Macroeconomic Predictions are Worth Less Than Used Toilet Paper
This year, it finally became clear to me that the macro economy is truly unpredictable and most predictions are worth less than toilet paper.
I previously thought that you could predict the economy to a limited degree – i.e., you could use things like the yield curve and valuation metrics to show when animal spirits were high and a collapse was near. Now, I don’t even think that is possible.
The economy is more unpredictable than the actions of an individual that has recently consumed 10 shots of vodka and three red bulls. They’re not going to pass out – they’ve had 3 red bulls, after all. Of course, their brain is completely shut off from any semblance of rational thought. Who knows where the night will lead? Probably nowhere good, but the specifics will be quite unpredictable. Butchered karaoke? A fall on concrete? An ill-advised romantic liaison? An iPhone in a toilet?
Actually – scratch my earlier comment – 2020 showed that toilet paper can be quite valuable and worthy of brawls similar to those over big TV’s on Black Friday.
Let’s go with this: macro predictions are worth less than used toilet paper.
Who could have predicted in January that a pandemic would spread throughout the world and that governments would respond by completely shutting down their economies? An economic shutdown is something they didn’t even pursue in 1918. Shutdowns were like using shotgun blasts to kill a mouse. As fun as that sounds, it isn’t the ideal solution.
In April, who could have predicted that the pandemic wasn’t going to spread as fast as we feared? Who could have predicted that once restrictions were lifted that GDP would rapidly recover and unemployment would begin declining?
There are a bunch of people who did recognize COVID early on – but with rare exceptions, these are mostly the same people who have been predicting a Mad Max style economic apocalypse every day for the last 10 years. From a markets perspective, they had their day in the sun for a month.
There are also folks who “predicted” the turnaround in markets and the economy and went all-in on stocks in March, but how useful is that if they didn’t successfully predict the March crash ahead of time and have cash to deploy?
It was also quite possible that a 30% decline wasn’t enough. Market history would suggest that that the decline would be more like 50% if the recession were anything like 1973-74 or 2007-09.
My conclusion is simple: trying to predict this stuff is impossible and a waste of brain matter.
I suppose that prediction can be viewed as a fun little game. Maybe it’s financial entertainment (isn’t that an oxymoron – like vegan chili?).
Unfortunately, for many people (including me), it turns into a lot more than that and people start thinking they can predict macro like they’re the next Stanley Druckenmiller (they’re not).
Where is the hyperinflation?
Since 2010, I’ve consumed a lot of very bearish content.
The details differ but the same thread pervades all of it: The Fed and quantitative easing are insane, the Fed is fueling a debt binge and a bubble in stocks & real estate, and the system will eventually collapse because of it. Zimbabwe, hear we come.
When you consume enough of this content, you eventually want to sell every stock you own and load up on gold/puts/bitcoin. In more extreme scenarios, you may want to load up on guns, ammo, and canned goods. They’ll only take the Chef Boyardee from my dead, cold hands.
The trouble with this “the Fed is destroying the financial system” line of reasoning is that it has been wrong for a long time, even though it is quite convincing.
This was all of the rage circa 2010, as we emerged from the financial crisis. The Fed responded to that financial crisis aggressively. Back then, I thought that all of this “printing” would eventually have some kind of dire consequence.
After all, as someone who grew up Catholic, I always assume that any degree of fun or success will be swiftly punished.
This video became widespread around this time that sums up the zeitgeist pretty well:
There was also this letter to Ben Bernanke written by some of the greatest financial minds of the planet warning that quantitative easing must be stopped.
From the letter: “The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment.”
The problem is that the hyperinflation and dollar collapse never happened.
Here is a look at the inflation rates by decade:
The 2010’s actually had the lowest average inflation in the last six decades. This is quite surprising after a “money-printing” tsunami has engulfed the world after the financial crisis. The US dollar also strengthened in the 2010’s.
There are a lot of explanations for why inflation didn’t happen. I tend to think it has something to do with the declining velocity of money.
Whatever the explanation, the key thing is that everyone was wrong.
When I hear people complain about inflation today, I think it’s pretty funny. I remember as a teenager in the 1990’s that people were elated that inflation was so “low” because their baseline was the 1970’s. It was viewed as an economic miracle that inflation was only 3%.
It’s funny how three decades of low inflation can transform people’s perspectives. Now that memories of the 1970’s have faded, 2% inflation is viewed as unacceptable debasement that will trigger the collapse Western Civilization.
Meanwhile, 10% inflation in the 1970’s didn’t cause a collapse, but we were unfortunately subjected to disco.
The Doomers will go on to say that inflation is here, but the government is lying about inflation rates. They’re not wrong, the government is lying. Indeed. The higher numbers on my bathroom scale have nothing to do with the pasta I’ve eaten in quarantine – the scale is obviously broken and fraudulent.
Healthcare & Education
The Fed hating Doomers will often point to health care and education as examples of inflation that aren’t covered by the official statistics.
First off, healthcare and education are included in the CPI. If you want to read the actual methods that the government uses to calculate CPI, then read it here.
Of course, why bother reading about the BLS’s actual methodology when you can hate on the Fed and rely on anecdotes for inflation? Have you been to the grocery store lately?
But, whatever. Let’s take the argument at face value. Healthcare and education are examples of inflation that the government is misleading us about.
The relevant question is this: are the increases in healthcare and education caused by the Fed?
Healthcare costs have outpaced inflation since the 1960’s. Education costs have outpaced inflation since the 1960’s.
If the price increases of a good exceed inflation by a few percent a year – and you compound that over 50 years – it will become extremely expensive. That has basically been the story with healthcare & education since the 1960’s.
If these increases weren’t caused by the Fed, then what caused them?
I would argue that government policy caused them.
The Higher Education Act of 1965 made it very easy for students to borrow money to go to college. The government also started to back student loans in the 1960’s as a result of this legislation. This meant that a flood of money (with little price consciousness) poured into a limited resource – higher education. This made price increases outpace inflation.
Compound that for 50 years, and you get really high tuition rates.
Where does the money go? Anyone who has been on a college campus in the last 20 years can tell you. There are recreation centers better than most private gyms fully equipped with “free” saunas and personal trainers. There are administrators with titles like deputy vice president of community climate affairs that make $158,000/year.
Healthcare is a bit more complex but the dynamics are the same. There is little price consciousness in healthcare. No one directly pays for anything. Your health insurance company pays.
This dynamic came out of the high tax rates of the 1940’s. As tax rates increased during World War II, employers looked for ways to pay their employees in ways that wouldn’t be taxed. They found that health insurance was a good way to reward employees and avoid the tax man. Employees liked it.
The result was that health insurance became linked to employment. As health insurance became widespread, instead of going to a doctor and paying out of pocket, everyone started using health insurance for even routine treatments and check-ups.
When people stopped paying directly, they became less price conscious, and this helped fuel inflation in the healthcare sector. Before all of this, you would just pay out of pocket and would shop around for the best price. If your doctor charged you $500 for aspirin and a band aid, you’d say: “What the hell, man?”
With health insurance, you went anywhere you wanted and didn’t really care about the price because the insurance company was paying for it. Compound this for 50 years, and you get a situation where a Band-Aid costs $629 in a hospital.
I was briefly without health insurance and found it annoying how it was hard to get a cash price. When I called a doctor’s office to explain that I would pay with cash, it made their heads explode and they couldn’t quote me a price.
Also, in the 1960’s, the federal government introduced Medicare, which covered the healthcare of seniors. Seniors are the biggest consumers of healthcare. This – predictably – led to increases in the cost of healthcare.
The government kept trying to Band-Aid healthcare inflation over the following decades, but it only compounded the problem.
The core problem with healthcare is that traditional laws of supply and demand don’t work because no one is directly paying for anything. If you compound something that outpaces inflation over 50 years, you get really high prices.
US healthcare costs are now 17.7% of GDP – which are the highest in the world.
The US has an odd healthcare system that combines capitalism with government-fueled taxpayer cash and no price consciousness. It’s like we took the worst aspects of both socialism and capitalism and combined them into an unholy hybrid – like orange juice and toothpaste.
Bottom line, I don’t think that the increases in healthcare and education have anything to do with the Fed, even though they are blamed for all of the problems in the world.
What to Do?
Perhaps you’re like me and you often worry about this sort of thing.
What if the Doomers are right and the economy is a ticking time bomb about to unleash a tsunami of hyperinflation?
They’ve been wrong for 10 years and never apologize for their failures or are held accountable – but let’s take these arguments at face value.
There are many ways to protect a portfolio from inflation without betting the ranch that it will actually happen.
Personally, I have 20% of my asset allocation in gold. Over time, gold will largely retain its purchasing power. It will also be worth something even if the US government collapses, as it has retained value for 5,000 years of human history.
Note: with gold, the road to “retaining purchasing power” is incredibly rocky and volatile, but gold prices have a track record of going bonkers when inflation rates are accelerating when interest rate sensitive assets are getting crushed.
I also have 20% in real estate. Real estate ought to also keep up with inflation. Not only will property itself increase with the inflation rate, but rents will increase with inflation as well.
Another solution is TIPS – or treasury inflation protected securities.
My preference is for gold instead of TIPS because I’m a worrier who is concerned with things like the collapse of the US government and the dollar. This is a side effect of downloading too many bearish predictions of doom into my brain.
If you’re not as worried as me about total collapse, then TIPS are a fine solution. TIPS are treasury bonds that adjust the principal balance for inflation. The coupon on TIPS are determined based on the inflation-adjusted principal of the bond, so both the interest and the principal are adjusted for inflation.
It makes a lot of sense to protect a portfolio from inflation. It ought to be a goal of every portfolio.
Inflation is certainly one of the greatest risks that an investor faces. Over time, a slow and steady rate of inflation will erode the purchasing power of currencies. This is very bad for someone whose asset allocation is cash-in-a-mattress or Walter White’s storage locker:
A rising inflation rate will also cause issues with other assets, as higher interest rates will lead to lower prices for stocks (P/E’s will decline) and bonds (interest rates will go up and bond prices will go down).
However, while inflation protection is essential for a portfolio, that’s different from making a one-sided bet that high inflation is a guaranteed outcome.
There are also plenty of ways to protect a portfolio from a sharp decline in stocks. I use long-term treasuries, but that is far from the only solution. Hedging strategies are also available. Cash helps. Most inflation solutions (TIPS, gold) also tend to hold up well in a crash.
Having these elements in a portfolio as insurance is different from trying to predict them.
As the last year and decade have demonstrated, this stuff is unpredictable. The best economic minds thought that higher inflation was certain in 2010 and they were completely wrong. In March, it looked like the US economy was headed into a second Great Depression. That didn’t happen, either.
The beauty of a good asset allocation strategy is that you don’t have to predict anything.
With something like the weird portfolio, I sleep well at night knowing that no matter what unfolds in the macro-economy, I’m covered. I own an asset class that will do well in most macro environments.
I think that’s the better way to approach this stuff rather than pursue the fool’s errand of attempting to predict the future.
Also, the weird portfolio isn’t the only solution. There are plenty of others. I learned a lot from Harry Browne’s Permanent Portfolio, which you can read about here.
The key takeaway is that macro is completely unpredictable. Anyone selling you a prediction is either a fool (this is the case with my predictions) or has an agenda – like pumping up the price of an asset, selling ads on a podcast with provocative content that boosts ratings, or selling books.
Don’t get swept up in it.
Shut it off.
Prepare, don’t predict.
If you are looking for a different take on the Fed (from someone who actually got it right in 2010), then I highly recommend the work of Cullen Roche. This is an excellent post he wrote addressing common misconceptions about the Fed.
One of my favorite TNG episodes:
PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.