure. So Buffett’s observation is extremely insightful. For sure, inflation is coming.

The danger of rapidly rising inflation, of course, is that it will eventually reach a saturated point where consumer buying power is eroded and companies suddenly face slow or declined earnings. Again, no one knows when this turning point will be. It could be a year or two or it could be many many years from now.

What to do

As always, Buffett and Munger were very frank and honest with what they can do and what they can’t do. They readily admitted that they have no idea on the near term future of economy and markets. On the other hand, they just stick to their old way of doing business: just focus on running a solid business (or businesses in their case), invest based on their long adhered principles and let the nature take care of the rest.

This is exactly one should do, regardless whether they are quants, traders or long term stock investors: you stick to a sound plan through thick and thin.

For us at MyPlanIQ, we believe it’s a fool’s game to predict. Instead, one should adopt a sound strategy that reacts to market actions and avoid big loss when markets eventually go on a big correction. What we advocate:

Invest in low cost stock index funds and some excellent fixed income funds if desired. Even Buffett instructed the trustees of his estates to invest substantial assets (90%) to S&P 500 index fund. Stocks or equities can deliver inflation beating returns in the long term.
Have a proper asset allocation. Though bonds are yielding little, no one knows whether their prices will continue to go up (thus yields will go to zero or even further negative). Furthermore, allocating to relatively safe assets gives you peace of mind and a good capital to deploy when markets experience a huge sudden loss (remember Black Monday in 1987).
Avoid large loss by tactically reducing risk assets such as stocks and risky bonds when markets are in a downtrend. Strategies like our Asset Allocation Composite (AAC) or Tactical Asset Allocation(TAA) avoid large loss and capture returns in up trends. These strategies can achieve a reasonable (comparable or better than buy and hold) return in the long term with much lower interim loss.

Market Overview

These days, it just feels that investors don’t talk about the valuation and market risk anymore (or much). The Q1 earnings reports continue to be stellar in aggregate. Here is the latest on April 30, 2021, last Friday:

60%% of the companies reported by last Friday, the blended earnings growth was 45.8%, compared with 33.8% the week before, 30.2% two weeks before and, 23.8% on March 31, 2021.

So indeed companies continued to surprise positively, the blended earnings growth rate just kept going up as more companies reported earnings.

Though stocks have risen so much, there is no sign for investors to abandon them. This is of course understandable as we can see that even Buffett and Munger are feeling TINA (There Is No Alternative) to stocks.

Of course, good things will not continue indefinitely. We are again cautiously optimistic and reiterate the following practice:

For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation now reached another high. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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