What should investors do now?

The ‘fog of war’ is a term used to describe how difficult it is to know what’s going on in a battle when you’re in the battle. There seems to be a parallel in financial markets: the ‘fog of recession’. No one seems to know what’s going on, so it seems smart to avoid making any significant decisions on how to put money to work. Even Warren Buffett, who once said, we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful, is responding to this crisis by raising cash at Berkshire to all time highs.

There has been, and always will be, the possibility of low probability events shifting our course in dramatic ways.

Given this certainty regarding uncertainty, how should you invest? You could follow the general consensus by fund managers and shift your portfolio into cash and/or treasuries. History and intuition tell us that these assets will under perform over the long term, but they may be the appropriate response to a long depression. I believe that the true death rate of Covid-19 is far below 1%, the infection has already reached far more of the global population than we are currently accounting for, the threshold for herd immunity is far lower than the 60–70% being mentioned, and that science will allow us to return to our pre-Covid habits in 2021. If this turns out to be true, it’s likely that cash and treasuries will significantly under perform other assets in the near term.

Regardless of what the future holds, in times of uncertainty (which is all the time), it’s important for investors to focus on what we know to be true. What we know to be true, based on both history and intuition, is that assets are priced based on narratives around two factors: growth (i.e. the rate of increase in the amount of goods and services produced each year) and inflation (i.e. the rate of increase in the costs of those goods and services).

It’s going to be helpful to understand why these two factors matter so much for investors. Virtually all assets are priced in relation to the rate investors are willing to lend to the U.S. government (the risk-free rate), and this rate is reflective of the consensus around growth and inflation over the length of the loan. If you expect high growth and inflation, you will demand a higher interest rate from the government and vice versa.

These interest rates, which are driven by expectations around growth and inflation, and central banks’ response to these expectations, influence how all assets are priced. All other debt (mortgage, corporate, municipal, etc.) is essentially lent at an interest rate of: risk free rate + additional interest to compensate for the risk of a given bond.

The pricing of stocks is also significantly influenced by these interest rates. A stock is a claim on the future earnings of a given business, and those future earnings are discounted to today’s level using the risk-free rate and some risk premium associated with a given stock. Even safe haven assets such as gold, and maybe even cryptocurrencies, are priced in relation to expectations of how real risk-free rates will shift.

A lack of understanding of how risk-free rates impact the pricing of other assets can create confusion around market reaction to events. As of this writing, the S&P 500 is down about 15% from levels experienced a few months ago. Nearly every media outlet is reporting that this seems like an inadequate fall for an event that’s resulting in the greatest economic contraction since the Great Depression. What this reporting fails to realize, is how significant the revaluation of stocks has been.

As stated earlier, the value of a stock is its claim on the future earnings the underlying business will produce, discounted to today. The job of determining an appropriate price for a set of stocks like the S&P 500, is two fold. First, determine the future earnings stream of these 500 companies, and then, discount that earnings stream back to today.

Looking at stock prices in relation to expected earnings alone, to gauge how optimistic the market is about the future, is incomplete. These traditional pricing metrics miss a key step of the pricing process, which is the discounting of earnings: something that happens at a discount rate based on factors mentioned earlier. A complete measure of investor confidence needs to consider how prices are in relation to both an earnings stream and a discount rate.

A valuation metric I made up to try to do this is the price divided by the last 10 years of earnings and multiplied by the 10 year risk free rate. This metric connects prices to both an earnings stream and a discount rate. I have this data going back 140 years, and it shows that large spikes indicate excess optimism and deep troughs indicate excess pessimism towards the future:

This indicator reached 18.9 in April, the lowest reading ever, with data going back to 1881

Risk free rates have hit all time lows in response to the crisis

After also taking into account how much interest rates fell in response to the current crisis, the level of pessimism around the market is historic. Narratives that markets are underestimating the impact of Covid are misguided because they fail to consider how much the discounting calculation has changed in response to the crisis. The market is treating this event as a once in a lifetime economic catastrophe. The price in relation to a discounted earnings stream is at the most depressed levels in recent history.

As long as discount rates stay this low, stocks will be historically cheap. Right now, being long stocks and short treasuries makes sense to me as a way to benefit from the current pricing, and protect against it becoming less attractive in the form of higher interest rates.

That being said, investing as a task is never done. The pricing of all assets is highly sensitive to narratives around growth and inflation. As such, the job of an investor is to relentlessly focus on the following two items:

1. Understand the narratives around growth and inflation
2. Find assets that are trading attractively in relation to one’s understanding of these narratives

As we enter a new decade, there are many narratives around growth and inflation to consider. Some of these have been altered by the pandemic, but many haven’t. I believe having a strong understanding of the truth underlying these narratives will be key to navigating markets, since market consensus around growth and inflation affects the pricing of all assets.

Narratives that can lead to higher growth:

1. Continued development of artificial intelligence and associated gains in productivity
2. Innovation required to address concerns around C02 emissions
3. Impacts of globalization on those living in poverty, particularly in South Asia and Africa
4. The possibility of new frontiers to for individuals to innovate in: Ex. Space

Obstacles for growth:

1. Demographics: Low population growth rates and rapidly growing elderly population will cause labor force growth rates to shrink and turn negative in some countries.
2. Debt: Global Debt to GDP levels are at all time highs. There are persistent and growing deficits at the federal and state levels in the U.S. Also, very importantly, the effectiveness of monetary stimulus is reaching its limit.
3. Limited runway on historical innovation platforms: As software, mobile and the internet have now achieved widespread adoption, growth rates will continue to slow.
4. Permanent lifestyle changes in response to the pandemic: Ex. commercial real estate losing value because of permanent work from home, airlines losing value because of sustained drop in business travel, etc.

Narratives that can boost inflation:

1. Declining investment in energy and materials in response to Covid could result in an inflationary impulse in 2021: companies in these sectors have slashed investment spending and that could lead to inflation once demand recovers, if supply isn’t there
2. Growing nationalism/peak globalization: if developed nations continue to work to bring manufacturing back home, this could result in higher prices for goods, as companies moving manufacturing overseas was a deflationary force over the past few decades
3. Redistribution of wealth: policies enacted to transfer money from the investor class to the lower/middle class will likely result in greater consumption and inflation associated with it
4. Shifts to address CO2 concerns: policies enacted to limit fossil fuel use will result in higher prices if alternatives are not as cheap

Obstacles to inflation:

1. Excessive debt levels: when governments, corporations and individuals take on debt, they are capable of consuming more than they produce. When they pay it back, they consume less than they produce. As debt loads reach historically high levels, we may see lower spending and lower inflation alongside it.
2. Aging populations: For most people, retirement is partnered with a lifestyle of less consumption and more saving. As the retired population grows, this is a force for deflation.
3. Technological innovation: As technology enables us to make better products for cheaper, prices will fall (the good kind of deflation).

All of these narratives are important to consider to navigate markets going forward. There really isn’t much to worry about if you can stay focused on developments in these narratives, especially given that there is already a lot of worry priced into the market. All of my investing heroes seem to disagree with me about the risk/reward in the market now, so we’ll see (fingers crossed), but I think now is a great time to bet on America.