If That Was a Bubble, What Is This?

Are you aware that Warren Buffet’s performance on Berkshire Hathaway (A) was about 1.6% last year? While that performance squeaked out a positive return, he also saw a 30% drawdown as stocks plummeted in the COVID-19 lockdown of 2020. Not to beat up Mr. Buffet for a difficult year. On the contrary, financial performance is always evaluated by looking at your net return in comparison to the drawdown or risk that you experienced. Earning 1.6% against a 30% drawdown is emblematic of what 2020 represented for so many.

Warren Buffet is an investing legend. Historically his returns are incredibly impressive. Most people wish they had put a small amount into Berkshire Hathaway in the 1970’s and just sat on it.

Having studied and read Mr. Buffet’s shareholder letters for many years, I find his wisdom to be very helpful in terms of defining value in the marketplace. Here in 2021, traditional value stocks are as difficult to find as hen’s teeth. If Warren Buffet’s performance provides us with a clue, the idea of buying and holding for the long term seems to be fraught with huge risk in today’s economy. By traditional valuation methods almost everything is massively overvalued. Benjamin Graham, who was Buffet’s mentor and teacher at Columbia, emphasized investing must focus on safety of principal above all else. As Buffet’s returns clearly illustrate, buying stocks or bonds today provide neither safety of principal nor adequate returns for the market risk one must accept.

Last week I wrote an article reviewing the returns of the different asset classes and stock market sectors throughout 2020. You can read the article here. The overall primary challenge confronting traders and investors as we enter 2021 is what has changed from 2020? Money supply growth as measured by M2 appears to be growing at a 20% to 25% year over year growth. This is at the forefront of anyone’s mind who deals with money. If a company is not growing its earning by at least the equivalent of M2, the company is deteriorating in comparison to the new amount of money that is being created.

Mr. Buffet created an indicator that is monitored closely by the Saint Louis Federal Reserve. The “Buffett indicator” compares the total value of the stock market to quarterly GDP, gauging whether it’s overvalued or undervalued relative to the size of the economy. The ratio climbed past 180% in December 2020, not far off its peak of 187% in the second quarter, when GDP was 8% lower. Throughout his investing career, Buffet has repeatedly praised the indicator as the best single measure of where valuations stand at any given moment.

Here is a chart of the Buffet Indicator:

The Warren Buffet Indicator

What Buffet intrinsically understands is money printing is probably the most important component of stocks valuations. When the money printer goes “Brrrrrrr,” stocks immediately rally. When the Fed threatens to step off the monetary gas pedal, the stock market tanks. This is a dream environment for traders who know how to trade volatility for the short term. It’s an absolute nightmare for investors schooled in the ideas of traditional valuation and “buy and hold.”

So, what exactly is happening here?

The financial system is being manipulated. It’s that simple. Central banks around the world are contributing to this crazy, manipulated financial eco-system. The jury is still out as to whether they can do this for months, years, or even a decade or more, but we do know there is direct causation between central bank intervention and skyrocketing asset prices. Study the chart below and overlay it on any of the stock market indexes or compare it to any of the stocks you might hold in your portfolio.

Federal Reserve Balance Sheet

The Federal Reserve and central banks around the world are pumping so much liquidity into economies it’s nearly impossible for asset prices to go down for any significant period. When assets do decline, Wall Street simply throws a “taper Tantrum” to get more money injected into the system. The new money is inflating financial asset prices far beyond any normal valuation that we have ever known. It also explains why value investing legends like Warren Buffet have not fared well in this environment.

I was watching Squawk Box on CNBC recently and the visiting contributors, Mike Novogratz and Muhamad el-Erian both agreed that what we are witnessing is the great “store of value” chase as currency is quickly being converted into other forms of value.

Central banks will continue to pump liquidity into economies at an unprecedented pace. Expect the results that financial markets will be completely untethered to any corporate, social, or political realities or valuations as they are manipulated upwards aggressively.

There’s a great story about a professor of economics who was challenged by his peers about his examinations. The professor always posed the same exact questions to his students. The professor was challenged by his peers, as how could his students fail the test. He replied simply, “it’s true the questions don’t change, but the answers do.”  In economics and finance there are a handful of questions which keep repeating themselves:

• How do we retain prosperity?
• How do we achieve normal healthy growth?
• How do we preserve the purchasing power of our money?

We’re living in interesting times and these questions are every bit as relevant today as they ever have been. We’ve never witnessed this amount of unbridled money creation in the history of our country.  William McChesney Martin who was the Fed Chairman between 1951 and 1970 once quipped that the entire purpose of the Fed is to remove the punchbowl just as the party is warming up. Today it seems that Fed Chairman J. Powell either feels that the party is just getting started or that it will never end. The monetary punchbowl is perpetually filled to the brim so that asset prices can rise.

Traders should brace themselves for some serious volatility. The question to pose to yourself is, “If that was a bubble, what is this?”

When Warren Buffet, one of the greatest investing legends, returned 1.6% on his fund, with a 30+% drawdown, it is emblematic of what the market’s risk-return narrative is.

It’s not magic.  It’s a strategic shift. 

It’s not about new technologies.

It’s not about new products.

It’s not about new solutions.

Risk and return are the key.

Some readers may not know.

IMPORTANT NOTICE!

No representation is being made that these securities are guaranteed, or that the information is accurate at the time of publication. The risk notice applies to all securities listed, including options, futures, and derivatives.

DISCLAIMER: STOCKS, FUTURES, OPTIONS, FUTURES, OPTIONS, and other investment products carry risks and potential losses. No guarantee is made that investors will achieve any particular result. Each investor’s strategy and risk tolerance must be accounted for.