Investors should consider choosing the path of least resistance in these uncertain and challenging times
Traders work on the floor of the New York Stock Exchange. Photo by Michael M. Santiago/Getty Images files We are at an important crossroads where what has worked so well in the past no longer works so well in the present, so instead of fighting it and resisting change, perhaps investors should at least consider choosing the path of least resistance in these uncertain and challenging times.
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Ben Hunt of investor adviser Second Foundation Partners LLC and creator of the Epsilon Theory, recently wrote a wonderful piece on this, highlighting that the relationship between the price of money and real-world behaviour is non-linear, just like water.
“See, we all know that when gases or liquids get colder, they get denser. They get heavier. The molecules in the gas and the liquid are less energetic as they cool off. They bounce around less. They sink. This is why pool water and lake water and ocean water get colder the deeper you go. It’s a perfectly linear relationship … the colder the water, the heavier the water … the colder the water, the more it sinks,” Hunt wrote.
“But when water gets to 4 C, this nicely linear relationship between temperature and density stops happening. In fact, it reverses. It’s not only non-linear, it’s non-monotonic (a $10 word that means reversal). As water gets colder than 4 C, it no longer gets heavier. It no longer gets denser. It no longer sinks.”
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Our entire monetary policy is also designed around a linear relationship, which is fine until it, too, suddenly reverses and we realize that we pushed it too far. Ultra-low-to-negative nominal interest rates aren’t natural. Printing money to support massive deficit spending isn’t natural. As Hunt highlights: “cutting rates from four per cent to zero per cent did not spur real world inflationary behaviours, it spurred market world financialization behaviours.”
These financialization behaviours included a focus on financial engineering such as share buybacks instead of hiring more people and organically growing a business. It caused the bigger-is-better environment, resulting in oligopolies being built under the guise of digitization, something that would have been broken up in past times — remember IBM?
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In Canada, it resulted in massive real estate speculation that resulted in a non-producing asset becoming the biggest driver of economic growth. One in six Canadian homeowners now own multiple properties and one in 59 workers in Toronto sell homes for a living, according to Better Dwelling.
Inflation is ending all of this. And when central banker’s linear models no longer work, they first tell us inflation is transitory and then when it isn’t, they use terms such as “extraordinarily elevated.” Or they try to find reasons why the man behind the green curtain is getting it so wrong, blaming it on supply chain disruptions or “Putin inflation.”
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Article content The adage that past performance doesn’t indicate future performance couldn’t be more relevant today, especially for those models built on past linear relationships continuing forward indefinitely. Look at the money managers smart enough to ride this world financialization wave. Their assets under management exploded during the past decade. But things are not going so well in this new world judging by their performance in the recent quarter.
It’s also affecting the traditional 60/40 portfolio (60 per cent equities, 40 per cent bonds). Inflationary pressures and worries over interest rates are wreaking havoc in bond markets, which, therefore, offer zero protection in a correcting market environment, something that hasn’t happened in a very long time.
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Article content Meanwhile, the “growthier” segments of the equity market are dependent on low rates for profit margins and premium multiples. Try running a five-per-cent rate in discounted cash-flow models and then compare it to when you run 0.25 per cent. The result is not pretty.
The point here is that your portfolio needs to be more like water and less like the models that are dependent on trying to direct its flow. Mother Nature is in charge, as she periodically reminds us, even if it takes a decade or more to do so.
Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.
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