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Why non-transitory recession is coming and how to face it as an investor
You can listen to a professional narration of this article below:
This is part 2 of my essay excerpted from our latest IMA client letter. Last week in part 1, I discussed the sorry state of the US housing market. If you missed it, I suggest you read it before you embark on this week’s essay.
One more thought. I received inquiries asking my take on what is going on in the markets. The last few months were devastating to bubble stocks, speculative assets, and anything crypto-related. Bubbles always deflate – that is what they do. It’s one of the constants of investment physics. You just don’t know when.
Higher interest rates are bringing common sense back to financial markets. It has been a breath of fresh air for value investors, including yours truly. Capital markets are starting to work again. They have started paying more attention to cash flows and less to the discounting of profitless dreams that might materialize decades in the future and treating them as the reality of today. (This is what zero/negative interest rates do to people’s imaginations.)
Higher interest rates are making value investing great again (I might have jinxed it by writing that). Historically, value investing has outperformed other strategies because it is grounded in common sense.
If you do the responsible thing, you invest; you don’t gamble with your clients’ life savings. Then you have to be prepared to look like an old has-been while the news feeds coronate new Warren Buffetts… who later turn into highly levered magnates overseeing empires built on crypto-sand (or whatever the latest fad is), as stocks that are insanely overpriced go 5x higher.
I don’t celebrate this meltdown, because it is not happening in a metaverse far far away; there are real people whose dreams and savings are being destroyed. If this dotcom 2.0 collapse plays out like its 1.0 cousin of 2001, then everything expensive will be crushed to dust.
Tech companies are going to go through a tough few years, as they’ll have to right-size their businesses and focus on generating cash flows. This also means they’ll need to learn how to stop diluting shareholders by giving 5–15% of their company away to employees every year in stock-based compensation. I am very optimistic about their future that lies beyond the Sea of Pain.
So my job today is not to celebrate their fall from grace, but to study the very businesses that were out of reach for decades because they were overvalued. A lot of them are down 70-80% but still too expensive. (This shows how overvalued they were.)
They’ll be hated with the same intensity as they were loved in 2021. This is what gains and losses do to you – they magnify emotions. The beauty of owning a portfolio of individual stocks and having clients who bought into your philosophy is that we have the luxury of being patient, not feeling the pressure to make forced decisions, and remaining rational while the world around us is anything but.
If you’d like to take a stroll through the essays I have penned about the bubble, here are some of them:
ARKK Stocks Sunk
I Kid You Not Crazy
This Holiday, Will Mr. Market Eat Too Much Pi?
How to Invest When There’s Nowhere to Hide
Curmudgeon on Cryptocurrency
Value & Growth Demagogues
I am not an economist, but, looking at this picture, it is hard to see how we can avoid a recession. Ironically, we’ve been in a recession most of 2022 – real GDP declined in the first and second quarters. Economists attributed declining GDP to a “transitory” recession caused by an overhang of pandemic-induced supply chain issues.
As inflationary pressures squeeze consumers from all directions, they simply will not be able to buy as many widgets as they bought the year before. Demand for widgets will decline; companies will have to readjust their workforce to the realities of new demand and thus reduce their employee headcount; and this will lead to higher unemployment. All this, in turn, will lead to lower demand, and voila, we’ll find ourselves in a non-transitory recession.
Recessions do not worry us. Though I am sympathetic to people losing jobs and suffering economic hardships, recessions are a natural part of the economic cycle. They force both companies and individuals to become more efficient and thus make them stronger in the long term.
Recessions are like forest fires – small ones are healthy for the forest, as they get rid of dead wood and convert it to fertilizer. However, the longer you suppress the fire (with the best intentions, thinking you are doing a good thing) the more dead material the forest accumulates. Eventually, when fire does pay a visit, it is more devastating and its effects are more long-lasting.
Some folks are upset about what the Federal Reserve is doing now. First off, it is not clear that it is the Fed that is in control of interest rates today and is responsible for their going up. Since inflation is running 7–9%, where would we expect interest rates to be? Second, we should be upset at Uncle Fed for allowing negative real rates for almost a decade, manipulating the price of one of the most important commodities of all, the interest rate (the price of money). This caused bubbles across all assets except one: common sense did not experience much growth.
Since we are on the subject of uncles, we should also not forget to thank another uncle – Uncle Sam. The one who ran our debt from $10 trillion in 2008 to $31 trillion today. When our debt is $31 trillion, each incremental 1% interest rate increase costs the government about $310 billion in interest payments, which equates to a major category of our government spending. The cost of the first 1% increase equates to about how much we spend on Medicaid, a 2% hike in rates costs us about as much as our defense spending, and 3% about equals our Social Security outlays.
Though we have to accept the new reality that income tax rates are likely going higher, it is going to be difficult to tax ourselves out of the current situation we are in – the hole we have dug is simply too big and deep. Also, we are not going to cut Medicaid, Social Security, and especially defense (now that we are in the foothills of Cold War 2.0 with China and/or Russia). That would be a sure way for politicians to lose their jobs. No, we are going to do what every country that can issue its own currency has done since the beginning of time: We are going to print money and thereby try to inflate ourselves out of trouble.
Summing up, the economy is likely heading into a non-transitory recession, and this one may last longer than past ones (we have accumulated a lot of dead wood).
The recession should lead in time to lower interest rates (good news for the housing market) and higher unemployment (bad news for the housing market). Consumer spending is going to be under significant pressure from all directions – a significant headwind for the economy.
Recessions in theory should reduce inflationary pressures. However, the combination of lower tax revenues and higher interest expense (interest rates may decline from the current level, but they are unlikely to come back to 2021 levels) means that our government debt will continue to climb, and the resulting money printing will bring higher inflation (more money chasing fewer goods), thus keeping interest rates not far from their current level or even pushing them higher.
As unemployment rises and we slide into a recession, the Fed may start lowering rates and fall back on its old tricks (buying back government bonds) that we saw over the last decade and a half. However, if inflation persists the Fed may find that the problem it has created over that time is bigger than it can handle.
If reading this gave you a minor headache, imagine what I experienced writing it. Neil deGrasse Tyson has observed that “The universe is under no obligation to make sense to you.” This also applies to the current economy.
To make things even more interesting, while we are facing this economic whirlwind, the market (the average stock) is still expensive. Bonds, though they are yielding more than they did six months ago, still provide negative real (after-inflation) yields and are thus not an attractive asset from a long-term capital-preservation perspective.
What is our strategy in an economy that makes little sense and is under no obligation to do so? Invest humbly and patiently. Humbly because we don’t know what the future will hold (nobody does!). You handed us your irreplaceable capital, and thus we’ll err on the side of caution.
We’ll invest patiently because we don’t get to choose the economy or the overall market valuations we find ourselves stuck with – Stoic philosophers would call those externals – and we have no control over them. The only thing we can control is our strategy and how we execute it.
(Stoics would call that an internal.) We are going to continue to do what we’ve been doing: patiently and methodically keep building a portfolio of “all-wheel-drive,” undervalued, high-quality companies that have pricing power and should get through anything the economy throws at them.
In fact, if you look carefully through your portfolio – and this is the beauty of custom, separately managed accounts – you’ll see that the revenues of most of the businesses we own are not tied to the health of the economy.
Also, though we may end up being wrong on this (not the first time), the consumer seems like the weakest link in the economy. Though completely eliminating the consumer is an impossibility in a diversified portfolio, over the last year we have significantly reduced our exposure to consumer spending. Our current exposure to the consumer is tiny.
One last thing: We’ve been slightly reducing the size of individual positions to avoid the potential impact of unknown unknowns, shifting us from 20–25 to 25–30 stock positions.
I wrote the following to clients on tax loss harvesting, which is something many investors are either contemplating or doing this time of year. Feel free to skip this portion and go on to the music section.
Tax Lost Harvesting
I enjoy writing about taxes as much as I enjoy going to the dentist. But I feel what I am about to say is important. We – including yours truly – have been mindlessly conditioned to do tax selling at the end of every year to reduce our tax bills. On the surface it makes sense. There are realized gains – why don’t we create some tax losses to offset them?
Here is the problem. With a few exceptions, which I’ll address at the end, tax-loss selling makes no logical sense. Let me give you an example.
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Let’s say there is a stock, XYZ. We bought it for $50; we think it is worth $100. Fourteen months later we got lucky and it declined to $25. Assuming our estimate of its fair value hasn’t changed, we get to buy $1 of XYZ now for 25 cents instead of 50 cents.
But as of this moment we also have a $25 paper loss. The tax-loss selling thinking goes like this: Sell it today, realize the $25 loss, and then buy it in 31 days. (This is tax law; if we buy it back sooner the tax loss will be disqualified.) This $25 loss offsets the gains we took for the year. Everybody but Uncle Sam is happy.
Since I am writing about this and I’ve mentioned above I’d rather be having a root canal, you already suspect that my retort to the above thinking is a great big NO!
In the first place, we are taking the risk that XYZ’s price may go up during our 31-day wait. We really have no idea and rarely have insights as to what stocks will do in the short term. Maybe we’ll get lucky again and the price will fall further. But we’re selling something that is down, so risk in the long run is tilted against us. Also, other investors are doing tax selling at the same time we are, which puts additional pressure on the stock.
Secondly – and this is the most important point – all we are doing is pushing our taxes from this year to future years. Let’s say that six months from now the stock goes up to $100. We sell it, and… now we originate a $75, not a $50, gain. Our cost basis was reduced by the sale and consequent purchase to $25 from $50. This is what tax loss selling is – shifting the tax burden from this year to next year. Unless you have an insight into what capital gains taxes are going to be in the future, all you are doing is shifting your current tax burden into the future.
Thirdly, in our first example we owned the stock for 14 months and thus took a long-term capital loss. We sold it, waited 31 days, and bought it back. Let’s say the market comes back to its senses and the price goes up to $100 three months after we buy it back. If we sell it now, that $75 gain is a short-term gain. Short-term gains are taxed at your ordinary income tax bracket, which for most clients is higher than their capital gain tax rate. You may argue that we should wait nine months till this gain goes from short-term to long-term. We can do that, but there are costs: First, we don’t know where the stock price will be in nine months. And second, there is an opportunity cost – we cannot sell a fully priced $1 to buy another $1 that is on fire sale.
Final point. Suppose we bought a stock, the price of which has declined in concert with a decrease of its fair value; in other words, the loss is not temporary but permanent. In this case, yes, we should sell the stock and realize the loss.
We are focused on the long-term compounding of your wealth. Thus our strategy has a relatively low portfolio turnover. However, we always keep tax considerations in mind when making investment decisions, and try to generate long-term gains (which are more tax efficient) than short term gains.
We understand that each client has their unique tax circumstances. For instance, your income may decline in future years and thus your tax rate, too. Or higher capital gains may put you in a different income bracket and thus disqualify you from some government healthcare program.
We are here to serve you, and we’ll do as much or as little tax-loss selling as you instruct us to do. We just want you to be aware that with few exceptions tax-loss selling does more harm than good.
Feel free to share it with your friends and perfect strangers. You can comment on it here.
I have stopped trying to figure out why the music of one composer is popular and the works of scores of others are not performed but collect dust in the obscurity of music libraries. At the beginning of the 20th century, the American public did not care for Edward Grieg’s Piano Concerto in A minor, but today it is one of the most-performed piano concertos. Mahler’s music was not popular in the US until Leonard Bernstein popularized it in the 1960s. Neither Grieg’s nor Mahler’s music suddenly got better; public attitudes towards it changed.
Over the last few years I’ve been actively trying to stretch the boundaries of my musical knowledge by going deeper into the music of the composers I am already familiar with and also by more widely exploring new (previously unfamiliar to me) composers.
When I listen to music that is unfamiliar to me, at first it’s work. Yes, work. At first, I don’t understand that music and it brings me little pleasure – it’s just random, unconnected sounds. I may have to listen to a new piece half a dozen times before it clicks with me. I remember listening to Puccini’s La Boheme a dozen times, and at first I was baffled at how this opera could possibly be one of the most-performed operas. Today I don’t see how it could not be.
Sometimes, even after a dozen tries the music won’t click with me, and I put it into the “I don’t understand” pile. I try very hard not to use “I don’t like” when it comes to classical music, for two reasons. First, it implies that I am a judgment-worthy connoisseur (I am not!), and second, “I don’t like” has a finality to it, while “don’t understand” leaves the door for me to understand the music down the road.
I “understand” some composers quicker than others. Russian composers take the least number of tries – there must have been something in the water I drank as a child growing up in Russia. Mahler, Sibelius, and Bach, on the other hand, took a long time for me to understand. I still don’t understand all of Mahler’s work.
This brings me to the latest victim of my explorations, Austrian composer Anton Bruckner (1824-1896). As I’ve been listening to Bruckner’s symphonies and reading about him, I have found that Bruckner the person is as interesting as his music.
Bruckner’s ancestors were farmers. His father was a music teacher. Bruckner was a very diligent student and became a very talented organ player. Robert Greenberg writes:
The Church was Bruckner’s refuge and solace for the entirety of his life; he was as devout a man we will ever find outside a monastery or a foxhole. He believed completely that everything he did should honor God.
Bruckner was a total country bumpkin: naïve, simple, overly trusting, deferential and pious to a fault. (Bruckner followed to a “T” the Church’s proscription against sexual relations not sanctified by marriage.)
Bruckner searched for a bride all his life:
He was 43 when he fell in love with a 17-year-old, whose parents put a stop to the relationship. He fell for another 17-year-old in his mid-fifties. Though the parents in this instance gave the relationship their blessing, the young girl tired of Bruckner, and his passionate letters went unanswered. Later still he became infatuated with the 14-year-old daughter of his first love – that came to nothing and at 70 he proposed to a young chambermaid. Her refusal to convert to Catholicism ended that. Piety and pubescent girls are not an attractive combination. Bruckner died a virgin and was buried under the organ at St Florian (from Gramophone).
Bruckner must have had a rather unhappy life. I have a theory that the less happy the composer, the better, richer, and more emotional his music. Pain is an incredible stimulant of creativity. But what really fascinates me about Bruckner is that he started composing symphonies fairly late in his life.
Per Robert Greenberg:
...the “eureka!” moment he experienced in his 39th year, when in 1863 he heard a performance of Richard Wagner’s Tannhauser in Linz. Bruckner was doubly blown away: not just by Tannhauser, but by the realization that what made Tannhauser great was that it broke so many of the rules of harmony and counterpoint he had so assiduously studied!
From that moment, Bruckner embraced Wagner’s music with a mania that changed his life. Convinced that it was his mission in life to become the Wagner of the symphony hall, he composed a Symphony in C Minor in 1866.
Bruckner was writing his music for God. This is what he wrote to then-young Gustav Mahler:
Yes, my dear, now I have to work very hard so that at least [my] tenth Symphony will be finished. Otherwise, I will not pass before God, before whom I shall soon stand. He will say: ‘Why else have I given you talent, you son of a bitch, than you should sing My praise and glory? But you have accomplished much too little!’
Bruckner’s drive to please God must have kept him going, as success came to him seven symphonies and twenty years later, when he was 60. Just imagine this: twenty years of constant writing and rewriting six symphonies, six symphony premieres, six flops. He kept going. I admire that.
Today Bruckner’s music is not very popular. Critics say his symphonies are very long and somewhat slow and that they lack emotion and extended melodies. There is also a practical limitation: His symphonies require a much larger orchestra, and since they lack the recognition of Beethoven’s or Mozart’s, they are rarely performed.
I started listening to Bruckner with his Symphony Number 4 – it was his most-listened-to recording on Spotify. It is one hour and nine minutes long. If you run out of patience, do what I did. Don’t think of it as a novel, think of it as book with four independent stories (parts/movements). Listen to each movement separately many times, starting with the first one. I am listening to the first movement as I am writing this, and I can hear bits from various symphonies in this one – there is the grandeur of Saint-Saens third (“Organ”) symphony; I can hear parts of Berlioz’s Fantastique; and Wagner’s brass and violins are definitely in there. The beginning of part two has some of Mahler’s funeral-march-like sadness. And then you listen to the last five minutes of the symphony and it sounds like nobody else but a humble, very odd, sex-deprived, religious fanatic.
I am including several performances and implore you to sample them; they all sound different.
Click here to listen.
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Vitaliy Katsenelson is the CEO at IMA, a value investing firm in Denver. He has written two books on investing, which were published by John Wiley & Sons and have been translated into eight languages. Soul in the Game: The Art of a Meaningful Life (Harriman House, 2022) is his first non-investing book. You can get unpublished bonus chapters by forwarding your purchase receipt to firstname.lastname@example.org.
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