Client Update: October 15, 2023
“You only find out who's swimming naked when the tide goes out.”
― Warren Buffett
The U.S. economy has been on a wild ride the past couple of years. After a long period of relative stability and accommodation by the Federal Reserve following the Great Recession, the pandemic pushed markets into a tumultuous and stormy period, which was then further complicated by accelerating inflation. Now, at long last, it appears that some of that tumult may be easing or at least slowing; the Federal Reserve just declined to raise rates, though there are hints it may raise rates slightly again this month. This moment thus offers us a good opportunity to catch our collective breath and take a look back at the events of the past 12-18 months. What happened, what lessons can we learn, and can we turn this hindsight into foresight?
Let’s begin by setting the stage. Prior to the pandemic, the federal funds rate had been hovering near or under 2% since the Great Recession (including two years at or near zero immediately after the pandemic hit). Then, starting in early 2022, it started shooting up. Now at nearly 6%, the funds rate is higher than it's been in two decades. Of course, that’s because inflation has also been unacceptably high, peaking at 8% for the year in 2022 (though now less than half that and trending downward).
In turn, this upheaval (exacerbated by other world events, like the Russian invasion of Ukraine) has caused or contributed to all kinds of economic drama, including the collapse of Silicon Valley Bank, the bond market entering virtual free fall, the rise and fall of NFTs, constant predictions of an always-imminent recession, and more. How did things reach this point? Obviously, the pandemic has played a significant role here, but we’re past the point of being able to pin everything on Covid-19. Instead, we would argue that complacency has played as much a role as any other factor in the economic dramas of the past 18+ months.
Bear in mind, economic forecasting is extremely hard even for experts. If we review predictions from early 2022, we immediately see that expert expectations regarding Fed policy were significantly off. On January 20, 2022, Goldman Sachs said it expected the Federal Reserve to raise rates four times that year. A Reuters poll of economists found, on average, they expected only three rate hikes. In fact, the Fed raised the rate seven consecutive times in 2022 (plus four more times so far this year) and, further, raised them more aggressively than most analysts expected. Economists correctly identified the trend but fell far short of the actual movement in rates.
Admittedly, it’s incredibly difficult to handicap rates and Fed policy, but many economists and businesses simply grew complacent. Extremely accommodative Fed policy had endured for such a long time that many organizations became lax, taking quantitative easing and/or a low-cost borrowing environment for granted. Then, when it began to change, inertia and resistance held them back from adapting quickly.
We saw the danger of this complacency and inertia play out in the banking crisis earlier this year, which was largely the result of people failing to get ahead of the interest rate cycle. Silicon Valley Bank (SVB), for example, invested heavily in U.S. government bonds while interest rates remained near zero. However, as the Fed aggressively raised rates, bond prices fell, pulling the carpet under from under SVB’s bond portfolio (which, just prior to its collapse, was yielding 1.79% returns versus the 3.9% yield of the 10-year T-bond at the same time). Simultaneously, higher rates meant many tech companies – the core of SVB’s customer base – had to start pulling more cash to repay debt. SVB deposits fell, creating a vicious cycle that quickly culminated in its collapse.
A year after the Great Recession, investor Warren Buffett said, “You only find out who is swimming naked when the tide goes out.” In other words, it’s easy to stay afloat in a bull market—or in an environment where the Federal Reserve and the U.S. government are being very, very accommodative. When the easy money and lax borrowing drains away, however, those who became complacent will find their bad decision-making exposed.
So too today: institutions like SVB were left exposed. Many other banks and businesses weren’t completely broken but did take a hit. This is partially why, for examples, growth equities suffered so much in 2022.
Something else has been striking about the last year or two, directly related to coming out of an accommodating environment: the prevalence of narrative-driven investments and ideas that never made much sense on the surface. Here, we have ample examples to choose from: cryptocurrency, meme stocks, marijuana stocks, AI stocks. NFTs perhaps stand out the most, though. After reaching a market peak of $17 billion in January 2022, the market subsequently crashed. Less than a year later, the market had lost 97% of its value. Today, a new report has found that the vast majority of NFTs are worth nothing at all.
At the end of day, investments like NFTs and meme stocks are a byproduct of complacency in a low interest rate environment that produces or enables a lot of liquidity in the system, combined with the human tendency to chase what’s new, trendy, and popular. Unfortunately, when the liquidity dries up, investment vehicles that can only survive in a low interest rate, easy-money environment, dry up with it.
While facts win out over the long-term, narrative is a major driver of market behavior over the short-term. People gravitate toward excitement and trendy stories. We as investors need to understand that there is a tremendous marketing apparatus that moves in our business. In fact, this industry wasn’t built by mathematicians or engineers. It was built from people selling to people who were so uninformed about their buying decisions they could only just trust the salesman (often a bad idea). Even today, when we listen to a conference call or read a sell-side report from an average analyst, it is startling to realize how many of the questions are superficial or narrative-based, rather than addressing the underlying fundamentals of the asset.
Combine a powerful narrative with a sense of complacency about the environment driving the investment, and even major institutions – like SVB – can make catastrophically bad decisions.
All this said, we should also note how relatively rare the events of the past year or so are. As investors, it’s extremely unusual to see the environment, from a Fed policy standpoint, shift so quickly or so much.
What all of this means, however, is that long-term thinking offers just as much value – if not more – today as it ever has. The news cycle thinks about last quarter and next quarter; wise investors think about next decade. In our own case, we pay attention to issues like inflation and interest rates, but they rarely definitively impact the companies we own or watch. We would never make an investment based on expectations rates would stay low. Indeed, some companies end up as beneficiaries of the changing environment because their competitive situation improves or because they can deploy a lot of cash at a high rate of return, and we always strive to remain prepared for market changes that create new opportunities.
The key is to always anchor investment decisions to the information that matters most, and that is particularly true in environments undergoing upheaval: what does the company do, what is their competitive position, what does their industry look like, what is their return on invested capital (ROIC), how are they financing their business from debt-to-equity standpoint, what is their CEO doing, etc.?
These are the kind of questions we at GDS Investments ask on your behalf every day. As always, we remain committed to the core principles of value investing: purchasing equities priced below value and positioned for long-term gains. GDS Investments will continue to implement its core investment philosophy and practices so that we are always able to take advantage of under-valuations in the marketplace.
As ever, I remain grateful to you and humbled by your ongoing support.
With warm regards,