CHG Issue #129: Disconfirming Information

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The learner will seek disconfirming information in preparation for a changing world. The learned will master the world only to find themselves equipped to deal with one that no longer exists.

The recent Birkenstock IPO is a great story of a 250-year-old family-owned company that turned to an outsider for leadership that could transform their company. It provides us with a different angle on the expert problem by revealing the kind of value a “non-expert” can create. But Oliver Reichert’s story isn’t just one of fixing problems, it demonstrates a deeper truth that is particularly relevant in the markets today.

…there are certain epochs at which the changes that take place in the social and political constitution of nations are so slow and so insensible that men imagine their present condition to be a final state; and the human mind, believing itself to be firmly based upon certain foundations, does not extend its researches beyond the horizon which it descries. Alexis de Tocqueville, Democracy in America

There are big changes underway in the world today and we risk falling behind by expecting a return to “normal.” A good friend, and reader, likes to say that normal is only a setting on a dishwasher. A great example of this is how the market has been persistently pricing in Fed rate cuts as it expects the normal monetary policy response to a slowdown in growth that we have seen over the past 40 years.

But what happens if the Fed doesn’t or cannot lower interest rates? The environment we are in today is unusual but not without precedent.

Economic growth is slowing as the lagged effects of higher interest rates weigh on demand and put pressure on highly leveraged balance sheets. The strong dollar continues to attract foreign inflows of capital, despite large trade and budget deficits, which supports the domestic economy offsetting slowing domestic demand and keeping credit availability high. The job market remains robust as credit availability is high and employers make nominal wage increases, but real incomes are falling as wages cannot keep up with inflation. Consumers have been forced to draw down savings to maintain spending and corporations face rising wages and interest costs.

We must go back over 100 years to the first two decades of the 20th century to find a suitable analogy to the conditions we face today. The world had experienced a prolonged period of prosperity, increasing political freedom, the spread of democratic institutions, and the steady lifting of living standards. Capital was flowing into the US and credit availability was high, technological innovations created a booming transportation industry, the yield curve was persistently inverted, and a rising trend in interest rates was underway. During this period the markets were often left to themselves to sort out supply and demand excesses and any resulting economic cycles. During the crisis of 1920-1921 the US experienced a sharp downturn in growth that was not met with the response from the newly created Fed that we would expect today. Short-term rates stayed high during the crisis but banks that had built up significant reserves during the prior cycle were able to supply credit to the economy and high interest rates were viewed as insurance against future losses. Only the strongest companies could afford them, and the high rates provided the lenders with a cash-on-cash buffer against future losses.

In this analogy we can see how the prevailing expectation that interest rates must fall during an economic downturn has not always been the case. It might have been that lowering interest rates would have resulted in capital flight which would have put even more pressure on the domestic economy and risked creating a classic balance of payments crisis. More importantly, we can see how private banks fresh with excess reserves were able to effectively ration credit and set the economy up for future prosperity. Remember, the Roaring 20’s followed the crisis of 1920-1921.

During this period, it was normal for stock and bond prices to move together. It wasn’t until Keynesian economic policies were enacted during the Great Depression and WWII that the current financial orthodoxy took shape.

The asset management industry was surprised by the poor performance of the 60/40 portfolio last year as stock and bond prices moved lower together which has been considered an outlier despite the pre-WWII experience. Modern portfolio theory and the 60/40 portfolio are based on how securities move and assume that price movements reflect fundamental information. These ideas have been developed, tested, and refined during a historical period that, like all historical periods, is unique. The security movements and relationships that have existed may not continue to exist in the future and they may change as economic policies and investor behavior change.

Investors today are increasingly allocating larger shares of their portfolios to less liquid investments like Private Equity, Venture Capital, and Private Debt and companies are increasingly able to finance themselves in the private markets for longer and longer. Taking these investments off public markets and exchanges where we can observe prices transparently has many implications. One is that the investments don’t move the same way they would if they were on an exchange which raises all sorts of questions about the real value of these investments and what sort of role they play in a portfolio where the primary focus is on price movements. Additionally, the decentralization of capital markets changes how credit flows through the economy and can render traditional economic forecasting techniques inaccurate as we have seen recently. Finally, the changing structure of the financial markets will change how security prices move and their relationships with other variables. This requires a deeper exploration of the fundamental cause and effect relationships in the economy and a move away from a reliance on price as the ultimate source of information. ?

The wealth management industry is ill-prepared for these changes. Advisors are ill-equipped to analyze alternative investments and negotiate favorable terms for their investors. Further, they are relying on a business model and market playbook that is becoming increasingly outdated. Luckily, we are seeing a shift in talent from the larger, institutional firms to smaller and independent wealth management firms and we are seeing advisors pursuing more innovative approaches to wealth management. Bob Elliott, who was on the investment committee and led the research effort at Bridgewater, co-founded Unlimited to make popular hedge fund strategies more cost effective for investors through portfolio replication technology. Bob recently shared the chart below which highlights how advisors have failed to take advantage of the low hanging fruit that an allocation to gold can provide a portfolio.

We shared this chart from Bridgewater in last week’s letter that shows how gold benefits when the 60/40 portfolio experiences drawdowns:

These two charts taken together show the massive bet the wealth management industry has taken on a return to normal for the 60/40 portfolio. But reason and historical experience beyond the post-WWII period suggests the next 40 years will look nothing like the last 40 years.

The recent banking panic should have struck fear in every financial advisor out there who may not have ever thought about custodian risk before. Custody is an afterthought for most advisors but as seen with the recent merger of TD Ameritrade and Schwab there has been a massive centralization of risk in loosely regulated firms. Over the past five years the AUM at independent RIAs has nearly doubled from $2.2T to nearly $4T today. Most of that money is held in custody at Schwab and Fidelity today, two non-SIFI banks that are allowed to run significantly more leverage than the SIFI banks. It is interesting that in an age where the decentralization of finance is all the rage, we are seeing an increasingly centralized wealth management industry.

The end of the secular bull market in treasuries will mark a historical turning point in the financial markets that will have far reaching consequences. Many of these will challenge existing beliefs and doctrines. We must take these as opportunities to learn and update our opinions and beliefs. The only constant in life and the markets is change and it is adapting to change that we must master, not the world as it exists today or in recent history. The world will end up imposing itself on you one way or the other, the only control we have is how hard we fight it.

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