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If the rest of 2022 looks like January, most savers are in for some pain. Asset prices (stock indexes and bonds) are down and inflation is up. In real terms (after inflation), the typical saver has a lot less money, like about 8% less just this month. If this continues for the next six months … that is a meaningful decline in real wealth.
Here is an abbreviated version of what is going on:
1. The central bank (the Fed) is slowing the rate at which they print money. Less printing = less demand for assets = lower prices.
2. Inflation is rising, due to a combination of strong demand and a disrupted supply chain. China, a critical node, is disrupted due to zero Covid tolerance and vaccines that don’t work well versus Omicron. Chinese ports may be impaired for years. That suggests the US central bank might need to raise interest rates a lot to slow demand because supply will struggle for some time. Right now, the bond market is betting the Fed will lift rates 1% this year. If market expectations shift higher, stocks will fall further.
3. Russia may invade Ukraine, which, depending on exactly how they do this, may drive commodity prices up further. Russia supplies raw materials to the rest of the world. Much of what we call inflation is commodities.
4. The Biden Administration is floundering. Afghanistan + Covid + inflation = Republican sweep of November elections and an end to additional fiscal stimulus.
The question, as always, is what to do. I will share my specific asset allocation answer with subscribers later this quarter. I will also host an “ask me anything” (AMA for hipsters) for subscribers Sunday January 30, at 2 pm New York City time. I’ll send out a separate subscriber-only note the day before as a reminder and with call details.
Stocks
A stock has two moving parts, the earnings of the company an investor owns and the price paid for those earnings.1 The earnings of many, not all, companies are likely to grow over the next year. The problem is with the high price investors pay for those earnings.
A combination of zero interest rates and high inflation meant investors lost money holding cash, so many, particularly households, bought US stocks. The chart below from Yale Professor Robert Shiller shows one perspective on this. It exaggerates how bad things look2 but is still useful. The average PE over the long term is around half what is on the chart, suggesting stocks are roughly 40% or 50% overvalued.
So an investor ought to sell, right? The answer is “it depends.” How big holdings of US stocks are relative to other assets held, age, where assets are held (taxable or not) all factor in. It’s certainly possible stocks fall a lot more. If I had all of my wealth in crypto and tech stocks (I don’t), I’d be concerned.
Taxes
While I’ve discussed asset allocation before here, I have not addressed taxes. In most of the world, savers are taxed twice. Many consider the first set of taxes, on income, but not the second set of taxes, on savings. I am not an accountant and this piece is neither investment nor tax advice,3 however, I will share my thoughts with you and you can decide what to do yourself. In the US, there are different levels of what are called capital gains taxes, basically taxing your savings. There are also taxes on dividends, which can be qualified (taxed like capital gains) or non-qualified (taxed higher, like income).
The chart below shows the periods of time since 1970 when US stocks have lost money and a horizontal line at the highest level of capital gains, 20%.4 As you can see, there are four periods (1975, 1987, 2001 and 2008) where you would be better off selling, paying the tax and trying to invest later (if you can time it right). Another example is 1929. There are lots of times stocks fall and, factoring in taxes, it was a bad time to sell.
This is a function of compounding. If you benefited from a big run up in stock prices and you sell, you write a check to the government. This means you are now compounding off of a smaller base. If stocks bounce, you are bouncing with less money, which means you need a bigger bounce to get back where you started. (If you like these charts, thank Rose Technology, a start-up that is fantastic at visualizing economic data).
So the question is not are US stocks overvalued, they are. The question for taxable investors is are we on the edge of 20%+ correction? My answer is: maybe, but I’m not sure because the earnings (in aggregate) will be OK. There is a bigger question that I will address at a later time which is this: years of stimulative policy have driven asset prices so high that bringing them back to earth will depress spending.
I’ve taken steps to protect myself and will share them with subscribers. Step #1 was holding a small exposure to tech to begin with. Mine was about 3%. Many institutions have also avoided holding a lot of US stocks. Households, however, disagreed, and have driven the last two-years of rally. What will they do next?
Constraints
I want to provide a follow up to last week’s post, Jail Break. I realize, particularly for younger readers, the title is a bit disingenuous. In truth, you never break free; rather, you constantly negotiate constraints. That’s true in two basic life vectors, work and relationships.
Consider the relative merits of working for a big corporation or yourself. A corporation offers scale. Scale widens your circle by putting you in contact with new people, makes you part of something bigger. It also embeds you in a bureaucracy. Managing your boss, negotiating colleagues, budget and salary become the work, in addition to the actual work. Tired, you leave (“jail break”) and start your own gig. Now you have to build an idea from scratch and there is no one to blame but yourself for the outcomes.
Relationships obey the same physics. Being monogamous creates constraints, dating (which I last did in the 1990s) creates different constraints. Constraints are inescapable, chose them well. Life, as Chekhov said, is a vexatious trap!
Russia and Ukraine - A number of readers asked me about this. In brief, if rule of law matters, Russia can not violate Ukraine’s borders. That’s the Western perspective. If rule of law is a mushy concept, what matters is power. If the US isn’t willing to put troops on the ground, Russia can seize territory. The gap between Russia and the West regarding rule of law began opening up in 1215 when the Magna Carta came into being and continues to this day. In terms of the markets, invading is terrible for Russian productivity. The cost of capital goes up and talent gradually leaks out. I spoke about this before here.
Reading and watching:
Watching: Passing. You can read about the film here. I don’t think this film could have been made 20 years ago. Our culture is in motion and great art moves the conversation forward. Soros, a documentary about the man, who I have met a few times. It captures him well.
Reading: Undermoney and a bit of Ulysses. Undermoney is a new word. As the author, Jay Newman, defines it, it is “money which is unknown publicly but that controls individuals and events.” It’s also the 100-year anniversary of James Joyce’s work. I’ve started but never finished the book and, in his honor, dipped my toe back in.
I thought about today’s post while walking here:
Put aside dividends, which are paid out of earnings.
Shiller is using a 10-year average of earnings…which means that if earnings have picked up over recent years, this measure will decline and look less scary. Investors often look at what earnings will be in the future, which would bring the PE down further.
Investing is RISKY. You can and will lose money.
If your income is less than $40K, you don’t pay capital gains; from $40 to $440k, you pay 15%; above $440k, you pay 20% (based on Google).