What a time! Some used car prices have jumped to over the price of a new car! We are just coming out of lock downs, shutdowns, and face-downs and now the biggest European war since World War II has erupted. What are investors to do?
It reminds me of two of the great investors. Warren Buffett said: “Be greedy when everyone is fearful and fearful when everyone is greedy”.1 Peter Lynch said “When I ran the Magellan Fund, the market had 9 declines of 10 percent or more in those 13 years. I had a perfect record. All 9 times, my fund went down.”2 Lynch averaged a 29% annual return over those 13 years, and yet people lost money. They sold during the lows and bought back during the highs. They did just the opposite of what should be done.
It seems like a crazy time right now. As I listen to the talking heads and pundits on TV and read the guru-talk in magazines and papers, I am struck by the number of comments that the Fed has lost control. In my opinion, they face a difficult task and are, so far, in control. I am not sure these commentators really understand what the Fed does.
Nor does it seem to me that they have a grasp on what the war means for individual stocks and earnings. It seems like rationale has departed and fear drives decisions.
First, consider inflation. There are two types of inflation: “supply push” and “demand pull”. Supply push inflation is driven by a shortage of supply and subsequently prices increase to meet demand. The used car market is an excellent example of supply push inflation. New car production is lagging because of a shortage of chips, therefore buyers have been purchasing used cars. Because, of course, there are only a limited number of used vehicles on the market, the prices of those remaining have been marked up.
When the supply chain rights itself and production returns to normal, price pressure will subside, and supply push inflation will abate. But that is only one factor where inflation is concerned.
The Fed has a great deal of control over short-term interest rates because they set the rate at which banks can borrow from one another – the so called “Fed Funds Rate”. Longer-term rates are dependent on the market. Every week, the US treasury auctions off treasury bills, notes, and bonds. The funds from these newly issued treasuries are used to pay off maturing debt and the current deficit. It is during that auction that prices and interest rates are set on longer-term treasuries.
The Fed mints money. When you and I purchase a bond, we write a check against funds in our checking or brokerage account to pay for the bond. If you deposit a $100 bill in your bank account, a $100 credit is added to your bank account ledger. When you pay a $83 bill, that withdrawal also becomes an entry in your ledger.
The Fed has no checkbook or checking account. They can simply buy a bond by making a ledger entry in the seller’s account. In doing so, the Fed has created money. The Fed has been doing that for many years now, and they have $9 trillion in assets for which they have created money. That is the process for “printing money”.
With that in mind, consider “demand pull” inflation. This occurs when there is too much money chasing too few goods. If the Fed had been “printing money” in normal times, there is little doubt that inflation would have soared. However, that was not the case in 2020. Consider the airlines. When COVID hit and the airlines shut down, the US government granted a chunk of money to the airlines to keep them from bankruptcy. During normal times, the plane seats would be filled by passengers paying for their flights. During COVID, the planes did not fly, and so in this way the government was essentially buying the unsold seats. Government dollars replaced passenger dollars filling the gap.
But now the Fed faces a new concern: they already have $9 trillion in assets on their balance sheet. If they reduce, or “deleverage”, the impact will be the same as “DE-printing money”. As the Fed sells those assets, they will receive payment. However, that act would essentially remove the money from the financial system.
That could increase interest rates but at the same time be deflationary – too little money chasing too many goods. It would be the opposite of demand pull.
And all of this will have no impact on the US government’s debt. The $22 trillion debt remains the same; the shift comes in who holds the debt. When broken down, $7 trillion of US debt is held by foreign countries (Japan is the largest holder with $1.32 trillion; China is second with $1.07 trillion). $3.6 trillion is held by mutual funds. Some $12 trillion is held by banks, insurance companies, individuals, and other institutions. The Fed owns $5.7 trillion.
The debt will remain the same and may, in fact, increase with added need to cover the deficit. To deleverage $5.7 trillion would put significant pressure on treasury prices.
In my opinion, the Fed has not lost control, but they do face a daunting problem. They must figure out how to unload 25% of the US national debt plus another $3+ trillion in corporate debt without sending the national economy into a deflation cycle and without creating a troubling bear market in bonds
All that and recovery from COVID and now a war. This is not an easy time. But there are companies still making money and in the longer-term I believe that means, for those companies that are increasing earnings, their share prices will eventually reflect this reality.
We have been through these downturns before. Irrationality and fear set in, but they have very little to do with the fundamental value of stocks. This is not the Great Recession where company earnings fell. This is not the Dotcom bust where tech stock prices soared even when the companies had no revenues let alone earnings. This is a full employment recovering economy with many companies reporting record earnings.
During his 13 years managing the Magellan Fund, Peter Lynch averaged an annual return of 29% per year, and yet there were those who lost money. They got fearful and sold when the fund was down, and they got greedy when the fund was up and bought. They sold low and bought high. Those who benefited from the 29% return rode through the ups and downs.
That has been a lesson not lost on many financial advisors and individuals. However, there is a caveat. Peter Lynch out-performed the market over the longer-term. The downs were offset by the upside. Just holding on, in my opinion, only works when there is superior stock selection in addition to resolution. I believe the only way to evaluate that is to look at the long-term track record of the manager. If there is no track record posted on the advisor’s website, what do you think the reason would be?
There’s an old saying: “When you are up to your bellybutton in alligators it is hard to remember your original objective was to drain the swamp”. To paraphrase this, “When you are up to your eyeballs in war, inflation, insurrection, pandemic, and everything else it is hard not to think the light at the end of the tunnel isn’t a train”. It may only seem like a train, but we have been through this a number of times, and it had worked itself out before. I believe it will again.
1. Buffett, Warren E. “Chairman’s Letter – 1986.” Berkshire Hathaway Inc., February 27, 1987. https://www.berkshirehathaway.com/letters/1986.html.
2. Viewpoints, Fidelity. “Peter Lynch: Secrets to Success: Investing Lessons.” Fidelity, September 18, 2019. https://www.fidelity.com/viewpoints/investing-ideas/peter-lynch-investment-strategy.
