Wins and Losses

December 19, 2021

For those of you new to Things I Didn’t Learn in School, welcome. You can read about what these posts and podcasts are about here. While the topics I cover range, one of them is sharing how I invest. This is something I didn’t learn at school and I hope being transparent will both force me to be more thoughtful and allow you perspective on how another person is managing to navigate, in practical terms, a complex world. If I write something confusing, reach out.

Looking back, the best way to invest is always obvious. Looking forward, the best path is always uncertain, probabilistic. That’s the nature of investing. This year, I earned a low double-digit return.1 Given almost 7% inflation, that means I modestly grew the value of my savings in real (inflation-adjusted) terms.  Here is how that happened.

What helped:

1.     Owning stocks, particularly banks and commodity producers. The S&P 500 rose by over 20%. Some bank stocks I owned, like Wells Fargo, rose by almost 60%. I thought the economy would get better and financial firms and raw material producers would do particularly well in such a scenario.

2.     Selling US bonds (betting prices would fall) in the first-quarter. I thought as the economy strengthened and inflation rose, bond prices would fall.

3.    Owning certain commodities, like copper, which rose over 20%, amid a shift toward more environmentally friendly energy production, which requires a lot of copper.

4.    Lending money to distressed borrowers. Early in the pandemic, there was a lot disruption and borrowers were forced to accede to terms favorable to lenders. As conditions stabilized, distress eased and prices rose.

What hurt:

1.     Selling bonds after April. After declining in the first part of the year, bond prices stopped falling, even as inflation rose. The link between higher inflation and higher bond yields broke down.

2.     Owning Chinese stocks. Chinese stocks lost about 5% as Beijing cracked down on entrepreneurs and entire sectors, like education. Certain popular stocks, like Alibaba, fell 40%. I had thought Xi was anti-civil liberties but pro-capitalism.

3.     Emerging market bonds. I thought money printing in the US and high interest rates in emerging markets would favor emerging market bonds. Instead, bond prices in places like Russia fell, in part as Putin stationed troops on Ukraine’s border.

4.     Owning gold, which lost about 5% this year in part because investors moved into crypto instead.

Essentially, some of the things I did to protect against rising inflation (like selling bonds and buying gold) didn’t work. I also took too little risk. After tracking my investment returns for years, I know I generally (but not always) make money. Yet, I’ve seen so many once-famous investors get wiped out because of hubris that I’ve always worried about my own hubris.

Looking Forward

The economy is strong and there are a lot of exciting, productivity-enhancing technological changes afoot (like mRNA vaccines). This is good for asset prices. Yet, the pandemic means:

1. tens of thousands more (only 16% of Americans have a booster!) likely deaths,2
2. inflationary production and distribution disruptions and
3. central bank printing less money (tightening) to combat this inflation.

Tightening is bad for assets. The challenge is basically how to own the good and protect against the bad. A key question is guessing how much the central bank tightens. I know this sound technical. Trust me, this really matters.

The price of an asset—a house, a stock, a bond—is set by supply and demand.  Demand comes from many sources, but the biggest source of demand is, ultimately, the central bank for the simple reason that they have unlimited resources. The central bank creates zeros on a computer and money flows into the economy and assets. For a person like you or me to buy an asset, we need to earn money, which is much harder and can only shift so much. An individual can also borrow money, but ultimately that is paid back with income.

What Are Reasonable Expectations?

Markets are expectations.  The price of Apple stock today incorporates expectations for how many iPhones they sell in coming years. For a price to change, there needs to be a shift in activity relative to expectations. The price of suburban houses rose after Covid because there was an unexpected shift in demand as buyers fled cities.

The central bank (the Fed) has gone from saying inflation isn’t a big deal, to saying it is. That happened in a few weeks. Is it possible they will soon say inflation is a BIG deal? Maybe. Expectations about their policy translates into numbers.  If I lend the government money for two-years, I earn 0.65%. This interest rate is priced to rise to 1.5% in two years.3 If the central bank raises interest rates faster than what they are now expected to do, this process will suck money out of markets, like stocks.

This graphic created for me by DGFX Studios capture the idea pretty well.

It’s a matter of degree. Below (courtesy of Rose Technology) shows previous times the central bank has acted. History is a guide but is not predictive. I worry what we face may be worse than what has occurred in decades, because both stocks and bonds may loose value at the same time.4

How Big of a Hedge?

I have around 40% of my money in the stock market. Half that is outside the U.S., where similar stocks are not as expensive.   In response to the risks described, I have significantly shifted my bets, as you can see below, selling bonds that should decline in price if the central bank tightens more than what they are currently expected to do.

It’s a tricky because I am guessing what the central bank will do months from now. Between now and then we will get more information about Covid and inflation. The central bank will only make a decision after this information is received, while as an investor I need to make a decision before. I suspect that because we are in a new wave of Covid, the interruptions that have caused inflation to rise will persist and that this will force the Fed to act faster than they are expected to. Given that real (inflation adjusted) interest rates are deeply negative, moving them higher may cause losses in stock, bond and commodity markets, pain I am trying to mitigate. This isn’t certain, but it’s a risk, a risk big enough in my mind to justify the shifts I made.

• Investing