Brave New World

7/26/23

In 1931, Aldous Huxley was just older than I am now when he wrote his dystopian classic, Brave New World. In 1943, Jackson Pollock was just younger than I am now when he painted his Mural (above). Arguably, both Pollock and Huxley depicted the struggle for identity through their respective media.

This memo will be a shorter note given the serious uncertainties in the market, and such little advice than can be provided therefore. Like Pollock and Huxley posited, I also believe people are struggling to maintain identity. Part of this, in Huxley, is maintaining our identity as economic leaders.

In our brave new world, we need to adapt to the new environment intelligently, meaning we need to avoid making financial mistakes. In a changing environment, this is the trap humans have historically fallen into. I appreciate the past. The past is full of mistakes. Those mistakes were just practice for today. We learn from those mistakes. We learn by practicing those things that challenge us. In the past, bubbles seem to have formed right around the times when humans believed something new has come along to make all their problems go away. In South Carolina, we called that "snake oil".

Today, I see shades of the same thing. I suspect nothing much has changed therefore in 100 years since Pollock and Huxley, and nothing will change much in the next 100 years. Bubbles always have the potential to form. But if we study history, we can stand on the shoulders of Huxley and Pollock instead of falling into the same traps that their contemporaries fell into.

Equities will continue to perform, but compared to what? The spread of equity returns/yields to bond returns/yields, which historically has been a very strong indicator, is either too uncertain to know or is too thin to be favorable to equity investment. Furthermore, bubbles are popping up, arising from strong speculation on Artificial Intelligence, not simply with the 'pick and shovel' businesses, but 'ancillary businesses' that will indirectly benefit. Investors I talk to were calling both for these ancillary businesses to make significant, though very indirect, gains but also speculating that the global economy would ameliorate. Artificial intelligence is real, but how can we know what will happen?

Perhaps this is obvious to state, but with so much uncertainty, why would you take risks? Phrased a different way, how can you reliably make money right now in a way that beats, with weighted consideration, 5% yielding bonds? Why not be patient until a better landscape materializes? Also important to note - what if artificial intelligence is mostly hype in terms of economic benefit? What if the costs of implementing those technologies overwhelm productivity and profitability gains for years to come?

Moreover, this is, without exception, a stock picker's market. An index investor likely has an even lower chance, in my opinion of outperforming that 5% bond. I note that Microsoft will currently yield on a free cash flow ("FCF") basis roughly 3.3% based on my proprietary pro forma estimates over the next 12 months, Google will currently yield about 5% and Apple will yield about 4.5%. The largest stocks in the market are yielding less than several bond tenures. The first question becomes - what of those companies that are much smaller and looking to grow into those FCF yields? Secondly, what bond tenure should an investor compare those equity FCF returns/yields to? Any given tenure of bond is both currently volatile and elevated based on the last 20 years of yield history.

Thus, if you first consider the comparative current yields of all asset classes, you'll notice that the spreads in comparison to bonds, specifically, are uncertain and volatile. The yields of the bonds used to provide that spread analysis are also uncertain and elevated. In consideration of the pickup yield on equities, an equity buyer today will expect either equity FCF yields to relatively increase or bond yields to relatively decrease in order for stocks to outperform. As Morgan Stanley noted, that pickup (otherwise known as "equity risk premium") is historically narrow. I reiterate that it is also historically difficult to go even that far given the volatility of all current and predictable yields.

Warren Buffett always said to jump over the 1 foot hurdles as opposed to the 5 foot hurdles. He also missed the entire tech boom of IBM, Microsoft, and Apple in the late 20th century. Warren might see the same thing that is noted in this memo, but based on his history, a drop would not bother him. I have little advice for many folks outside of 'control your emotion' during times like these. As my 3rd grade teacher used to always say, "Better safe than sorry." Shouldn't we heed that advice and be more fearful when others are greedy?

Perhaps the best benefit of those very short maturity bonds that yield 5% is the evasion of volatility. The chance of losing money for any reason is much lower at yields historically high than that of purchasing stocks at a spread that's historically low.