But I’d forgotten how much value there is in simply bringing together a bunch of really smart people and positioning them around a basic agenda. This group was a particularly diverse and interesting one. We literally had all the bases covered: wealth management, equities, hedge funds, fixed income, private equity, commodities, high frequency trading, macro strategy, tax & estate planning, legal. I stood out like a sore thumb, but in a way, every participant did.
This is a good thing. What fun (or use) is a research group where everybody looks the same and thinks the same thoughts about the same issues?
The topic this year was extreme markets, particularly inflationary ones. The basic goal was to discuss and debate the risks and see what we could do about assembling a cohesive, multi-pillared counter-strategy to combat the destructive effects that inflation can have on an individual’s wealth.
Given the epic monetary stimulus and quantitative easing of the last few years, many today would argue that the pump is primed for runaway inflation. But longtime readers of this newsletter all know that I’ve always been hesitant to buy into that thesis. I have viewed and continue to view even something like 5%+ inflation as a small probability in the coming years.
That said, I can think of few big picture risks more important and systemically-destructive right now than out-of-control inflation. Especially if it’s accompanied by economic contraction.
So last week we came up with a few things you can do about it. And the best news is that these strategies all work great during normal environments as well. Unlike going all-in on gold or shorting the heck out of 30yr Treasuries, they aren’t outright bets on inflation, which means they won’t get blown up should hyper-inflation not materialize.
There’s a lot to talk about and this issue is going to run longer than usual. So I’ll work extra hard to keep it fun and interesting.
Fixed Income in Inflationary Markets?! Yeah, Right.
This was the portion of the summit that I was most looking forward to. Apparently somebody was going to show us how to make fixed income work during inflationary environments. I literally could not wait for this panel.
See, everybody knows that during inflationary, rising-rate environments, fixed income gets taken out for slaughter. It’s as true as anything in the market. And today, this is without a doubt the single biggest risk in the bond market. Every fixed income guy I know has this black fear in the corner of his mind about what the heck he’s going to do if we get a secular cycle of steadily higher interest rates.
Different managers have responded to that risk in different ways. Many have chosen to simply ignore it so as to avoid some sort of existential crisis. On the other end of the spectrum is PIMCO. The firm that used to call themselves “the authority on bonds” is rebuilding their entire business around equities.
The guy leading this discussion was an ace, having formerly overseen the alternative asset division for Stanford’s endowment. I listened closely and took away two important points — one simple, one complex — about how to make fixed income work in inflationary environments.
The simple strategy is to keep duration short. I actually wrote somewhat extensively about this in the February issue of Alpine Advisor. It was neat to listen to someone more experienced than I make an even more robust case for it.
To quickly recap, a bond portfolio with generally shorter maturities is a whole lot less sensitive to interest rate changes than one with longer maturities. By keeping your duration tight, you actually accomplish two things: your losses stay relatively small when interest rates go up. Plus you get your principal back sooner, mitigating a depreciated Dollar from saddling you with inflation-adjusted losses.
As you can imagine, when it comes to hyper-inflation there are few worse investments on the planet than the 30 year bond.
How much less valuable will your dollars be in 30 years?
I think this is probably also why several of the participants have the 30yr yield on their radar screen as an early-warning signal for future inflation. Should the market catch a whiff of anything approaching 70′s-style inflation, the 30yr canary will theoretically croak first.
So if you’re going to play intelligently in the traditional fixed income space, you have to do pretty much the opposite of the 30yr Treasury. You have to keep your duration short.
The other, more nuanced strategy was to employ a relative value approach. This was something I’d never thought of, and probably never would have without listening to people a whole lot smarter than me.
This type of strategy takes a lot of skill to execute, obviously. But the potential benefits are huge and it can all but eliminate any sort of inflation risk. In fact, you can even structure your bond trades in such a way that they actually benefit from inflation! For example: short a longer-dated maturity and go long a shorter-dated maturity from a similar issue. In that instance, you lock in the spread between these two bonds. You win or lose depending on what happens to market rates, and your gains and losses are significantly muted relative to holding either bond outright.
The bad news is that this type of relative value approach is difficult for the investor at home to employ. You can’t do this with mutual funds or ETFs. Your financial advisor is probably going to look at you and go, “huh?”
This is the kind of thing you have to step into the alternative space to find. And that’s where you need the guidance of a firm who knows what they’re doing. Plus, all of these products have strict net worth requirements — the federal government uses net worth as a proxy for “investor sophistication.” I’ve spent ten years working in the hedge fund industry and if you ever want an unbiased, objective opinion about this or that, send me an email or use the general contact form. Just keep in mind that I’m not registered as an investment advisor which means I cannot give advice specific to your personal investment situation.
If you are looking for specific investment advice, I’ve worked with some really good RIAs over the years. Most of these guys cater more towards high net worth investors (most of the good RIAs do). But I’m always happy to make an introduction to some of them if you’d like. Just send me an email. Also: I don’t receive any compensation or kickbacks or anything like that. They’re people I either know personally and trust or people who impress me in one way or another.
Lastly, most of our group was extremely sour on high yield debt.
But this was a group of professionals who are really plugged in, and I would have been surprised to find anybody in the room bullish on junk bonds. The phrase everybody kept using was “negatively asymmetric risk profile,” which is awesome. Because that’s exactly the phrase that best describes the opportunity set in high yield debt right now. That’s how you describe something that contains a whole lot of risk and not much return.
Real Assets: The Easy Strategy.
This was my turn to contribute and I tried to keep the core of my case as basic as possible.
If you go back and look at a bunch of data from the last time we had extreme inflation in this country, the years between 1969 and 1981, a few things become really clear. Some assets did well, some did really well, and some got destroyed.
I prepared this helpful chart:
Take a minute and really let that image sink in.
(Funny story: I printed this out and handed it to Mrs. Concord to get her feedback. She said, ”I have no idea what I’m looking at. What’s that word you use? Analysis paralysis.” She tossed it on the floor. So I apologize in advance for making your eyes glaze over.)
Most of this data didn’t surprise me. We’ve all heard the stories about The Inflation. But some of this did surprise me and an interesting pattern emerged.
I saw how easily the story could be folded into the classic Capital vs. Labor debate.
If you were Capital in the 1970′s — if you were a wealthy individual or managed a large pool of financial investments — you got crushed.
The Dollars on deposit in your savings were worth less than half of what they were at the beginning of the decade. Your investments in the stock market went essentially nowhere with tremendous volatility to boot, which means you probably made some bad decisions along the way and suffered more heartburn than you originally bargained for. Your bonds got slaughtered over the course of the decade as Treasury yields rose from 5% to 15%. Especially the longer-dated ones which is almost certainly what you would have been chasing in 1971, hungry for a good yield.
On the other hand, if you were Labor in the 1970′s — if you were just a regular guy with a job and a house and living basically from paycheck to paycheck — you actually came out OK.
Your home appreciated in value right alongside the inflation rate. Even better, if you had a mortgage on that home you were paying it off with much cheaper dollars by the end of the decade. Your wages went up, too, which means you preserved most of your purchasing power in your month-to-month lifestyle. As it happens, inflation, home prices, and wages are all intimately linked and always have been. And for good reason, too. They each impact each other directly. This fundamental relationship kept your primary assets, your job and your house, completely intact.
I say this with a bit of sensitivity, however, because the 1970′s weren’t a total cakewalk for Labor.
There were several nasty recessions and some hefty unemployment. It was a scary time. I won’t even attempt to describe what it was like, because Paddy Chayefsky already did in Network, one of my all-time favorite movies and the single most prophetic piece of fiction to ever come out of Hollywood.
I don’t have to tell you things are bad. Everybody knows things are bad. It’s a depression. Everybody’s out of work or scared of losing their job.
The dollar buys a nickel’s worth, banks are going bust, shopkeepers keep a gun under the counter. Punks are running wild in the street and there’s nobody anywhere who seems to know what to do, and there’s no end to it. We know the air is unfit to breathe and our food is unfit to eat, and we sit watching our TV’s while some local newscaster tells us that today we had fifteen homicides and sixty-three violent crimes, as if that’s the way it’s supposed to be.
We know things are bad – worse than bad. They’re crazy. It’s like everything everywhere is going crazy, so we don’t go out anymore. We sit in the house, and slowly the world we are living in is getting smaller, and all we say is, ‘Please, at least leave us alone in our living rooms. Let me have my toaster and my TV and my steel-belted radials and I won’t say anything. Just leave us alone.’
Well, I’m not gonna leave you alone. I want you to get mad! I don’t want you to protest. I don’t want you to riot – I don’t want you to write to your congressman because I wouldn’t know what to tell you to write. I don’t know what to do about the depression and the inflation and the Russians and the crime in the street. All I know is that first you’ve got to get mad. You’ve got to say, ‘I’m a HUMAN BEING, God damn it! My life has VALUE!’
So I want you to get up now. I want all of you to get up out of your chairs. I want you to get up right now and go to the window. Open it, and stick your head out, and yell, ‘I’M AS MAD AS HELL, AND I’M NOT GOING TO TAKE THIS ANYMORE!’
Isn’t it interesting to compare and contrast that with sentiment of today?
Keep in mind, Network was made in 1976 (and by people of wealth i.e. Capital). The movie was a cultural response to the first half of the 70′s. Inflation had just peaked above 10% and unemployment had peaked at “only” 9%. It was before things got really bad.
In any case, the data suggest several dimensions to the story. If you were middle class and part of the 90% of the population who stayed employed, for the most part, you made it through the 70′s financially intact. And you beat the pants off Capital in relative terms.
This brings me to my inflationary investment thesis and philosophical framework:
During inflationary environments, Capital should disguise itself as Labor.
I realize that sounds a little awkward, and I’m not sure how well it was received in an all-Capital crowd of way-above average wealth. It’s a basic, philosophical framework for building strategies in an inflationary environment. But whether that feels uncomfortable to you or not, I think the pragmatic strategy derived from that basic concept is rock solid.
This simply amounts to: borrow money to buy real assets that generate streams of income that will rise alongside wages & prices.
If you think about it, that’s not really what Capital does. Not generally, and especially not today. Most of us are speculating on values in some form or another. We’re buying this stock because we think it will go up in price or we’re buying that bond because the yield is good. We’re heavy on financial assets and Dollar-linked assets. We’re long the Euro and short the Yen. We’re relatively light on real, hard assets.
That’s a terrible strategy for inflationary environments. If you still need convincing of that, scroll up and look at that chart again.
One of the easy and obvious answers is something we’ve talked a lot about on here in the last few years.
I was enthused to find a lot of love for real estate in the room. It wasn’t crazy, “flip-this-house” style euphoria. This was old school appreciation for what real estate can do as a portfolio diversifier, wealth builder, and inflation hedge. These people were intimately familiar with what a cap rate is. Some of the participants had built their careers around real estate and made the kind of money would make your head explode.
Real estate is a key pillar in an inflation-fighting portfolio. The rents you collect rise alongside wages and property values appreciate in accordance with the CPI. It’s not sexy and it’s not going to make you a ton of money overnight the way speculating can. But it’s virtually guaranteed to protect your wealth over the long run if the Dollar takes a nosedive.
One of the things I’ve noticed is that with normal, middle class investors, real estate dominates their portfolio. Their home is almost always their single biggest asset. This is why the last crisis was the most gut-wrenching the country can remember; it tore The Middle to pieces. But as you move up the wealth curve, at some point real estate starts representing less and less of an individual’s asset portfolio.
Unpopular though it may sound, if wealthy allocators of capital want to survive a hyper-inflationary environment, they might want to take a page from the little guy’s playbook.
So that’s the easy strategy: real estate and other real assets.
Let’s look at another way Capital can disguise itself as Labor that you might not have thought of. (I sure didn’t.)
We didn’t have much time to formally discuss private equity, but the topic came up during some personal discussions. I know it may sound counter-intuitive, but this is a strategy that sophisticated investors should seriously look at to guard against inflation.
See, by owning real businesses, especially businesses that make commodities or other goods that increase in price alongside inflation, you can preserve a whole lot of your wealth. A business like that will maintain its core value even during inflationary environments. The purchasing power of your dollars may decrease over time, but the volume of your cash flows will increase in accordance with inflation, as will the enterprise value of the business.
Public equity markets don’t care much about things like enterprise value or EBITDA multiples or cash flows. They do to an extent, but almost all of the day-to-day movement and a meaningful portion of secular moves is driven by changes in sentiment. There’s just so much noise in the stock market.
The private equity market, by contrast, is almost completely silent.
I understand that private equity is strategy that is exclusive to the wealthy. Whether you own these businesses personally or whether you own pieces of them through a private equity fund, the strategy qualifies you as financially elite. Sorry. However, given the fundamental forces that drive the private equity market, it’s one whose fate is largely tied to the fate of the masses. Ultimately, these are businesses that make things and provide services to the other 99% of the country.
Not convinced? Answer this question:
If you had secret knowledge that the next 10 years would feature very high inflation, how awesome would it be to borrow a bunch of money, maybe 70% at low single-digit long-term rates, to buy a bunch of businesses that made stuff — real stuff, boring stuff like paper or lumber or glass or steel, stuff that goes up in price right alongside inflation and wages — at a sensible enterprise value or multiple of EBITDA?
That’s how awesome.
This is another super sneaky way that Capital can disguise itself as Labor.
Capital is more than welcome to keep parading around the way it has in the last decade, lending money to the government at 1.8% or to rickety companies at 7% or buying common stocks and companies like Citigroup that are trading a historically high earnings ratios. That may very well be a great strategy for the next few years. But if we get some inflation, even just a little bit of above-average inflation and especially if it comes alongside slow economic growth, Capital is going to get blow’d up with that approach.
It’s fine for Capital to look like traditional financial Capital.
Just not if it wants to survive inflation.
I confess, when I started brainstorming about counter-strategies for inflationary environments, this was my first, almost-automatic response. I’ve spent the bulk of my career looking at manged futures, trading futures strategies, and analyzing other firms that trade futures.
So I have some obvious bias here. How much bias, you ask? I named my fantasy football team “The Efficient Frontier”.
But there were people at the summit even better-versed than I on this topic and I knew it’d be wise to just shut up and listen to them.
The neat thing about managed futures is that it’s a world that is entirely indifferent to direction. Or rather, price direction is the only thing it’s concerned with and there aren’t any constraints on playing it either way. In the futures markets, it’s just as easy to play prices to go up as go down. Inflationary markets are, of course, all about price movement.
This part of the discussion was dynamite. Instead of looking at the strategy in general, we drilled down on a sub-strategy in particular: trend following.
As an experiment, these guys built a trading robot that employed a simple trend following model. They loaded it up with a mountain of data and set it to generate a bunch of historical returns.
I can’t talk about the specifics, of course, but the big takeaway point was that trend following futures is a strategy that works really well in certain environments and doesn’t work at all in others. In particular, the strategy really shines during environments where both volatility and correlation are high. In qualitative terms, those are environments of “panic.” Every futures trader I’ve ever met will tell you the same thing. But I wonder how many of them have good data to back up their basic intuition.
Inflationary environments, as the data illustrate, are definitely environments were volatility and correlation are high.
This means that managed futures are an interesting powerful hedge against inflation. Everybody in my circle knows this. But everyone in yours may not.
Plus, the classic value proposition of the managed futures strategy is that it doesn’t correlate with other asset classes. This alone makes it a worthwhile addition to an investors’ portfolio as a useful diversifier during any market.
I apologize for this issue running longer than normal. It’s just that I feel that these topics are so important and so interesting and so potentially useful.
There’s a lot more to talk about, too. I haven’t even begun to touch on our discussion about specific indicators & warning lights that investors should monitor for signals of upcoming inflation.
I’ll save all that specific talk for this month’s Alpine Advisor, though. In the March issue, Pro subscribers can look forward to the rest of this discussion about what specifically to look for as a signal for inflation as well as a few other ways to implement an inflation fighting strategy. That should be arriving in your mailboxes towards the end of next week. (Click here if you want to subscribe.)
Before we call it a week, I’d be remiss to leave out the real highlight of last week’s trip.
Can a wine portfolio act as a hedge against inflation?
I dunno. Probably.
What I do know is that it’s definitely part of the strategy for living the Good Life.
And at the end of the day, that’s what really matters, isn’t it?
Geek’s Note: That Fortis is as fine a cabernet as you’re likely to taste. At $165/bottle, it’s way outside my normal drinking price range, but wow, was it good. If you’re looking for something special or need a gift for the discerning enthusiast in your family, pick up a bottle. I’ve done tastings and tours at a bunch of wineries throughout California, and the folks at Pine Ridge were top notch. If you’re ever down there and are looking for a great place to taste that’s off the beaten path, be sure to check them out in the Stag’s Leap district.