Predictions are Worthless

I hope you had a great Thanksgiving!

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.

Random

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:

Eat any good books lately?

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.

Beware of Gurus Peddling Predictions

My Macro Obsession

I have a problem that I think a lot of investors have: I love macroeconomics.

There are few things more fascinating to me than trying to predict the economic cycle. I want to know if we’re going to have a recession or if we’re going to have a boom. I want to know if inflation and interest rates will roar back to life. I like to look back in history and analyze the twists and turns and hope that can shed light on what will happen next.

It’s a fun exercise, but it’s largely a waste of time.

The trouble with my macro-obsession is that it has led to poor investing decisions and outcomes. I failed to buy a number of stocks that were attractively priced in March because I was convinced that the United States was headed for a second Great Depression. I looked at the overvaluation of mega-cap stocks and used that as a reason to avoid other, more attractively priced, stocks that were outside of that universe.

I was completely wrong and blew it, as did many others in the market. At least I admit it.

Getting that wrong was a humbling experience for me.

I could have doubled down — I wasn’t wrong, the Fed is merely compounding their errors! I wasn’t wrong, the collapse was simply delayed! I’m not wrong; the government is lying about the unemployment and inflation statistics!

Do those responses seem like a rational explanation, or are they an example of bargaining and an attempt to rationalize an error?

Instead, my experience has led me to a different conclusion: macroeconomics is really hard and a waste of time. I want to have a portfolio that is prepared for different macroeconomic outcomes — but I’m not going to bet on a single one of them unfolding.

Some might say that macro prediction is worthwhile. I might have been a dummy about it, but they’re not dummies and they can do it!

Well, the question I ask of them: How many people can you name off the top of your head that became rich with their macroeconomic predictions?

If you go through the Forbes 400, there aren’t any macroeconomists. In other words, no one who has devoted themselves to a study of what makes the world’s economy tick have been able to get rich by predicting economic cycles, currencies, or interest rates.

Macro Gurus

The most famous macroeconomist in history is John Maynard Keynes. What is most interesting about Keynes is that he started out investing by trying to predict the economic cycle. He tried to predict recessions, currency movements, and the prices of commodities.

In the early 1930’s, he lost 80% of his money. He failed at attempting to predict macro-economics. This caused him to move on from top-down economic analysis to a focus on value investing: buying individual businesses at a discount to their intrinsic value.

If Keynes can’t do it, what makes you think that you can?

Within the Forbes 400, there are only two people who have used macro-economic predictions to consistently make money: George Soros and Ray Dalio.

For those two individuals, it’s also important to note that they don’t bet everything on a single outcome, and they are frequently wrong.

Dalio successfully predicted the financial crisis of 2007–09, but he has also been saying that we are in a situation similar to 1937 for most of the last decade. The 1937-style market decline has never materialized. He also proclaimed that “cash is trash” in early 2020 shortly before the COVID crash, when many hoped that they had more cash in their portfolio.

Dalio isn’t the only one who can get macro wrong.

There are plenty of other gurus who got things wrong.

Here is a macro prediction from Seth Klarman:

“By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

This was not from April 2020. It was from May 2010. If you invested $10,000 on the day that this prediction was made, you would now have $35,000. Klarman got it wrong.

It’s also worth noting that Klarman isn’t rich because of macro predictions: he’s rich because he shrewdly buys assets when they are at a sharp discount to his estimate of intrinsic value, which he is quite skilled at calculating.

George Soros is famous for a successful bet against the British pound in 1992. He has become a billionaire by making outsized macro bets. But he’s hardly foolproof.

In 1987, he argued that the world’s reliance on the dollar would lead to: “financial turmoil, beggar-thy-neighbor policies leading to world-wide depression and perhaps even war.”

It didn’t happen.

In 1998, he made similar predictions in his book “The Crisis of Global Capitalism” and those predictions did not materialize.

If Soros frequently gets it wrong, then how is he successful as a macro trader?

The thing is: he’s a trader and he acknowledges errors and corrects positions when they’re wrong. He never bets everything on a single prediction. Soros makes many bets and never bets the ranch on a single outcome. He’s flexible and will move out of positions when he is wrong. Soros himself has said: “I’m only rich because I know when I’m wrong.”

In 2010, a who’s-who of the financial world wrote a letter in the Wall Street Journal imploring the Federal Reserve to stop their quantitative easing program. In their words, they believed that quantitative easing would risk “currency debasement and inflation.”

They were wrong! The reality is that the 2010’s witnessed some of the lowest inflation on record. The US Dollar actually strengthened after quantitative easing.

Of course, perma-bears and Fed critics will scoff at this. They’ll say that if you actually measure inflation by their metrics — inflation is actually higher than the government’s lies!

Another argument is that inflation hasn’t come through actual increases in the prices of goods — the entire stock market boom of the last 10 years has been inflationary.

Another argument would be that the only reason that the USD has strengthened is because other central banks have ramped up their “money printing” more than the rest.

Does this sound to you like sound reasoning, or does it sound like bargaining and attempt to rationalize a prediction that was wrong?

They never seem to consider the possibility that they just got it wrong. What’s more likely? That they were wrong 10 years ago, or that government statistics are lies and the debasement occurred anyway?

As for the “it didn’t affect prices of goods, just assets” — well, if all of this “money printing” was going to cause asset inflation, then why didn’t these people buy financial assets? Why weren’t they able to predict that it would cause a decade long bull market and successfully position for it?

Hindsight is 20/20. No one likes to admit that they’re wrong, so they invent excuses instead of facing the possibility that they might have just been wrong.

The reality is this: no one can predict the macro-economy. The two people on the Forbes 400 that were actually able to predict macro are error prone. When they do make errors, they own up to them and quickly correct their position. This is a sharp contrast to the macro guru’s that you’ll find on Twitter.

If there aren’t any rich macroeconomists — if there aren’t any rich financiers who did it by predicting the macro economy — if the only two people that got rich from macro make errors — then what makes you think that you can do it? What makes you think that your favorite Twitter guru can do it?

Be Wary of Gurus Bearing Predictions

There are a many gurus in the financial world. They make their proclamations on Twitter, on podcasts, or on TV. They sell books proclaiming their predictions. They exude total confidence.

My question is simple: if they can predict what’s going to happen, then why aren’t they already rich from it? What makes them better than George Soros, Ray Dalio, or John Maynard Keynes?

This is the reality that I wish I absorbed earlier. I suppose it’s something I had to learn via experience.

The reality is that nobody knows what is going to happen.

Most of the people confidently proclaiming financial predictions are selling something. Always approach their predictions through that prism. What are they selling? How do their proclamations tie into what they are selling?

They are attempting to sell books. They want higher ratings on podcasts. They want you to subscribe to their videos or sell ads.

Saying something like: “Have a balanced portfolio prepared for different outcomes” does not generate clicks and ratings. Proclaiming our imminent doom does generate ratings and clicks.

They have an agenda and it’s important that you realize that before consuming that content.

This doesn’t mean that macroeconomics is a total waste of time or should be ignored. I simply think that it is folly to imagine that any of us can predict the next turn in currencies, inflation, interest rates, or the economic cycle.

It does make sense to imagine how a portfolio would react in different situations. There should a plan for different outcomes. I think it makes sense to hold a diversified portfolio of assets that will deliver a return in different macro environments.

This is what Harry Browne tried to do with the Permanent Portfolio, which is a better template to think about these matters than trying to find the guru with the right crystal ball. The Permanent Portfolio is prepared for different macroeconomic outcomes. I have my own spin on this with the Weird Portfolio.

Whatever the mix, it doesn’t matter. The key is to acknowledge that macro prediction is really hard and likely a waste of time.

While it makes sense to have plans for different outcomes, it doesn’t make sense to think that you can actually predict the twists and turns of the macroeconomic landscape. Prediction is a fool’s errand and I’m a fool for attempting. I was a fool for trying to do this. At least I own up to it.

Will the Doomers eventually be right and will we have inflation? Well, I own some gold in case that happens. Will we have another deflationary bust? I own long term treasuries if that happens. I have some cash in an emergency fund. Will the US be replaced as a superpower? I have assets in other countries in case my country falls behind.

Will civilization collapse? Well, then it won’t matter how a portfolio is positioned, anyway. Guns and canned goods will carry more value than gold bars, puts on the S&P 500, or Bitcoin. (I have guns and canned goods, too, because I’m a bit paranoid!)

If you find yourself totally absorbed in a single macroeconomic thesis, I would caution strongly against it. The greatest names in Finance frequently fail at that game. There aren’t any rich macroeconomists.

Be careful out there and be wary of gurus peddling predictions.

Random

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.

Swing, You Bum!

I hope you had a fun Halloween!

60% Cash

For most of this year, I’ve had most of this account in cash.

At the end of last week, 60% of this account was in cash, earning nothing.

With my new strategy – a concentrated 12 stock portfolio of wonderful companies purchased at wonderful prices – it is going to be difficult to deploy all of this cash right away.

I am on the hunt for rare birds – wonderful companies at wonderful prices. My goal is to fill up a portfolio with 12 of these positions. The problem is that these situations are rare, so it will take some time to find 12 of them.

So far, I have 4 of them: Charles Schwab, General Dynamics, Enterprise Product Partners, and Biogen. I need 8 more.

I find myself going through many different stocks, and passing up on most of them. Each week I am researching at least three different companies. I am saying “no” a lot.

This is a sharp contrast to my old approach, where I would settle for lots of subpar stocks just to fill up a portfolio and hit the 20-30 stock target that you’re “supposed” to own.

My biggest hurdle – only buy positions I would be comfortable holding for 10 years if I was forced to – is particularly rigorous.

I am finished with settling with mediocrity in my portfolio. I am no longer going to settle for 80% conviction. If I buy a stock, I want to be 100% comfortable with the business and the valuation. I only want to swing at the fat pitch.

Warren Buffett explains this philosophy better than I can: “The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!” – ignore them.”

The Temptation to Swing

With that said, being 60% cash is a tad ridiculous. It’s a stealth form of market timing, which is something I want to move away from.

If there is one thing that 2020 has taught me, it’s that I am unable to time the market and predict macro. Market timing isn’t something I should do, whether it’s overt (like my purchase of short ETF in March), or stealth (like keeping 60% of this portfolio in cash).

Another issue with holding all of that cash is that it tempts me to buy stocks that I don’t feel 100% comfortable with owning.

This leaves me with a unique problem: what to do with 60% of my portfolio that is sitting in cash, earning nothing?

I could simply buy SPY, but that’s not something I want to own. The market is ridiculously expensive and I don’t think market cap weighting is the optimal way to invest, as I’ve talked about on this blog.

I also don’t want to go 100% small value. I still want something that will be cushioned if stocks drop, so I have “dry powder” to pile into wonderful businesses at wonderful prices. Small value isn’t a place to hide during a severe recession.

The Weird Portfolio Solution

Fortunately, I already had a solution and it was staring me in the face: the weird portfolio.

Why have most of this account sit in cash, when I’ve already developed a sensible asset allocation: global small value, real estate, gold, and long term treasuries?

This is an asset allocation with built in protection for multiple economic environments and an asset allocation that I am confident will grow over time.

Why not use the weird portfolio for all of this cash I’m sitting on?

Rather than hold cash while I await the opportunity to buy wonderful businesses at wonderful prices, I will hold the weird portfolio instead.

That is what I do with the rest of my money outside of my cash emergency fund, so I will do the same for the cash in this account.

I think it will prevent from settling for subpar businesses or subpar prices.

The urge to “swing, you bum” is strong and hopefully this will reduce the temptation to swing at subpar pitches. I only want to swing at the fat pitch. While I wait, I’ll camp out in the weird portfolio.

Random

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.

Trades

Rather than have 60% of my portfolio sit in cash while I await the opportunity to buy a wonderful business at a wonderful price, I moved my cash balance into my weird portfolio approach.

As I’ve stated – my criteria for buying individual stocks are now very strict and I’m not going to settle for something I’m not 100% comfortable with. It will take a long time to find 12 of these positions. Rather than hold cash while I hunt for these opportunities, I will have my cash balance in my weird portfolio approach.

I think this is a better approach than sitting on such a large cash balance.

Bought 56 shares of VBR @ $115.31

Bought 62 shares of VSS @ $103.17

Bought 85 shares of VNQ @ $77.40

Bought 66 shares of VGLT @ 96.80

Bought 335 shares of SGOL @ $18.173

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.