How much time do you have?

Monday, 30 August 2021 — Laramie, Wyoming

[7 min read]

‘State to state. No papers.’

That’s what Captain Marko Ramius (played by Sean Connery) said to Captain Second Rank Vasily Borodin (played by Sam Neill) the ‘90s film The Hunt for Red October. Borodin told Ramius that once the officers of Red October (a fictional Soviet typhoon-class missile submarine) had defected to the US, he would move to Montana, marry a fat American woman (who would cook the rabbits he raised), and buy either a pickup truck or a recreational vehicle.

The idea that you could travel from, say, Montana to Wyoming and cross the border without border control was novel to the Soviet officers. Internal border controls — movement licenses if you like — are the logical step in a centralised, authoritarian society. Having to ask permission to travel freely means you’re not really free.

I’ll come back to that in a moment. But first, did you see the cyclically adjusted price-to-earnings ratio (CAPE) went above 39 last week? It’s the first time it’s done that since 2000. And you know what happened then, right?

In case you forgot (or weren’t born yet), have a look at the chart below. The peak-to-trough loss in the Nasdaq 100 was almost 78% over the next 28 months. If you were late to the buying party and bought near the top in 2000, you would have spent 15 years out of the money, waiting for the NDX to make a new high in 2016 (which it finally did).

The big loss is brutal

One school of thought is that this proves a simple point: stocks win over the long run. If you’d had the courage or foresight to identify the low in early March of 2003, then buy and hold through thick and thin, richer or poorer, in good times and bad, you’d be up 1,456% on an NDX index fund. The best-performing members of the index have likely done far better than that.

So which is it? Stocks for the long run or avoid the big loss?

The biggest variable — and the one that’s unique for every investor — is time. How much time do you have? Do you have enough time left in your investing career to let ‘stocks for the long run’ make up if you take a 50% drawdown (or more) in the value of your portfolio? And can you be sure that stocks will resume marching right back up if they do indeed experience a mean-reverting crash?

These are the questions we took up in the latest issue of The Bonner-Denning Letter (to be published later this week in Australia). At the top end of a bull market, valuations don’t matter. Liquidity is what matters — at least with respect to momentum. As long as the money flows (financial and monetary conditions remain ‘easy’) then a certain asset class (stocks) and certain sectors (tech) will make new highs.

But valuations do matter in the sense that they tell you where you are in any given market cycle. The richer they are, the later in the cycle. You know it’s late (and people are getting nervous) when you start to see long and elaborate articles on why valuations don’t matter. For example, I saw one on MarketWatch titled ‘Why stock market bulls may be right to push valuations so high’.

It’s not complicated, although it would be better if Greg Canavan were here to explain it. It comes down to the relationship between the risk-free rate of return (as usually defined by a government bond) and the discount rate you use to value growth assets (stocks). The higher the risk-free rate, the higher the discount rate, meaning (generally) a lower valuation on growth assets. Why?

If the risk-free rate is high, it means investors are uncertain about the future, including future cash flows. They require (and receive) a high interest rate on ‘risk-free’ government bonds to compensate them for the amount of time they’re locking their capital up (or exposing it to shocks like recessions and inflation).

And because economic (and earnings) conditions are more uncertain in a higher interest rate environment, investors (the old-fashioned kind) tend to use a higher discount rate when valuing stocks. In plainer terms, you can’t afford to take future cash flows for granted, so you discount them at a higher rate, which tends to hurt growth stocks.

Why does any of this matter? Because, through financial repression (to reduce the cost of huge debt burdens), central banks have reduced the risk-free rate to zero (or negative, if you look at the 10-year US Treasury in real terms). The risk-free rate of return in government bonds is, in real terms, negative in places like Germany, Japan, and the US.

How do you value a growth asset when the risk-free rate of return is negative? You don’t! You get on the liquidity bandwagon, take your hat off, wave in the air, and shout ‘Yippee!’ or that valuations don’t matter when liquidity is abundant, and the risk-free return is negative.

My point is that those are extreme conditions. And like extreme conditions in nature, they’re very dangerous to attempt, even for ‘experts’. It’s ironic in a way, that the risk appears to be the highest when the ‘risk-free rate’ is historically low. But that’s why Bill and I have been saying all asset prices are fake, to the extent that they’ve been willfully distorted by rigging interest rates.

We’re advising readers that instead of risking your capital on future gains, job number one now is to avoid the big loss. Some people to think that the Fed won’t allow a big stock market crash now (or ever again). The stock market has become a proxy for economic confidence. It’s too important to be allowed to fail.

But that kind of thinking, too, is typical late in the bull market cycle. It could never happen here. It’s a new era. Hakuna matata! Which brings me back to how to be free in an unfree world…

Australia, and many parts of the US, had suddenly slid into a new era of government control. The closing of state borders, the introduction of movement license or mandatory vaccination, the idea that exercising your freedom and taking responsibility for your own life is selfish, dangerous, and maybe even criminal…these are all examples of a breakdown in civil society through massive government overreach.

What we learned in the last two weeks is that you can spend 20 years patiently building up an illusion (nation building in Afghanistan), and that it can fall apart in days. It can happen for any narrative based on belief. That includes stock markets and lockdowns too. Tick, tock.

Until next time,

Dan Denning,
Editor, The Rum Rebellion

Some day in the future…we’re going to understand the world better.

Among other things, perhaps we will have a clearer view of that wonderful, wacky world of cryptos…

Are they investments? Are they alternative forms of ‘money’?

Or are they more like an art form…or just entertainment?

Maybe they’re a kind of financial pornography…exciting, but ultimately, phony, and unsatisfying?

When we figure it out…you’ll be the first to know, dear reader.

Signal event

Similarly, the COVID-19 panic needs a deeper insight.

Our friend, and former US budget director, David Stockman, reminds us that the signal event in the first chapter of the COVID-19 calamity was the isolation of the cruise ship, the Diamond Princess.

The ‘novel’ COVID-19 virus was found on board in February last year. And the passenger list was heavy with old people — every one of whom might have been exposed to the death bug.

‘Order the lilies,’ said one and all. ‘Those people are doomed.’

But they weren’t doomed.

Out of the 3,711 people trapped on the death ship, only seven died, according to Stockman. While that was a much higher mortality rate than on the average holiday cruise, it was not exactly the plague.

Besides, nearly every one of the dead was over 70, the age when death normally begins peeking in through the portholes.

Blind panic

That was then, when nobody really knew much about the virus, and the initial reports had the whole world in a panic.

Now, it is 17 months later. We’ve seen that the disease, and its variants, are very hard to stop. And that it really has it in for old people.

Some countries fought it tooth and nail. Yes, that got pulses racing too — as if the planet had been invaded by hostile aliens.

Other countries took a more relaxed approach. And the results — in terms of death tolls — were all over the place.

But then…hallelujah! Suddenly, a miracle — a vaccine! The Russians…the Chinese…the British…even the Cubans had one of their own.

With the shot in the arm, the human race was saved. Take the shot, says Dr Anthony Fauci, and you are protected.

Continued hysteria

But what’s this? Here’s a headline that appeared on Bloomberg during the week: ‘Get Shots or Get Out: US Employers Are Telling Workers’.

And here’s The Washington Post on the same theme: ‘More companies are weighing penalties for unvaccinated workers’.

Meanwhile, my better half is back in the US, she reports the following:

‘We got an invitation to a lawn party. It looked like fun. So I was going to take [our grandchildren].

‘Then, I read it more closely and saw that the “invitation is extended to all those who are vaccinated.”

‘I don’t get it. Dr Fauci was on the news today. He clearly said that the vaccines are effective and that vaccinated people don’t have too much to fear. Even if they get the virus, they suffer much less from it. So why are people so afraid?’

If the vaccine is as effective as Dr Fauci says, it makes COVID-19 — to vaccinated people — no more of a threat than the common cold or the typical flu.

People who take the medicine are no more likely to catch the coronavirus, and die from it, than they are to die in a traffic accident on their way to the party.

So why the fear?

Why don’t vaccinated people go about their lives like normal people — without masks — and let the unvaccinated take their chances?

Why the continued hysteria? Is it just a fake excitement…a porno-like thrill, full of sound and fury, panting and moaning, but signifying nothing?

Questioning our assumptions

We don’t know…but like cryptos, we’re on the case.

And we have a suspicion that both the crypto craze…and the COVID-19 panic…are related to our subject this week.

But what isn’t?

We’re exploring how an economy actually functions…and how false signals, sent out by the feds, created a kind of porno-economy…full of fake action and unrealistic expectations.

This week, we dug down to the bedrock…the hard foundation of ideas that helps us understand what is going on. If we’re wrong about them, we may be wrong about everything:

Maybe you really can get rich by printing money…

Maybe it’s not really sweat, toil, saving, and innovation that create wealth; maybe prosperity comes from government decrees…

And maybe we owe our standard of living not to Henry Ford, Andrew Carnegie, and Steve Jobs…but to those selfless politicians and bureaucrats, who so carefully regulate and control our lives…

Don’t they make sure that the ‘male’ and ‘female’ ends of the iron pipe screw together properly?

Don’t they tell us when we should wear our face masks…and exactly how much inflation — 2%, not 3% or 4% — the nation needs?

Saviours and protectors

Didn’t Franklin D Roosevelt’s ‘New Deal’ pull us out of the Great Depression?

Didn’t Federal Reserve Chief Ben Bernanke’s ‘Courage to Act’ save us from another great depression in 2008?

Didn’t Dr Fauci protect us from a catastrophic plague?

We’ll back up the tape and take a closer look this week.

Regards,

Bill Bonner,
For The Rum Rebellion