Allocation and Investment Committee Meeting 05/06/24
Our notes on the economy
As we wrote last month, we were having a hard time seeing the Federal Reserve Boar cutting rates in June. Now that seems like an impossibility. Inflation and the economy appear to be cooling, however, not enough for the Fed to start cutting rates just yet. The job market is still extremely robust with the unemployment rate staying below 4% for the last 27 months. The last time we saw this kind of streak was 1967-1970. We currently sit at 3.9% off the 3.4% we saw last month. Might we send the end of this streak? We don’t know.
Our discussion on the bond markets
We think that it is more important to be correct on the overall direction of any move than it is to be correct on exactly when a particular move begins. Where there is almost 100% agreement is that the Fed will start cutting rates and then continue to do so through the year 2026. That is the direction. One of the old adages that all of us were educated decades ago was that you do not fight the Fed...ever. If the Fed is telling us that rates will be cut, then we need to be ready for when that happens. How do we do that? Bond yields and prices have a counter relationship with interest rates. In other words, as rates rise, bond prices drop. As rates fall then bond prices rise. In simplest terms when rates are falling you want to own bonds at longer maturities. I remember way back in 1994-1995 when rates were rising quickly and steeply. At that point in time, it was possible to buy an AAA rated insured tax-free municipal bond that had a rate of 7%. You read that right. I spent all day talking to people about bonds and many conversations went like this: Brad “Yes this a AAA rated muni with 7% for 25 years'” Person “25 years? That is a long time. Why would I want to hold a bond for 25 years?” Brad “Because it is paying you 7% tax free. If it were 100 years, I would be buying.” Person “That’s just too long.” You think they regretted that? You bet they did. The long-term return of the stock market is only a few points higher than that (the S&P 500 annualized since 1957 is 10.5%) and that 7% rate was insured and tax free. At the 25% tax rate, this bond had a taxable equivalent yield is a whopping 9.33%. Who wouldn’t want that kind of return that is all but guaranteed? But the story gets better. As rates started their long walk downward, the prices of these bonds went up every year as well. So not only did the investors receive that 7% tax free yield, but they also saw their principle rise annually as well. The Fed is telling us that rates will go lower at some point, and it could take place for at least a couple of years. Wouldn’t it make sense to start buying longer-term bonds knowing this information? We are not suggesting 100-year maturities, however, if the ten-year Treasury hits 5% we would have to look very intensely at buying all we can for investors. That 5% sure would look nice in anyone’s portfolio if you ask me. I recently saw a chart that was published by Charlie Bilello. He pointed out that the single best predictor of future returns for bonds is the starting yield (in this case it was 97% correlation). With the recent rise in rates, we have not seen prospective returns for bonds this high since 2007.
Our discussion on the equity markets
An Uncrowded Thought on Growth AND Value Rather than join the crowded debates on more growth or value for the next market cycle, let us share with you a specific problem that may lead to extraordinary profits, yet is an opportunity that’s priced cheaply. Lots of investors’ attention and anxiety is being spent on the runaway success and risk of big technology right now. There is a different lens we want to share with you, to look at the same topic but from an uncrowded location in the markets. Nvidia is one of the most astoundingly innovative companies we have witnessed in our careers (and in history). We were fortunate to acquire a stake in the business several years ago, after a deep dive we took to learn how Graphics Processing Units could change most of what we knew about technology. We were simply curious, just as we are about this next opportunity.
Now what may be the most surprising thing about powering the future of technology, will be finding...the power. The next time you hear somebody reference the game-changing potential of “AI” - smile and nod with the uncrowded knowledge of what remains the most valuable game UNchanger – the electricity that all this technology needs. You could buy every share of every single energy stock combined, for less than the market cap of Nvidia. The operating income of the energy companies you’d be acquiring is 7x greater than Nvidia’s – and it would cost you less. You don’t have to disagree with the future of technology to see better values. In this remarkable case, the value is being multiplied BY that future. To share one specific example, after data center construction in Georgia, the utility delivering that state’s power revised its demand forecast by 2030 higher - by 17x!
We will hazard a guess that a few blackouts over the summer will remind Americans, no matter what their politics are, that each energy transition throughout history is actually a net addition of all sources. Natural Gas is the most reliable and affordable source. The companies producing, delivering and storing it have never had better balance sheets to take advantage of increased demand. But getting power to data centers and elsewhere also requires a lot of beautifully boring businesses that offer tremendous value for investors. Traditional and renewable sources of power generation take a lot of good ole fashioned wires and cables (a game UNchanger). A project manager of one of those companies – Encore Wire - with its entire manufacturing operations located in Texas (photo above), reminded us recently of a good ole fashioned business metric that is wonderfully uncrowded, when he said, “We still cut multi-million dollar deals with a handshake.” Those trusting us to find these opportunities to invest in were rewarded with a buyout offer for their shares last month. The direction of the overall markets do not matter to the limited supply of undervalued businesses with increasing demand from their customers.
Interesting thoughts we discussed
According to the state lottery commissions and the Census Bureau, the Economist reported that Americans in the poorest 1% of zip codes spend nearly $600 a year on lottery tickets. What amount do you think the richest 1% spend on lottery tickets? $150 a year. As a percentage of income, the poorest households spend 30x more than the richest households. At first this fact really wowed me. But then I guess it started to make a little more sense. Maybe, for many of the poor, this is their only hope of ever making their way out of their financial situation. Ryan sent me an email the other day. It was a You Tube video of Nvidia CEO Jensen Huang speaking at the Stanford Insitute for Economic Policy Research. The audience was varied including a fair number of some of Stanford's top business students. The interviewer asked him what he would leave with these students. His answer was at first a bit shocking and was met with nervous laughter.
“If I could wish anything upon you, I would wish upon you ample doses of pain and suffering.”
He went on to explain that only through tough times do companies and people grow in character. There is no growth when all is well. So, when he hears news about his company that shows that there is pain ahead, he can greet it with cheer. This pain is nothing but an opportunity to grow as a company.
Allocation suggestions
Taking in all the above and we continue to maintain that our portfolios have a base allocation that is comprised of:
50% Stocks
30% Fixed Income
10-20% Private Investments or Alternatives
All investors and their plans are created differently, and every investor should have an allocation that fits their needs. The above allocation is what we call our “base” which primarily is for people looking to grow their assets. The percentages will change depending on where clients are in their lifecycle and plans.
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