Seeker of Truth

We are just one month into 2021 and already it feels as if things have started off on the wrong foot. Several countries / cities have re-declared state of emergencies and re-imposed lockdowns due to the virus, the distribution of vaccines has not gone as smoothly as expected (which I predicted in my previous post), oh, and for the first time in nearly 207 years, the United States Capitol was overrun… On January 6, 2021, a mob of Trump supporters stormed the Capitol Building and disrupted a joint session of Congress that was in the middle of certifying President Elect Biden’s victory in the 2020 election. Some have called this an act of “domestic terrorism” or “insurrection.” What we can say with full certainty is the last time the United States Capitol was overrun dates back to 1814 when the British Army sacked the Capitol during the War of 1812.

Do you know what else dates back to the 19th century? The publication of Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds” in 1841. Over the past month, I spent some time re-reading this classic and the lessons contained within are just as relevant today. The first three chapters of Mackay’s seminal work focuses on economic bubbles. Chapter 1 is about the Mississippi Company bubble of 1719–1720, Chapter 2 highlights the South Sea Company bubble of 1711–1720, and Chapter 3 focuses on the Dutch tulip mania of the early 17th century. What could these three episodes dating back 300+ years (almost 400 years in the case of the Dutch tulip mania) possibly have to do with 2021?

Quite a bit, in fact.

The long bull market that we have experienced in the aftermath of the Great Recession has now evolved into an undeniable bubble of spectacular proportions. The “Warren Buffet indicator” (the ratio of total stock market capitalization to GDP) is about 190% (well above the record high of ~143% at the peak of the dot-com bubble in March 2000) There have been 480 IPOs in 2020 and more than half that number (248) in backdoor listings through Special Purpose Acquisition Companies (SPAC). Due in part to services such as Robinhood, the volume of small retail purchases (less than 10 contracts) of call options on US equities has increased 8X compared to 2019 levels.

Speaking of small retail purchases and Robinhood, a community of retail traders on the online discussion forum Reddit have recently received widespread national media attention after their trading activities caused shares of the struggling brick & mortar video game retailer GameStop (ticker: GME) to soar from less than $20 a share at the beginning of January to a high of $483 a share on January 28 at 10:01 AM (Sidenote: You can retrieve such precise stock market data from Alpha Vantage), causing investors who were short the stock (betting that the stock would decrease in price) such as Citron Research and Melvin Capital to incur massive losses. Many of these retail investors used Robinhood’s “free” brokerage app to buy GME stock.

I use the words “free” in quotation marks because the service is not really “free,” much in the way services such as Facebook are not really free. Yes, it is free for Robinhood users to buy and sell shares or options on the app, but the reason behind that is because Robinhood users are not actually the “customer” but are in reality the “product.” The outspoken venture capitalist Chamath Palihapitiya – who incidentally was an early employee at Facebook who led the team at Facebook that created features designed to systematically increase the addictiveness of Facebook grew the user base from 90 million (the level at which Facebook’s user base was stagnating at the time) to a path towards 1 billion by the time he left  – recently put out a tweet describing as such:

Facebook and @RobinhoodApp are the same:

They both trick you into thinking you are the customer. But, in fact, you are the product and your data is the asset.

These assets are then sold to their true customers who pay them money and always at your expense.

STOP BEING TRICKED!

— Chamath Palihapitiya (@chamath) January 29, 2021

In an unprecedented move, Robinhood and a select number of brokerage firms on Jan 28, 2021 disabled the ability for its users to buy shares of GameStop and a few other companies (it was still possible to sell), which caused the price of these securities to crash over 44%. The official stance of Robinhood and these other brokerage firms is that this was done due to capital and regulatory requirements, but there is strong evidence to suggest the real reason was to allow stakeholders on the wrong side of the bet such as Citadel (which is Robinhood’s largest actual customer, accounting for hundreds of millions in revenue to Robinhood each year), Point72 Asset Management, and Melvin Capital (Citadel and Point72 collectively invested $2.75 billion in an emergency influx of cash to stabilize Melvin Capital) to regroup and get a respite from the unrelenting short squeeze.

As a neutral observer of this all (I have never owned any GameStop stock or any of the stocks that have been part of this recent phenomenon), I’ve had two thoughts: One, it is an unfortunate reality of the world that we live in that there exists two different sets of rules. One set of rules for the rich and another set of rules for everyone else; Two, as someone with a significant portion of my net worth tied to the stock of publicly traded companies, these recent events have dismayed me at how corrupted our capital markets have become from their original purpose.

Well functioning capital markets are absolutely essential for a modern economy as they allow businesses that need capital to be connected with those who have capital to invest. Businesses that have capital are able to use it to grow which (hopefully!) results in the creation of new jobs, innovation, and prosperity. Unfortunately, capital markets today have devolved into something similar to a casino in which gamblers speculators are engaged in zero-sum games that create incredible fortunes for the few winners but very little of value created for the rest of society.

A friend from grad school asked the other day in a mutual chat group that we share if any of us were participating in this stock run-up, and my answer was unapologetically “no” — my investments are mostly in no-thrills Vanguard index funds with a few individual names here and there.

While it is still too early to tell how this will turn out, it is impossible not to draw parallels between this current mania and the extraordinary manias described in Mackay’s book. In the short-term, Robinhood is facing multiple class-action lawsuits and lawmakers from both sides of the aisle have taken notice.

This is unacceptable.

We now need to know more about @RobinhoodApp’s decision to block retail investors from purchasing stock while hedge funds are freely able to trade the stock as they see fit.

As a member of the Financial Services Cmte, I’d support a hearing if necessary. https://t.co/4Qyrolgzyt

— Alexandria Ocasio-Cortez (@AOC) January 28, 2021

Many people draw similarities with this current bubble to the dotcom bubble at the turn of the century, but there is a key difference. Back in 1999-2000, the 10-Year US Treasury yields were at 6%. It is also worth mentioning that Nobel laureate Robert Shiller – who correctly called the 2000 and 2007 bubbles – is hedging his bets this time, recently making the point that his iconic cyclically adjusted price-to-earnings (CAPE) ratio (which suggests stocks are nearly as overpriced as they were at the peak of the dot com bubble) shows that stocks are not overvalued given where interest rates are. Shiller’s new excess CAPE yield (ECY), which is the inverse of the CAPE ratio (33.8 as of 1/29/2021) or approximately 3.0%, minus the interest rate on 10-Year Treasury Inflation-Indexed Security Rate of -1%,  results in a excess CAPE yield of 4.0%, indicating that equities are more attractive than bonds yielding 1% or less in nominal terms.

Another important difference between this bubble and previous bubbles is the strength (or rather the perceived strength) of the economy. Previous bubbles have combined expansionary monetary policy with economic conditions that are perceived at the time, rightly or wrongly, to be favorable and extrapolated to remain indefinitely so in the future. Today’s economy is starkly different: only partially recovered, with reasonably high expectations of an eventual slowdown, and most definitely facing high levels of uncertainty, and yet the market today is at a much higher point today than it was last fall when the economy was seemingly doing just fine and the unemployment rate was at historic lows.

It certainly feels that this time, more than in any previous bubble, investors are relying on favorable monetary conditions and zero interest rates extrapolated indefinitely. The problem is that it is impossible for such conditions to last forever, for as in physics, for every action, there is an equal and opposite reaction. When central banks expand the money supply, that money has to go somewhere. Since 2008, that money inflated asset prices of the wealthiest class, which is why stocks, luxury goods, and rare artwork have seen such dramatic increases in their prices.

If you believe the numbers released by CPI, it may appear that there hasn’t been much inflation in the “real economy” – but as one of my favorite sci-fi writers William Gibson says, “The future is already here, it’s just not very evenly distributed.” In a similar vein, inflation is “already here, it’s just not evenly distributed.” One need look no further than the prices of education, housing, and medical care over the past decades, which increased at rates far above the rate of inflation.

Moreover, prices are going up because the money supply is expanding at a rate far higher than growth in the actual economy. The S&P 500 is already at unprecedented high levels, but it could very easily continue to climb higher because of accommodative monetary conditions and endless money printing. Stocks like Tesla and now GameStop, which have completely defied all logic, could continue to rise in price since fundamentals and reality are essentially decoupled in a bubble.

What will cause an end to this madness? As I’ve already said, accommodative monetary conditions and zero interest rates cannot last forever. At some point, rates will have to increase. It could be some kind of major geo-political event such as war, or perhaps a change in the reserve currency, being blindsided by another health crisis (this time with a disease that is much more deadly than covid-19). If that does not seem plausible, just remember that it was not too long ago when it was conventional wisdom to believe that interest rates would stay high forever and shares in the common stock of corporations were consider at best speculative investments, and at worst poor investments.

The great Yogi Berra once said, most likely apocryphally, that “It’s tough to make predictions, especially about the future.” I will not hazard a prediction when rates will eventually rise or some other event that changes the current investing environment, but I am absolutely convinced this bubble will go down in financial history as one of the greatest bubbles of all time ranking right up there with the South Sea bubble, the Great Crash of 1929, and the more recent ones over the past two decades. As they say in the language of my forefathers: Plus ça change, plus c’est la même chose. 

—JOP

This will be my first post on this new blog (second if you include the “Hello World” post that was automatically created upon account registration). I was hoping to have something more profound to share in a first post, but with less than four days remaining in 2020, I feel it is appropriate to start with a reflection on the past year and end with some thoughts on what I think will happen next.

If you are anything like me, this entire year has felt like one big blur. I am not exaggerating when I say I can barely remember a single meaningful thing that personally happened to me this past year. I believe the culprit behind this is the WFH thrust upon me due to the pandemic. When you are stuck indoors and only able to interact with other people virtually, it is very hard to get those interactions to take root in one’s mind.

When the crisis first began in the early spring, I was highly skeptical of the data coming out from Wuhan and assumed that the Chinese government was lying about the death rate and that the virus was far more dangerous than they were claiming. Back then I was in favor of the (belatedly) cautious approach taken by the US government and I thought the initial lockdowns were completely justified.

Since that time, the data shows strong evidence that the virus is really not that dangerous for most people. Even if one were to accept the “official” numbers of nearly 1.8 million deaths (as of 12/28/2020) at face value, that is still a small proportion of the tens of millions or even hundreds of millions of infected. For reference, in a normal year, nearly 50 to 60 million around the world die from natural causes.

I admit that back in the darkest days of the beginning of the pandemic, I was slightly fearful that COVID-19 could be another “Black Death”-level event (estimated to have killed between 75 million to 200 million of the world’s population in the 14th century) or even comparable to the Spanish Flu of 1918 (estimated to have 17 million to upwards of 100 million deaths). It is clear now that those initial fears were completely overblown.

Now, do not get me wrong, this virus is still deadly and absolutely must be taken seriously. The fact that there are a significant number of cases of young, previously healthy people getting the virus and not fully recovering or having lingering symptoms (so-called “long haulers”) means this is a virus I do not want myself or any of my family and friends to get. Heck, I probably would not even wish this virus on my worst enemy. Thankfully, none of my family or friends have gotten the virus, though one of my colleagues at work has a niece who got the virus back in the spring and has become a “long-hauler” who, despite being young and previously healthy, continues to have lingering symptoms nearly 9 months later.

Yet, while this virus is deadly and must be taken seriously, I do not believe the approach taken by our government has been optimal. The US bungled its initial response to the virus by underreacting and then later did a complete 180 which in my view was an overreaction and overreaching. In essence, the government started treating the virus as the only problem (instead of one of several problems) and that it had to be eliminated at any cost – even if it meant destroying economies or causing more long-term health problems (e.g. missed or deferred surgeries, diagnoses, etc.)

I have been in the Boston area for the entirety of this pandemic, where a strict lockdown was imposed and where I estimate the mask compliance rate is comparable to the 97% of New York City and San Francisco metropolitan areas. Despite all that, we still experienced a second wave with rising cases and deaths. In theory, masks should significantly reduce infection rates. In reality, it is unclear to me whether they are an adequate solution as claimed by the so-called “experts.” The best data illustrating this is that after cities and states imposed mask mandates, infection rates continued to increase. If 95%+ compliance in major cities is ineffective, what will work instead? Is there a significant difference between 95% and 100% compliance?

Again, do not get me wrong, I am not against masks. In fact, I grew up in a country (Japan) in which it is culturally acceptable to wear masks for not only health reasons but even non-health reasons (e.g. women wishing to take a break from makeup, celebrities avoiding paparazzi, etc.). Whenever I venture outside of my home (which is admittedly rare), I am always wearing a mask. Yet, from looking at the data, it seems increasingly harder to justify that wearing masks is a panacea to all of our problems.

It also certainly does not help that many high-profile politicians and leaders in government have privately engaged in hypocritical behavior that run counter to the public messages they have espoused. Just look at stories such as the one of House Speaker Nancy Pelosi visiting an indoor hair salon (breaking a rule that such services needed to be performed outdoors) without properly wearing a mask, or California governor Gavin Newsom going to a dinner party in Napa in violation of heath protocols even after he told Californians to stay at home and avoid gathering in groups.

Some may argue with me that in a country such as the US with its exceptionalism and unbridled optimism, it was inevitable for the virus to spread, but I truly believe that if the government had proper leadership that took the virus seriously much earlier, the country would be in a much better place today.

When we eventually put this pandemic behind us, I am also certain that the results for any given country/region will have more to do with the size/demographics of each country’s population and climate rather than any government policy. Let’s take a look at the US and Africa. Both have terrible healthcare systems and healthcare infrastructure (a topic for another day!), but the number of deaths in Africa have been much lower relative to the US.

Why?

Well, the population in Africa is much younger, and the obesity rate is low (whereas the obesity rate in the US is an absurd 40%) and the weather in Africa on average tends to be warmer than many parts of the US. Am I saying these are the only factors that matter? Of course not, but I am certain they at least partially explain the difference in the death rate.

I would like to eventually shift the tone of this post into an optimistic one, so you may be thinking “What about vaccines?” Alas, despite the enthusiasm surrounding vaccines developed by Pfizer and Moderna, it remains to be seen how many people will actually volunteer to take one of these vaccines. Given that it has been hard to get people to simply wear masks in certain parts of this country, a vaccine feels like it would be an even steeper uphill struggle.

Worth noting that the resistance might not be limited to states in which voters overwhelmingly supported Trump in the recent election, as I recently asked my mother – a left-leaning woman in her sixties living in California who was ecstatic about Biden’s victory in the presidential election – and she said that she was unsure whether she would get the vaccine as soon as it became available. I asked her why and she said that she has “never even gotten a flu shot before…” (perhaps another topic for another day…)

I feel like there are more people out there like my mother than we realize. Reasonable people who have no trouble wearing a mask and following other rules but will take a “wait and see” approach when it comes to the vaccine. If cases and deaths have fallen by spring next year (simply due to warmer weather), then it will give people like my mother even less incentive to take a vaccine.

There might also be logistical challenges involved, as distributing and administering them to millions/billions of people is not an easy task. Indeed, as of this writing, only six percent of the 20 million vaccines that were supposed to be distributed by the end of the year have actually been distributed.

Not to mention that nobody has any idea if there are any side effects or potential risks associated with receiving the vaccine as these vaccines have been developed and rushed out in recording breaking time. Of course, if they work as intended without any negative effects, the overall health situation will definitely improve sometime next year.

Unfortunately, many of the negative aftereffects that resulted from the crisis – the destruction of the job market, the massive expansion of power of the government, and central banks’ QE infinity – will continue long after the virus is eliminated. Let’s start with the first of these. Even if cases and deaths decrease and the overall health situation improves significantly next year, the job market will likely take much longer to recover. It is quite possible that millions of jobs in certain sectors such as hospitality and tourism might never recover to their pre-pandemic levels. Many companies have realized that videoconferencing works just fine and saves time and money, so it seems logical to conclude that business travel will remain at permanently lower levels.

The destroyed job market and resulting unemployment means lower tax revenue and decreased business activity. In response, the government will have no choice but to use the only tools they have at their disposal – namely imposing higher taxes. Though control of the Senate remains up in the air with the Georgia runoffs in early January, I do not think it is unreasonable to assume that we should expect higher taxes (both federal and state), property taxes, capital gains taxes, estate taxes, etc., in the near-term future.

Meanwhile, as the economy remains weak, politicians will propose stimulus checks, rent/mortgage cancellation, and even student loan forgiveness. Such policies will increase deficits and eventually lead to inflation, currency devaluation, and potentially even social unrest. Due to their experience with the pandemic, the government now knows that they have the power to continue imposing restrictions because they have learned that no one is willing to stand up against them. I will not be surprised if we start seeing red tape such as “virus-free certifications” added on top of the existing burdens that small and medium businesses (which make up approximately 50% of employment in the country) already have to deal with. This will especially be the case for businesses that have a physical brick & mortar presence.

These changes result in a nasty vicious cycle. Business activity and tax revenue decrease, so governments respond by increasing taxes while running up the deficit by handing out more “stimulus” money to Americans. At the same time, the government will start imposing more regulations and red tape ostensibly in the interest of “health” and “public safety.” The increased regulations will make it more difficult for companies to hire, which makes the job market become worse, which again results in decreased tax revenue and perpetuating the cycle all over again.

Meanwhile, central banks’ approach to addressing the crisis have been to pursue expansionary monetary policy. If we remember our lessons from Econ 101, an increase in the money supply, all else being equal, will cause a decrease in average interest rates. If the money supply increases faster than the growth in real output, the result will be inflation. Since 2008, the wealthiest Americans have been the beneficiaries of the Fed’s policies, as the stock market, rare artwork, and luxury goods have increased in price at eye-watering rates.

G10 Central Bank Expected Monthly QE in 2021, in USD

Speaking of eye-watering, the S&P 500 is already at unprecedented heights but could easily continue climbing even higher as the money printing continues in 2021 and beyond (see exhibit above).

Stocks such as Tesla – which is worth more than GM, Ford, and Fiat Chrysler combined – can continue to defy reality since hey, who cares about fundamentals anyway?

Many have drawn parallels between today’s bubble to the first dotcom bubble at the turn of the century, but it is important to highlight a key difference. In 1999, the 10-year US treasury yields were at 6% while today the rate is less than 1%

What will cause the music to stop? Or perhaps more importantly, when will the music stop? It is hard to say with any sort of precision, but I think it is safe to say that while the current environment of low economic growth, low inflation and low interest rates can continue for an extended period of time (and with Janet Yellen appointed as Treasury Secretary, perhaps even longer than we think…), it is ultimately unsustainable. At some point there will be an inflection point, where the global economy will take on a new course, whether by design or circumstances. What will be the catalyst for this change?

War?

Another pandemic or health crisis?

Some other man-made catastrophe?

Or a natural catastrophe?

I mentioned earlier in this post that I wanted to end on an optimistic note, and then proceeded to become very pessimistic… So here, finally, are a few positive trends that have emerged over the past year. The first and most obvious is WFH. Although I said at the outset that WFH is one of the reasons the past year became one big blur, I believe the benefits largely outweigh the negatives by a fair margin.

Companies can save time and money, while employees can choose to make decisions about where to live independent of where their employer is located. Obviously, remote work is not realistic or practical for all industries, but for many industries it is likely to be the norm and it is certainly nice to have as an option. Shameless plug: My company Alpha Vantage has been a “remote-first” (working remotely is the default option) company since inception and we are hiring!

Another positive trend that I see emerging is in higher education. Scott Galloway, who teaches marketing at NYU Stern School of Business, put forth the argument earlier this year that the pandemic would serve as the catalyst for an “implosion” in American higher education. A post made in July 2020 on his personal blog shows the analysis of 441 universities in the US that plotted each school across two axes “Value” and “Vulnerability” (each having the “low” or “high” designation for a total of four quadrants).

The best category are the schools that find themselves in the “high value / low vulnerability” quadrant, which he labels “Thrive.” These are composed of “elite schools” which includes most of the Ivy League (curiously Galloway had Brown in the 2nd best category of “Survive”) and other highly selective private schools such as MIT and Stanford as well as a few less selective but reasonably priced public schools that “offer strong value and have an opportunity to emerge stronger” from the pandemic.

The worst category are the schools that find themselves in the “low value / high vulnerability” quadrant, labeled “Perish” “Challenged” (he subsequently updated the label to be less morbid). These are school that are characterized by “high admission rates, high tuition, low endowments, dependence on international students, and weak brand equity.”

The unfortunate reality in the US is that many students graduate (or leave without a degree) saddled with massive amounts of debt and zero job prospects and universities are not held accountable because the onus to repay the debt lies solely with the student. As a result of the pandemic, schools across the nation have found their enrollments plummeting, and many of the less selective but still expensive private schools with small endowments that rely on student tuition will find themselves in dire financial straits. Many of these schools could very well be forced to shut down. Others facing less severe circumstances might be forced to accept more students at lower tuition rates. While I do not necessarily wish for the wholesale collapse of higher education in the US, I can say without hesitation that the current system is broken.

In spite of 2020 and my somewhat pessimistic view of what is to come, I am looking forward to 2021. We will have a new administration and we will have vaccines. How effective both will be remains to be seen, and neither will offset the damage that was caused in 2020, but they do mean that some problems are on their way to being solved, or at least being managed better than they are currently. I am not quite optimistic enough to say that 2021 is going to be an “easy” year, but I am hopeful that it will be “different,” and that this level of different makes it easier for the world to get back on track.

Wishing you all the very best of health, happiness, and success in the new year!

—JOP