Footnotes is a monthly publication which summaries our “First Friday” webinar presentations each month. The goal of the Footnotes publication is to capture our “First Friday” presentation’s most important data points, which will make it easier for The Abernathy Group Family Office members to make intelligent decisions based on facts and data – as opposed to potentially conflicted opinions from the mainstream media.
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As a short reminder to each Family Office member, The Abernathy Group Family Office has now sponsored 20+ “First Friday” webinars. All of them are available on our website and “YouTube” Channel if you would like to go back and see how we have interpreted the economic signals, while doing our best to cancel the noise over the last year plus. Our goal: to help you spend less time making intelligent financial decisions, by focusing on causal, predictive data (signals); and ignoring the clamor of biased, irrelevant data (noise).
Commentary from the November “First-Friday” meeting:
Steven Abernathy:
Today’s Presentation is titled “War – How to Invest Amidst Uncertainty.”
As we mentioned last month, we are going to discuss risks everyone is aware of – yet very few investors are actually prepared for.
So, we going to start off with a question which may make you feel a bit uncomfortable, yet which is important to ask – and to have answered.
Are you prepared for an unpleasant future to become a reality which we all fear?
If your answer is no, why not? Are you sure this unpleasant future will not happen?
In our last webinar, we discussed the elephants in the room.
Some of those large challenges staring at us right in the face are avoidable. And even if we are unlucky enough to experience the unpleasant side of a few of those challenges, it would be unpleasant, yet our lives would not be significantly changed.
However, a couple of those elephants in the room, the ones that could actually change our lives, are given little if any value or merit within our investment portfolios.
While almost every investor knows this is the wrong way to invest, it happens more often than you would guess in the professional and non-professional investment portfolio. Why? The chance of these life-changing occurrences is so small that they fall into the category of “inconsiderable,” or “negligible.” In essence, they are forgotten.
A relatable example: when there is the slightest chance that something, even minor, is wrong with the plane you are about to board. What happens? Regardless of the tight schedule we all have after landing, and the fact that any delay is going to make you late for your scheduled meeting, most of us should welcome the diligence and the thoroughness of the inspection crew… a very small probability of a problem taking place while traveling in the air with the disastrous outcome of a crash or emergency landing, most would agree is worth avoiding.
As we said in last month’s webinar, there are well-known risks staring us right in the face. And over the last year, these risks have increased in likelihood.
While each of us hope and pray these risks avoid becoming a reality, the most consequential risks are indeed “outliers…” meaning they have a low probability of taking place.
However, some of these “outliers” are so impactful – despite their low probability of becoming a reality, they must be considered – and they should become part of our planning.
As the intelligent investor Ray Dalio would tell you, “Don’t make the mistake of overlooking events which have happened many times in history, just because they have not happened during our lifetimes.”
It is our goal today to show you how to prepare your investment portfolios for the possibility of an “outlier” event with a small yet disastrous outcome, yet to remain invested and receive reasonable returns in the event this outlier does not take place.
Our goal: to demonstrate a way to remain intelligently invested.
If the negative event takes place, we are not wiped out… and if we are lucky enough to avoid a negative destiny, our investment portfolios may continue to earn sufficient returns either way.
With that said, let me turn this meeting over to Matt Daley so he can ensure we cover the several incredibly important topics our members have asked us to discuss with you.
Slide 3
Matt:
As we discussed in our last meeting, we are going to do our best to discuss several uncomfortable topics.
However, like many important activities which involve difficult decisions, discussing uncomfortable topics before they occur can be the difference between success and failure.
An intelligent investment process ALWAYS starts with risk analysis. Why?
Because if the risk occurs, you lose the assets you are investing. This means you lose the ability to invest.
As Warren Buffett has said many times, don’t forget the first rule of investing. Rule number one: Don’t lose your money; Rule number two: don’t forget rule number one.
It’s a very simple and easy to understand concept, yet the vast number of investors we have spoken with over time do not focus on risk avoidance first. Why?
Because it’s clearly more fun to spend time on how our investments will deliver profits, and how smart we are going to look and feel when this set of circumstances, the positive outcome we planned on, becomes reality and our investment doubles in value!
This is bringing us to today’s topic –
We are going to discuss what some would say is the most difficult challenge in investing.
I am describing an event that has consequences which are so negative, and so large as to be life changing, yet with such a low probability as to be overlooked by most as being quite unlikely.
The problem? When you prepare for events like this, you are most likely giving up some or most of your upside rewards for the benefit of avoiding some losses, and in this case today – significant losses.
Yet the investment calculus tells us the event is so improbable that most will avoid preparing for it at all. And if it does not happen, everyone who didn’t plan for the negative event looks like they were acting intelligently.
Yet the reality? They were not intelligent investors – they were just lucky.
They avoided the earthquake. So, they saved the money it cost to buy insurance and prepare. They avoided the car accident… so there was no need to wear the seatbelt.
The problem comes when the random or “outlier” event takes place. When an earthquake occurs, or when a car accident happens. Either could be catastrophic.
Today, we are going to discuss several risks which are clearly visible, and as said, are staring at us right in the face.
Some of these risks are not life-threatening, yet may be unpleasant enough to prepare for, and some are so catastrophic that no matter how small the probability of the event taking place, you must prepare.
We are going to do our best to discuss whether the financial markets are pricing in these risks, and if not, why not?
First, we will briefly discuss inflation and its well-known challenges in society.
The capital markets believe inflation is firmly under control. Is this a realistic expectation? What if they are wrong?
Next, we will discuss the many outcomes surrounding our Presidential election next month. Is there a risk the outcome will take place without acrimony? Or is there a real risk that there will be some level of conflagration which could lead to an uncomfortable change in command of the most important country on earth?
Of course, we hope and pray this does not happen, yet, what if we are wrong?
Next, we will spend a very short time on our deficit spending.
We know it’s out of control. We know it’s unsustainable. However, there have been no consequences so far. And other countries are also unsustainably indebted – so why should we worry?
What if we are wrong?
And lastly, as we discussed last week – in our estimation, the most serious risk, and the risk that is being least priced into the market – the risk of current wars escalating into a global war, which will instantly increase the risk of a nuclear conflagration.
And finally, just as we did last month, we will do our best to discuss the options available to the U.S. Federal Reserve, as the parent in the room in charge of mopping up each of our country’s missteps.
With that said let me turn it over to Steven Abernathy to answer our first topic of the day.
Matt thanks for giving us such a complete background on today’s topics.
Clearly there are a number of risks each of us must be aware of simultaneously.
And as said previously, understanding that there are many risks which are possible at any time – is standard operating procedure for every investor.
There are always risks, and there are always activities we don’t believe are risky, yet which turn out to be incredibly risky.
Slide 4
Today, we are going to tackle the potential risks in two categories.
The first category will include the risks which are challenging, and could create a difficult and problematic future, yet will not be life changing.
The second category will be the risks and events which could be significant enough to change our lifestyle and the way we live.
Then as always, we want to give each of you an update on what the data tell us is our most likely future, along with what we believe our U.S. Federal Reserve is planning to do if each of the risks take place – both the minor risks, and the major risks.
With that said, let’s jump in and discuss the first topic which is widely discussed so we will take only a small amount of time on it – largely because the historical data tell us to expect an outcome which is different from current expectations.
The first event is inflation.
The market’s expectations are that inflation will slowly decline to the 2% level by the end of 2025.
We do not think anyone can guess what pathway inflation will take without understanding the administration in Washington’s spending plans. If Washington decides to continue deficit spending in the 5-10% of GDP level, inflation will not dissipate. Inflation will grow to levels few consider reasonable today if we continue to spend more than our country makes.
Slide 5
History tells us to expect inflation to continue to plague our country for an average of 8 years or so, with a variance of as little as 4 years and as many as 16 years, once it exceeds 8% – which it clearly did in 2021.
The short answer to the inflation question is, if inflation went back to the 2% level in less than 4 years it would be the fastest return to normal in recorded history, and it would surprise those of us who look to history for clues about what the future is likely to offer us.
We do not believe inflation has left the playing field and it’s too early to declare victory. However, we clearly admit that the economy is slowing, and slowing considerably, which is an event considered to be a leading indicator of inflation reduction – and recession.
What to watch for – the employment reports will give each investor a leading indicator of the U.S. Federal Reserve’s actions.
If the U.S. Federal Reserve believes we are heading into a recession, they will likely slam on the brakes and start to reduce the Federal Funds interest rates. If the U.S. Federal Reserve believes inflation is starting to accelerate, interest rate increases are in our future.
To note: if interest rates begin to increase again, it will be a complete surprise for the equity markets. Expect turbulence if interest rates increase.
Slide 6
Let’s move on to the election results.
This is a complicated topic, and one we do not want to take a side on. However, we will repeat the data that tell us over 75% of the U.S. citizenry did not want either candidate to become our next president. The reason we bring up this fact is that despite the drastic perturbations from both sides of the voting extremes, it seems unlikely that there will be a civil war inside the U.S. regardless of who wins.
The market is starting to price in a Trump victory. However, the tea leaves and thus the market changes frequently on this topic
In short – we do not believe this risk, if it occurs, is one that will change the way of life inside the U.S.
History tells us it is difficult to predict who will win when the polling numbers are as close as they are today.
That said – a Trump win will likely be a bit more inflationary in some categories, and a Harris win would be inflationary in other categories – yet both are planning to spend approximately 6-10% in deficit spending.
Jim Grant quote – what is the market pricing in as a risk for the election? Understanding that the polling shows that over 75% of all U.S. citizens didn’t want either of the current candidates to run for office – the market is pricing in the risk that one of the two will win.
Slide 7
The next risk we have in front of us is one that could – and will eventually change the way we live.
It is our national debt. Our debt load today is unsustainable. Why do we say that? Because when you do not have enough income to pay the interest payments alone on the U.S. debt, it is unsustainable. This is not hyperbole or exaggeration. It is a mathematical fact. Today, the U.S. has to borrow money just to pay the interest alone on its outstanding debt.
So, something has to change. And it would be a disaster if the global markets make us change – it would be much more noble, and fitting – if the global superpower called the U.S. had the backbone and will, to stop overspending voluntarily or to tax our citizens appropriately.
What is the market expecting? The market seems to be expecting the next administration will continue to create deficits and increase our debt load. You can see this as the yield on the U.S. 10-year note continues to increase. You can also see this in the price of gold, as gold’s price tells the market that global central banks are net sellers of U.S. bonds and are buying gold as an alternative.
Historical data tell us this is a slow-moving process at first, and then in a short time span of a year or two, the world gets fed up and change takes place. Our belief is that if the U.S. does not handle our spending responsibly, the global markets are going to make us act responsibly. Either way, we expect the transition from abundant money to intelligent spending, within our means, will be a painful transition for most U.S. citizens.
What should we watch for? We should pay attention to the interest rates on the long-term U.S. bonds and notes, along with the price of gold and other commodities.
Slide 8
What would happen if the current global conflicts which are bubbling up get to a tipping point and a global conflict which we will call a world war begins?
I must admit that this is a very uncomfortable topic to address. The reason? Because it could be a long-term war – in which lots of lives will be lost… or it could be a short-term war, which likely means there is a nuclear solution – and global destruction is the outcome.
Either outcome is almost unthinkable.
However, let’s do our best to stay on topic:
The market’s expectations are that there will NOT be a world war. We hope the market is right, and we pray the market is right. We also believe the market is right. We believe solutions will appear, and cooler heads will prevail before a global conflagration erupts.
Remember, humans are mostly logical – except at extremes. Game theory tells us that humans will react rationally, which means they will not take actions to begin a massive event resulting in genocide.
What history tells us is a bit different. World wars are much more common than the vast majority of investors would guess. However, today, technology allows us to be so well armed that it is likely cooler heads will prevail – as most countries know that a nuclear conflict will only end in a level of destruction which is unthinkable and which could change the planet’s geography, not to mention all of its inhabitants.
What should we be watching for? The most intelligent analysts pay attention to activity, and not words.
How should intelligent investors be prepared for an event categorized as a world war or an outlier event?
For an event that is highly improbable yet potentially cataclysmic – it makes sense to own physical goods. It also makes sense to own physical goods within the nation’s control as national alliances may change based on expected winners and losers of a world war.
If war becomes global and not on U.S. soil, owning energy assets, real estate, and manufacturing become strategically important within our geography. Energy has, during the last two World Wars, been one of the most strategically important assets in determining who wins and who loses. Without energy all activity stops. The U.S. is energy independent, which is a strategically important fact, and one that the rest of the world is aware of. Manufacturing capability is also an asset which becomes more valuable as tensions increase.
We have made a significant commitment to energy assets at our Family Office, as energy is undervalued, and we are first and foremost value investors. Energy also offers us a hedge against the continued threat of war. Second, because the overall market is priced for perfection and perfection is a seldom achieved state, we have avoided capitalization related market indexes, opting instead for companies we categorize as “value-based” investments (companies with actual earnings, paying dividends, buying back their stock, reducing their debt, and operating within their means AND are priced at levels offering investors the expectation of a reasonable return on their investment).
Note, in an overpriced market, we want to have safe income generated in the 5% plus range. The reason? History clearly tells us that when markets are priced at current levels, either a significant correction is due, or, more likely, a decade or so of little to no appreciation in security values is likely.
If the conflagration comes on U.S. soil, there will be few places for intelligent investors to hide outside of gold. There may be a digital currency established and backed by gold in an extreme situation. In short, a war on U.S. soil is almost a calamity of unthinkable proportions. History clearly describes the host of any war on its home turf as the loser, regardless of the outcome.
As said, we hope and pray that current wars do not morph into global conflagrations.
Let’s move to the next topic which is “What is priced into the current market valuations?”
Slide 9
Currently the stock market is expecting the world to be a wonderful place forever.
Current pricing indicates the market expects almost a 15% growth in earnings for many years to come, despite historical growth of approximately 3% earnings growth.
While we are not sure the reason this expectation is so widespread, we believe it is due to the amount of money the last two administrations have pushed into our economy combined with the returns the stock market delivered over the last 10+ years.
We suspect “recency bias” is at work here (recency bias describes the expectation that former events will be repeated into the future). Remember, many people calling themselves experts have less than 25 years of market experience. Someone with less than 25 years in the business means that all they have really experienced is interest rates continuing to fall, and as a consequence, earnings growing at 10% plus each year.
While this is not what history tells us to expect, it is equally likely that most investors (or those calling themselves experts) have not read enough history and certainly have not experienced enough history to give them a balanced and informed opinion of what to expect.
Slide 10
Here is what the current market pricing tells us.
We are at stock market valuations seldom seen over the last 50+ years. Higher current valuations portend lower future valuations. This statement is axiomatic, as higher current valuations allow future returns to be realized today… thus, lower future returns.
Higher current valuations also indicate the expectation that interest rates will continue to fall, and earnings will continue to grow at 10% plus each year into the future. While we admit this would be a wonderful outcome, market valuations at these levels have occurred 3 times over the last 100 years. Each of these overvalued starting points delivered years of, and possibly decades of abysmal returns, including downside volatility exceeding 40% for the general market and over 50% for the more speculative NASDAQ.
Of course, this time could be different. Dangerous words for sure.
Our expectation is that the current indebtedness of our country will hinder growth. Slower U.S. GDP growth does not support corporate earnings growth at 10% or more per year moving forward (much less the 15% growth Wall Street tells investors to expect in 2025). History tells us that U.S. GDP grows at approximately 3% per year, and that corporate earnings deliver similar returns. However, U.S. history delivered those returns with a small fraction of the debt handicapping our country today. Therefore, our expectation is for lower earnings growth in the future to continue until the U.S. deals with its indebtedness.
Slide 11
On the other hand, the commodity market tells us that there is a decent value to be had for those interested in commodities.
This could be creating an interesting opportunity for those interested in hard assets.
What should intelligent investors watch as relevant signals, and what should be dismissed as irrelevant noise? Signals most often accurately display themselves in activity, while noise is often displayed in unsubstantiated discourse. Those predicting the future without statistically significant historical substantiation should be dismissed as just that – another unsubstantiated prediction.
Let’s sum up our “outlier” events discussed in this conversation:
For Inflation – the reliable signals will be higher wages, continued shelter increases, and a tight employer market along with government spending exceeding our income (meaning deficit spending). All of which add liquidity to the economy. Liquidity leads to spending, which leads to higher prices. History tells us it’s difficult to contain inflation once it surpasses 9%, and when it is contained, it takes an average of 8 years to return to the 2% level. The market believes the U.S. Federal Reserve has pulled a rabbit out of a hat, and we hope they have. History suggests caution regarding that hope.
For election results – the signal supports an orderly transition, as “recency bias” is just about the only evidence the talking heads have as they propagate noise surrounding the election. We are not paying too much attention to this potential event as one way or the other, the event is likely to be short-lived even if it occurs, and the event is unlikely to change our lives.
For National Debt – the signal tells investors to expect a continued lack of restraint concerning our national spending, and that this will end badly as history is strewn with examples of world hegemonies being dethroned. The noise around this is irrelevant, as the proof will be well broadcast. Watch for long-term interest rates to increase despite the U.S. Federal Reserve’s effort to lower short-term rates. This signal will tell intelligent investors that the world is losing confidence in the global leader called the U.S. We would expect an uncomfortable investment environment to follow. On the other hand, if the U.S. does begin acting as the responsible adult in the room and starts making intelligent and responsible decisions about living within our means, the investing public may justifiably celebrate. Either way this “outlier” event could change the way we live.
For War – again the signals will come from actual activity, as the rhetoric and posturing leading up to an actual conflagration often becomes defining. Investors should watch for alliances announced in the press (although the press continues to prove itself to be biased to the point of being unreliable recently) of countries which historically were not alliances. Signals will also be smaller wars beginning, which also create alliances where none existed before. Signals could also manifest themselves in cyberattacks and in terrorist activities. History also signals that war is more likely when economies are struggling, and the struggling countries are seeking a way to turn their economies around. War tends to increase nationalism, and it puts people to work.