“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
The Sun Also Rises — Hemingway 1926
On February 19, 2020 the Dow Jones stood at 29,348. For the last 4 years running, it had steadily climbed 13,000 points most of which following the election of Donald Trump.
Everybody assumed that “betting on the stock market” was the safe trade.
Corporate America certainly did. Instead of using operating profits to invest in new plant and equipment or new lines of business, they did the “safe” thing — which was to buy back their own shares. The more stock they bought back, the more their shares were pushed upwards. Stopping or even slowing down buybacks became risky — in the short term, to the stock price.
The financial planning industry also did. As baby boomers grew old, and with bond yields below 5%, the “safe” thing was to allocate a minimum of 60% of boomer retirement accounts to equities — regardless of the price.
The government also did. With boomers and corporate America focused on share prices, managing any kind of control over the national debt became secondary. When Obama was sworn in, he immediately prioritized stocks over the government balance sheet. And Trump did exactly the same thing.
A Policy of “Playing it Safe”
How did we really get here? How did we end up with 20 Trillion in Goverment Debt, 10 Trillion in Corporate debt, a stock market at peak valuation relative to GDP and no margin for safety?
Ironically, I would argue that our policy for maximizing safety has ironically resulted in this fundamentally unsafe situation.
In a recent podcast with Howard Lindzon, Raoul Pal explains how the hedge fund industry essentially put itself out of business in the search for “risk adjusted returns” or Sharpe Ratios.
A Sharpe Ratio is basically your portfolio return net of treasury yields, divided by its volatility. For example, if you make 20% plus or minus 20%, your Sharpe Ratio is 1. Some years you are flat, the other years you make 40%. Good — but a better scenario is making 20% plus or minus 10% and achieve a Sharpe Ratio of 2. Some years you are up 30%, the other years you are “only” up 10%.
Armed with this new quantitative tool, the investment industry started optimizing for high sharpe ratios. And not only high quarterly sharpe ratios, but high monthly sharpe ratios as well. The more you could get something like a high yielding bond, paying 1% per month (plus or minus 1%) the better. “Just no losses” — as Gordon Gecko would say in the movie Wall Street.
Safety comes at a price
1% a month sounds great. Almost too good to be true. In the case of Bernie Madoff, who ran a 64 Billion dollar Ponzi scheme up until 2008, it was too good to be true.
Ponzi schemes are one way to create high Sharpe ratios. The other way is to effectively sell volatility.
From 2008 to 2020, corporate America pursued a policy of engineering high stock prices with buybacks. It was, in essence, a short volatility trade. Most of the time it was the right thing to do, the safe thing to do. And then in Feb 2020 it wasn’t.
After the crisis of 2008, large companies correctly assumed that if / when they screwed up the government would bail them out. In the interim, they could do the “safe” thing of buying back their own shares — which coincidently earned them massive bonuses. Financial planners also did the “safe” thing of parking their boomer clients in stocks, raking in management fees, and staying competitive with other financial planners. It doesn’t pay to be bearish in a bull market.
And now, the reckoning
Now, we find ourselves like Japan in 1990 in a bad situation. Our government is in debt. Our companies are in debt. We’ve neglected to actually invest in plant and equipment, choosing to outsource absolutely everything.
And in this, enter Corona. A biological enemy, that can’t be fully eliminated in less than 2 years with a vaccine. Restaurants, Airlines, Casinos, Retail, Hotels are just a few of the sectors that are going to be immediately impacted for 2020 and possibly 2021. European and Asian trade will be affected. The cost of this pandemic, regardless of how we address it will be immense.
Ironically — this will cause the average American to get even more risk averse. Spend less, save more. Don’t invest in stocks. Just hoard dollars. Pay the government (negative interest rates) just to store your money. Again, pay no attention to the deficit.
So now, where does this take us? With the government printing presses in full gear and interest rates at zero, bonds are dead as an asset class. The verdict is out on stocks, but it feels like it could be a lost decade, Japan style, cratering in a world where there is no retail interest in stocks at all.
In this world, crypto could do very well. Bitcoin specifically, because you can’t print any more of it, but also other forms of crypto as this emerges as a new “Internet of Money” that replaces the former Fed / Fiat / Banking complex.