The Most Important Thing

4/5/23

None of the following is investment advice.

What does Warren Buffett know that we don't? His lesson came at age 35. Nothing groundbreaking about it, but it transformed him from being a great investor nobody knew about to being a great investor everyone knew about. Buffett is, in my opinion, the greatest American archetype currently alive. He extolls confidence in America with his lectures and myriad videos, while emphasizing America with his vast wealth.

Nearly every memo I write references Buffett, but this memo describes a level of genius that I have only recently considered. He was a genius long before age 35, but much less successful, as defined in the truest definition of success - wealthy in vast quantities of money and time without any real stress to speak of. After 1965, his life became impossibly simple because he saw a trend that has happened throughout time.

This memo will be split into fourths.

First, I'll talk about economic happenings in the last few years. Second, I'll talk about a timeline of Buffett once he changed his investment philosophy. Third, I'll describe that investment philosophy, citing specific examples. And last, I'll talk about how to put that philosophy into practice. Considering the benefits - more time, money, and less stress - you should know it isn't easy or convenient to adopt the philosophy. All of us are capable of these tenets of wealth.

Part 1

Interest rates certainly are the fly in the ointment. The throbbing headache for investors and the government alike. This reality has never changed (every memo I author discusses rates), but relatively more pronounced volatility begets a more pronounced headache for all participants and in all assets.

In the past 6 years, The Federal Reserve ("The Fed") rose its effective interest rate from about 1% to 2.5%, lowered it to 0%, and raised it to the current 4.75%, signaling more hikes still to come.

Many of you will ask why rates have been so volatile, and most everyone will give an opinion, but I cannot. I have no idea why the rates change, but I know incremental changes can cause trillions of dollars in changes to asset values (think stocks, bonds, and real estate).

The headache mentioned above seems to be centered in the financial sector (think banks and insurance companies). Traditionally, banks earn money by taking deposits in and paying a rate while [lending] that money out and earning a rate. Since deposits are necessarily highly liquid, banks need to likewise purchase highly liquid loans. From 2020 to 2022, The Fed increased the amount of US dollars in circulation by about 40%, meaning that new money needed to be housed somewhere (such as deposited in a bank). Ironically, those trillions of new dollars coincided with that 0% effective rate mentioned above. Thus, the 'highly liquid' loans that banks earned a nearly 0% rate of interest, and remember that is on trillions of deposited dollars.

A chief risk for banks is interest rate risk, the risk that they invested in very low yielding loans whereas the effective rate has since risen. This has now occurred in a historic fashion - from 0% to nearly 5% in only 1 year. At such a point, bank checking and savings accounts still earn depositors roughly 0%, and frustrations mount on both sides. Depositors now look for an easy way to otherwise cash in on that 5% rate while banks don't want them to make withdrawals (think bank runs).

Faced with this issue, banks could 1) raise deposit interest rates to discourage customers from making a run on the bank in the first place and/or 2) sell loans to ensure the bank would survive a run.

In strategy 1), banks would incur losses, as the rate of interest paid to depositors would then be greater than the interest on the loans that the bank previously purchased, meaning that they would pay out more than they would take in, causing operating losses. Tricky still that those losses would continue until The Fed's effective rate was dropped back close to zero, theoretically. Banks would be staring down potentially years of losses to equity shareholders that would decimate share prices, but the system would be intact.

In strategy 2), the bank would take capital losses, selling 0% bonds that nobody really wants to make sure those depositors get their money when they do make a run. Remember that the run is due to those high interest rates - savers would run from banks all day long to earn 5% on investments with similar risk profiles. Those 0% bonds sold by the banks would then be sold at a loss because nobody wants to own a 0% bond when on-the-run, liquid bonds earn 5%. Tricky still that those losses would continue mounting until the bank has successfully covered all would-be withdrawals. Banks would be staring down potentially years of losses to equity shareholders that would decimate share prices, but the system would be intact.

If depositors made a run because rates were higher elsewhere and such deposits were not available, the system would disintegrate into a panicked quagmire. This would occur if banks failed to successfully incorporate Strategies 1) and 2).

This is exactly what has happened at banks - depositors have withdrawn significant sums from banks to invest elsewhere, and banks have just... failed. First Silicon Valley Bank and then Credit Suisse. A month later, the system is still intact, despite what many investors believed.

These banks were undercapitalized relative to the risks present a month ago, and other banks will likely be undercapitalized relative to the risks present in forthcoming months, quarters, and years. Why? Well, one year ago, The Fed concurrently announced those aforementioned interest rate hikes alongside 'Quantitative Tightening' (QT), a completely new experiment. QT promised to unwind a roughly $9 trillion balance of troubled assets The Fed has accumulated over the past couple of decades, in increments of almost $100 Billion per month. Although more than $600 Billion was relieved over the last 12 months, $400 Billion of that has been added back in the last month.

Without diving too deep, inflation seems to have been caused by those aforementioned new trillions of dollars that have recently entered the system. More money in circulation means higher supply, lower demand, and lower value, all else equal. Conversely, QT was announced as a potential indirect cure for inflation. Less money in circulation means lower supply, higher demand, and higher value. But less money squeezes the system and causes recessions or worse, depressions. Inflation is cured, theoretically, by much lower input prices (recessions) or much higher output (productivity).

A year after rate hikes and QT were announced, inflation seems to still be perniciously elevated, but QT is no more. What does this tell us? Seems as though inflation is less of a concern than recessions. Given the choice, The Fed would rather have inflation for longer rather than a controlled recession.

Case in point - FDIC insurance limits have been mostly ignored as banks have mostly ignored risk management (Strategies 1) and 2)). In theory, depositors of a failed bank should only be reimbursed $250,000 of their total bank deposits. For 90 years, FDIC has existed to ensure depositors would continue to store money in banks rather than, say, under their mattresses. FDIC did not exist before that because many banks were not regulated federally. When the Great Depression occurred in 1929, FDIC insurance was created in 1933, well after so many people had lost their money and, coincidentally, almost exactly when a bull market began.

This year, those limits were waved entirely. Some 90% of Silicon Valley Bank's total deposits were uninsured, meaning that the bank squandered more than $150 Billion in deposits that the government stepped in to bail out.

One shrugs the shoulders, as the government/The Fed seems to have definitively repealed a promise of QT and also waved away the $250,000 FDIC insurance limit as though these were both completely unimportant to do in the first place. Could the government actually insure the entire system of tens of trillions of dollars? Yes, and we should expect them to. Will this mean The Fed puts even more money into circulation, causing higher supply, lower demand, and lower value? Yes. Will more money in the system encourage banks to lend even more, creating this whole problem over again? Yes.

To reiterate, my perspective is that inflation is much less important than keeping the system going, which seems to be the grand plan. The system has such high levels of debt that even small recessions seem to now threaten the system. I cannot give any specifics around what the future might hold, but it certainly seems that the government will rescue the system from most any peril. Should we expect it to? Yes. Will it? We have no idea.

This is why I believe banks will continue to be largely undercapitalized, and The Fed will likely step in to print even more money. This is not a certainty, but seems likely based on recent history. Nor can we conjecture on the moral hazards that currently do or potentially would plague the system. My guess is that, just like inflation, moral hazards are much less important than the bigger plan of keeping the system going. At higher levels of debt, the goal of keeping the system going may be harder and harder to accomplish, but The Fed seems to be committed to doing whatever is needed, even if that's disregarding staggering plans like QT less than a year in.

From the outset, I described a volatile interest rate environment as the cause of investor headaches, but I feel this is only a symptom of a larger problem: that The Fed controls this market and we have no idea what The Fed will do next.

In 1973, asset markets were described by Burton Malkiel as "Random Walks" (A Random Walk Down Wall Street). Due to my discoveries above, I must generally agree with Malkiel, but with a caveat. The caveat being that if we invest in assets that are structurally important, those things that are the most "too big to fail", we will probably have more consistent, positive results.

In the forthcoming sections of this partitioned memo, I describe how Buffett began investing exactly that way and how you can too.