Perspectives On Long-Term Investing

 

“Predictions are tough, especially about the future.” Yogi Berra

On April 22, I took to these pages to reassure people about their investments after a big drop in Dow Jones Industrial Average (DJIA) that day left the index at 33,811. Today, the DJIA closed at 33,761. The obvious conclusion from this is that the index has not done much in the last 3 ½ months. If you have followed the markets, you know they have been anything but calm and stagnant.  The DJIA proceeded to go from 33,811 to below 30,000 and now has rallied back up to its current level, all in 3 ½ months! Normally, the stock market is calmer than this.

Which brings me to my question in all this: What does a long-term investor do in such volatile times? When I think of a long-term investor, I think of Warren Buffett and his company, Berkshire Hathaway. Berkshire Hathaway owns large holdings of various stocks. Berkshire’s well-known holdings include Apple, Coca-Cola, Bank of America and American Express. Some of these holdings have been in the company’s portfolio for approximately 30 years. Mr. Buffett will tell you that when he buys a stock, his preferred holding period is forever. Berkshire’s notable recent purchases include stakes in Occidental Petroleum and Chevron. The company is required to file a Form 13-F every quarter with the Securities and Exchange Commission (SEC). The 13-F’s are widely anticipated, followed and analyzed. What we saw from Berkshire during the first half of the year while the market was dropping was a firm that was doing plenty of buying and not any selling.

That is one of the lessons here. The big drop in the indexes offered up a chance to buy some high-quality companies at reasonable prices. A sharp investor will take advantage of such opportunities. Otherwise, it is just noise to the long-term investor. But it is the noise that gets investors into trouble. Their emotions will guide them to buy stocks when prices are high and sell when prices are low. This is the exact opposite of what smart investors like Mr. Buffett do. Mr. Buffett will tell you to be greedy when others are fearful and fearful when others are greedy. Most will be greedy when prices are high, and fearful when prices are low. While others rush to sell, he picks through the pile to find those gems that are cheap. When you are presented with that type of market scenario, one that offers you the chance to buy a great company for a reasonable price, you take it. These are the types of situations that could yield a return of 5x-10x-15x your money over time.

Unfortunately, those types of opportunities are not so obvious at the time. They do require an observant eye, nerves of steel and a faith that knows these great companies will bounce back. This is not for most people. However, many people invest regularly through a 401(k) or some kind of investment program. The long-term investor stays the course through the drops. If you have stayed the course through the market drop this past spring, you would have seen your investment rally to the point where it had regained all its lost value. A short-term price chart of stock prices can be all over the map. After all, what has the market done in the last 3 ½ months, right? But the long-term price chart only goes one way-up. I cannot predict future stock prices. As Yogi Berra told us, predictions are tough, especially when they are about the future. He also told us that the future is not what it used to be. Future stock prices are not guaranteed to go up, but I am willing to bet that they do.

Perspectives on Inflation - 2022

Today, the government reported the Consumer Price Index (CPI), the popularly reported number for inflation, at 8.3%. What does this mean? What we as average people know is that we are paying more for the stuff we buy, especially gasoline and food. This paper will share some of the root causes for inflation. I do not have the solution. What I do know is that much of the commentary I read on inflation is appalling. This includes commentary from so-called “experts.” My hope is to educate the reader on inflation. 

We have to start at the beginning. What is inflation? The dictionary defines inflation as, “a general increase in prices and fall in the purchasing power of money.” While technically correct, the definition does not get to any cause. A better definition, one I read many years ago, holds that “inflation is too many dollars chasing too few goods.” It gets to the causes of inflation: 1. Too many dollars; 2. Too few goods. Too many dollars is the key component. The great economist, Milton Friedman, once said that “inflation is always a monetary phenomenon.” When I refer to too many dollars, I am speaking of the money supply. “Too many dollars” refers to excess money supply floating around in the economy.

There are 3 basic definitions of money used by economists, called M1, M2 and M3. M1 is the narrowest and most liquid definition of money, M3 is the broadest and least liquid. The Federal Reserve no longer reports M3. The components of the money supply are as follows:

                M1: Currency plus checkable deposits. Travelers checks fall here but are seldom used.

                M2: M1 + short-term time deposits (such as CD’s), and money market deposits.

                M3: M2 + long-term time deposits

When economists speak of the “money supply” they usually refer to M2. When I speak of the money supply throughout this article, I will be referring to M2.

As you might have guessed, when I think about inflation, I focus like a laser on the money supply. Normally, the money supply growth should be in line with economic growth. If the economy grows 3% per year, and the Fed targets a 2% inflation rate, the money supply should grow by 5% per year. Now, if the money supply grows by 7-8% per year while the economy grows by 3%, this imbalance likely will not affect the overall economy, but the imbalance will need to be corrected in a reasonable amount of time. If done successfully, the Fed will engineer what is known as a “soft landing,” where they can slow down the economy a bit without sending it into a recession.

When more money is added to the system, each dollar becomes worth less than before. Policy makers will sometimes lower interest rates as an incentive to put more money in the system. Interest rates are the price of money. As rates drop, more money gets put into the system and each dollar’s value drops. With more money in the system, and with the value of money dropping, it takes more dollars to buy the same basket of goods as before. Hence, inflation is created.

What we have going on today is a great imbalance between economic growth and money supply growth (too many dollars). It started in 2020 with the great stimulus actions put in place by the federal government in response to the COVID-19 pandemic that swept the globe. During 2020, the money supply grew by 24.8% while GDP contracted by 3.4%. The gap was further increased in 2021 as the money supply grew 12.3% and GDP grew by 5.7%. While the overall inflation was just 1.4% in 2020, it is no wonder that the CPI jumped to 7.0% in 2021, and now stands at a 40-year high through the first 1/3 of 2022.

It is not just the money supply that creates inflation. Like the inflation of the 1970’s, there are supply shocks that spike prices (too few goods). In the 70’s, it was energy. Today it is semiconductors that go into a broad swath of products that we use. We see this described today as “supply chain” issues, but these are shocks to the system. In this case, I do not believe that the supply-chain issues will work themselves out quickly. It will take time to bring on board additional capacity to relieve supply shocks. Many of the semiconductor companies that are experiencing supply chain issues have cautioned that they expect these issues to last another 12-24 months.

It is not just the semiconductors. Prices will creep up all across the economy due to the increased availability of money. The next waves of inflation that hit the broad economy will likely be rents (shelter) and wage inflation.

How do we break this inflation? The model for this was served up by Federal Reserve Chairman Paul Volcker in the 1979-1982 timeframe. Unfortunately, this will involve a lot of economic pain. Economists are starting to call for a recession beginning in the late 2023, early 2024 timeframe. I fall into the camp of those who believe that we will see such a recession. Given the large disparity between money supply growth and economic growth the past couple of years, the recession could be severe. Volcker broke the back of inflation by raising interest rates. In 1980, inflation ran at 12% for the year. By 1982, inflation was at 4%, which is where is largely remained throughout the decade. However, in between 1980 and 1982 was the worst recession that we had experienced since the Great Depression (the 2007-2009 Great Recession eclipsed it). I consider Mr. Volcker the greatest Fed Chairman of all time because of his relentless action to break inflation. Current Fed Chairman Jerome Powell has indicated that he will likely follow the path that Mr. Volcker charted, though not near to the same degree. As I see it, Mr. Powell has no other choice.

A few final thoughts on this inflation. It will likely be the number one issue in the mid-term elections this fall. Unfortunately, what the politicians have to say about it will likely amount to a bunch of half-truths at best and outright lies at worst. Sad as this is to say, they will say a lot about this issue from a position of either ignorance, or just sheer stupidity or both. With that in mind, here are three observations to keep in mind to filter out the noise:

1.       It is not all Joe Biden’s fault. Yes, he has done some things to fuel this inflation, but the significant portion of the blame falls elsewhere. Sorry Republicans and Conservatives.

2.       Corporate greed has nothing to do with inflation. Sorry Democrats and Progressives.

3.       Oil is a special case. Oil is a global commodity. When a 13-nation cartel (OPEC) controls 75-80% of the world’s supply, and all international transactions are consummated in US Dollars (which have declined due to the large growth in the money supply), you have a very special situation. OPEC and the strength/weakness of the US Dollar largely determine oil prices.  War between Russia and Ukraine does not help either. The declining dollar plus geo-political instability in Eastern Europe have come together to send oil prices soaring.

This inflation will be with us for awhile. The actions needed to relieve the inflation will take time, likely several years. We will get through this. I do believe in people’s abilities to work their way through these kinds of troubles. 

Perspectives On the 1,000 Point Drop In the Dow

An old Chinese curse says, “May you live in interesting times.” Well, we certainly have that today with the Dow Jones Industrial Average dropping 981 points (2.8%) today. The S&P 500 also dropped 2.8% and the NASDAQ composite declined by only 2.6%. The drop in the equity averages was largely attributed to higher interest rates. Where do we go from here?

For the record, I am not an investment advisor of any sort anymore. I did spend 20 years of my life in the investments business and have maintained an interest in the financial markets. The drop today caught my attention. For a little perspective, the most dramatic day in stock market history had to be October 19, 1987, which saw the Dow drop 508 points, which was 22% of its value at the time. Think about that – investors saw 20% of their value wiped away in one day. I was a junior at Baylor that day, so I did not appreciate the enormity of that day like I do now. The Dow closed at 1,722 after that carnage. Today, after a 981-point drop, the Dow closed at 33,811, which is a 32,089-point increase since October 19, 1987. And consider all that has gone on since. Two Iraq wars. 9/11. A near depression in the 2008-2009 timeframe. A global pandemic. War between Russia and Ukraine. All manner of terrorist attacks, whether in Paris, Madrid, or Orlando among others. All that sandwiched in between two stock market crashes. And yet equities have managed a compounded annual growth rate of about 8.8%. Stocks are resilient and I expect they will recover from this as well.

Is this a buying opportunity? Just my opinion, so take it for what it is worth here, but my answer is not yet. When the market crashed in front of the pandemic in 2020, I believed that created a good buying opportunity. Turned out to be a better buying opportunity than I ever imagined. This time feels different. One of the pithy sayings that the old-timers like to say is “Don’t fight the fed.” Let the Federal Reserve be your guide. In 2020, the Fed unleashed the spigots and money gushed out. Today, they are tightening the spigot to the point where one wonders if they will ever put another dollar into circulation. Interest rates are rising, and now is not the time to get courageous and stand in front of that.

Why do interest rates matter? Anyone who has ever done a discounted cash flow analysis on a stock knows that Treasury rates (i.e. the risk-free rate) are tied to equity valuations. A discounted cash flow analysis yields an intrinsic value for a stock. As rates go up, that intrinsic value goes down. With the federal reserve sounding more hawkish than ever on rates, investors are betting that rates go much higher than originally expected. Higher interest rates get built into the DCF equation. Hence, the drop in stock prices.

Why do interest rates have to rise? Interest rates are the price of money. Back in 2020, interest rates fell to zero as money was injected into the economy to help fight the effects of the pandemic. Money was needed as millions of people were put out of work. When rates fall, more money is available from the banks, and credit becomes easier to obtain. With a low price of money, demand for money increases. When a wide swath of the population has more money, due to obtaining low-interest easy credit, it allows suppliers of good and services to raise their prices a bit. When there is a shortage of goods, it allows prices to be raised a lot. Supply shortages soon hit during the pandemic as production was either halted or slowed to a crawl. Lumber was the first shortage, but the most pronounced and longest lasting of the supply shortages has been in semiconductors. Semiconductors are used in a wide variety of products, with the big three being computers, phones and cars. When the supply shortages hit, prices rise dramatically and that shows up in the inflation numbers. In order to slow inflation, rates must rise, thereby reducing demand for credit, and bringing the supply/demand imbalances back into balance.

What is inflation? The best definition of inflation I ever heard is that it is too many dollars chasing too few goods. This hits at the causes of inflation. Too much money in the system on the one hand. Supply shortages on the other. We saw that in the 1970’s and we see it again today. The problem we have today is that the Federal Reserve tried to tell us last year that inflation was “transitory.” In the process, they continued to feed money into the system, making the inflation worse. By the time Jerome Powell realized what was going on, it was too late. Because the Federal Reserve was behind the curve all year, they made the inflation situation far worse. I believe that prices have gone far higher than necessary. The actions needed to correct the Fed created inflation will be far more drastic now than they would have been had the Fed started taking corrective action last year.

Would I recommend stocks at this point? First, like I mentioned at the beginning, I am not an investment advisor any longer. I do have thoughts and ideas. I still like to do my own research. Every person’s situation, preferences and risk tolerance are different. If you like to purchase individual securities, do your research first. If you have a financial/wealth advisor whose expertise you depend upon, consult him/her and develop your plan of action together. Or maybe you just invest in index funds and call it good. Nothing wrong with any of these approaches. My preference at this time to raise investable cash, and wait for the right buying time. In other words, don’t fight the fed. I’ll be getting my list together. For me, I like regional banks, semiconductors and a smattering of industrials.

Understand that this too shall pass. If today were as bad as 1987, the Dow would have dropped about 7,600 points today. It did not, it dropped 1,000. To believe that stocks will come back, as I do, is to believe in the resiliency of people. We will go on making widgets, working diligently at our jobs and being forever optimistic about the future.

A BUdding Rivalry?

On April 4^th, the Kansas Jayhawks won the NCAA Men’s Basketball National Championship with a 72-69 win over North Carolina. One year earlier, KU’s conference foe Baylor won the National Championship with a win over Gonzaga. For the first time ever, one of KU’s conference opponents had won a national championship, and perhaps, the fulfillment of one of Bill Self’s wishes was starting to take some shape. We have to go back to 2012 to find the beginning of this story.

During the summer of 2012, conference realignment took shape in a big way and in the process, Kansas lost its biggest rival, Missouri to the Southeastern Conference. In order to replace Missouri, Bill Self knew he needed a nationally significant basketball power to replace Missouri in the Big 12. His dream was that Louisville would be invited to join the Big 12. Louisville was looking to leave the Big East Conference, so they were available. The Cardinals were coming off a Final Four appearance in 2012 (along with Self’s Jayhawks), and they would go on to win the National Championship in 2013, since vacated. They had a high-profile coach in Rick Pitino, who had already taken three different schools to the Final Four. The Big 12 went a different direction, thanks to the University of Texas, and took West Virginia. West Virginia brought a high-profile coach and competitive teams, but nothing more than what already populated the Big 12. Nothing nationally significant.

Self’s Jayhawks would go on to dominate the Big 12 over the rest of the decade. Kansas State would win a couple of league championships, but would never mount a consistent threat to Kansas. Texas Tech would win a league championship in 2019 (tied with Kansas State), and go to a Final Four, losing the 2019 championship game in overtime to Virginia. But they would take a step back, going 9-9 in the league in 2020. Coach Chris Beard would leave Lubbock for his alma mater, Texas after the 2021 season. The Big 12 fielded strong, competitive teams top to bottom, but nothing nationally significant.

Scott Drew came to Baylor in the summer of 2003, the same time that Bill Self came to Kansas. The coaches came to their respective schools under entirely different circumstances. Self inherited a Kansas team that was loaded and expected to contend for a conference championship and make big noise in March. Drew came to a school that did not know if it would even field a team that first year. Baylor was up to its eyeballs in the worst scandal in college basketball history. What came out of that was a picture of a Baylor basketball program that was out of control and entirely lost under Dave Bliss. As a Baylor alum, I never want to see or hear of Bliss ever again. He thoroughly disgusts me. Drew was left to clean up the mess with 7 scholarship players. He and his assistant coaches went begging for kids on campus to come try out for the team.

Somehow Drew survived and by 2008, he had Baylor in the NCAA Tournament (as an 11 seed). He would take the Bears to the NCAA again in 2010 and 2012, and advance the Bears to the Elite Eight both times. However, he was unable to match that success over the rest of the decade, making it as far as the Sweet Sixteen in 2014 and again in 2017. Drew built the Bears up to a consistently competitive program that won some significant games, but never really competed for conference championships and was never all that nationally significant. The Bears did briefly rise to a Number 1 ranking in the polls in 2017, but that was just for a couple of weeks. The Bears failed to make the NCAA Tournament in 2018. They were picked to finish 9^th in the Big 12 in 2019.

There was no rivalry between Drew and Self, or Baylor and Kansas. Between 2004 and 2019, a period that covered 16 seasons, the two teams played 26 times with Kansas winning 22 and Baylor winning 4. That is not a rivalry, that is a beat down. During that time, Baylor did not win a single game in Allen Fieldhouse while Self’s Jayhawks won 9 times in the Ferrell Center at Baylor.

For Baylor, things began to change with the recruiting class of 2018. Drew recruited a couple of high
school kids, Jerod Butler from Louisiana and Matthew Mayer from Austin. He also brought in an international kid, Flo Thamba. Finally, he added a couple of transfers who would have to sit out a year, per NCAA transfer rules at the time, Davion Mitchell and Macio Teague. None of these kids raised any eyebrows, none made commentators and writers sit up and take notice. But this class formed the nucleus of what would be a national champion. Nobody predicted any sort of greatness, or paradigm shift in the Baylor program with this group. The other notable change for the 2018-19 season was that Scott Drew junked his zone defense, and embraced the type of man-to-man defense that Chris Beard was playing out at Texas Tech. As a Baylor alum, I have long believed that Scott Drew did his best coaching job in the 2018-19 season. The team that was picked to finish 9^th in the Big 12, went 9-9 in the league, finished 5^th and advanced to the second round of the NCAA Tournament before losing to Gonzaga. That was the season where Drew set in place all the things that were about to come.

In the 2019-20 season, Baylor finally beat Kansas in Allen Fieldhouse, and would win a Big 12 record 23 games in a row. After that Baylor loss, Kansas would not lose another game the rest of the season, closing out with a 16-game winning streak. They would need every single one of those 16 wins to edge out Baylor for the Big 12 championship. Kansas would close out the year 28-3, Baylor would finish 26-4. The NCAA Tournament was canceled that season due to COVID-19. Both teams had very high hopes for that tournament. It is reasonable to believe that both teams would have entered the tournament as a #1 seed.

For the 2020-21 season, Baylor would return 4 of its 5 starters from the previous, and they had their sights set squarely on the national championship. In addition to the returners, they added two significant transfers, Jonathan Tchamwa Tchatchoua and Adam Flagler. Again, no one that would make you sit up and take notice.  It was a strange season in college basketball because of the continuing COVID-19 pandemic that limited crowd sizes and had the games played in largely empty arenas. The Bears themselves were hit with a COVID-19 outbreak that forced them to miss about 3 weeks of the season. Even so, the Bears went on to win the Big 12 with a 13-1 record, losing 4 games due to the COVID outbreak that they were unable to make up. They entered the NCAA Tournament as the #2 overall seed (Gonzaga was the #1 overall seed) and a 23-2 record. Baylor had one the greatest NCAA Tournament performances of all-time, and one of the 2 or 3 most dominant Final Fours ever to win its first men’s basketball national championship.

Both teams entered the 2021-22 season with high hopes. Indeed, both teams shared the Big 12
championship with a 14-4 conference record, and the two teams split their two regular season games for the third year in a row. Baylor had a very disappointing 2^nd round exit in the NCAA Tournament while Kansas won its fourth NCAA Championship. Looking ahead to next season, both teams have been ranked in the Top 10 of every “way too early” poll that I have seen so far. Both teams have plenty of returning talent, and an influx of incredible new talent. Next year, we as fans will get treated to two games featuring the last two national champions, and I am excited to see two basketball heavyweights slug it out. I am sure that when the schedules come out, both teams will be the circling the other. And both teams will have every expectation of beating the other.

Beyond next season the big question is whether or not Baylor has staying power. We know Kansas does. KU’s last four coaches have each taken Kansas to at least two Final Fours. They have accounted for 31 conference titles, 12 Final Fours and three national championships. Baylor’s magical 2021 season was their first conference championship in 70 years, their first Final Four in 70 years, and their only national championship. Kansas has won more basketball games than any school in history. Kansas plays in one of the most historic basketball venues on the planet. Baylor is getting ready to break ground on a brand new, state of the art facility that ironically enough is drawing from Allen Fieldhouse for its arena design. It is tradition vs up and comer. I do not know if Baylor has staying power. Scott Drew seems wedded to Baylor, and appears unlikely to ever leave. Will the Baylor program thrive beyond that? I would like to think so. Bill Self and Kansas have waited nearly 10 years for a nationally significant conference opponent. They may finally have what they have longed for. As they say, be careful what you pray for…I can hardly wait to see what this rivalry could become.