Hamish Douglass on the global outlook, the risk of a 20% downturn and more
A common question from investors is: “What’s your outlook for the next 12 months?” My honest answer these days is: “I don’t know.” That’s because the world confronts its most complex set of economic circumstances for at least 30 years. Charlie Munger, Vice Chairman of Berkshire Hathaway, said at the company’s recent annual general meeting: “If you are not a little confused by what's going on, you don't understand it.”
It's not a time for overconfidence
I admit it is a little confusing and this may not be helpful if you would like clear advice. But it is not the time to be overconfident. As the great economist John Kenneth Galbraith said: “One of the greatest pieces of economic wisdom is to know what you don’t know.” If you hear other investors expressing strong opinions at the moment, it probably means they are either in ‘marketing mode’ or they are unaware of today’s complexities. Our view is that the coming 12 months could see either further gains on share markets or a major correction. Judging which outcome is more likely is difficult, if not impossible.
The case for continued robust market conditions is convincing. Economies are likely to grow, strongly driven by vaccines allowing economies to reopen, unprecedented fiscal expenditure and aggressive monetary policy (zero interest rates and substantial buying of government and other debt). The scale of government spending and central-bank asset buying is historic and breathtaking.
The problem is that the case for a major correction in stock markets (20% or more) in the next 12 months is also convincing. A slump could be triggered by rising interest rates in response to inflation, a mutation of the covid-19 virus that eludes vaccines, a panic in emerging markets sparked by rising interest rates and a stronger US dollar, a spate of corporate debt downgrades and defaults due to rising interest rates, or the bursting of asset bubbles.
It is foreseeable that any of these risks could trigger a major correction, yet almost zero risk is priced into markets, market risk measures are benign and few people appear concerned. This may be due to the euphoria associated with the reopening of the world’s economies. Or it could be the manifestation of our personal experiences as we emerge from covid-19 and maybe a ‘fear of missing out’ when everyone seems to be making easy money.
We have seen similar situations where markets are priced for perfection and know it often ends abruptly and badly. We are not smart enough to leave a great party at one minute to midnight, just before things turn to pumpkin and mice. It is even harder to judge when to leave a party where the clocks have no hands. We are custodians of your money and we will never reach for risk due to a fear of missing out. Our job is to remain rational, make fact-based analytical decisions, and not get caught up with what other people are saying or doing.
In 1965, Warren Buffett wrote in his letter to investors in the Buffett Partnership:
“We derive no comfort because important people, vocal people, or a great number of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought.”
We know we will inevitably make investment mistakes and it is important that we objectively recognise mistakes. In the past year, two mistakes stand out.
Our two mistakes
The first was Alibaba Group. After initially outperforming after we invested, Alibaba’s share price fell when the Ant initial public offering was pulled in November 2020 after Alibaba founder Jack Ma criticised Chinese regulators. While we never thought Ma would act so counter to his interests, I made a risk-management mistake in allowing our holding in Alibaba to grow via a higher share price to more than 8% of the portfolio.
There are times when we hold such conviction in a position that such an allocation is entirely sensible. The main reason I didn’t trim the Alibaba holding prior to the Ant IPO was because reducing our holding might have diminished the chance of securing a decent allocation in the listing. At the same time, Alibaba was performing strongly from an operational perspective and we assessed the stock to be undervalued. The plan at the time was to gain a holding in Ant before trimming the Alibaba holding to a more moderately sized position. In hindsight, this was a mistake and was likely due to overconfidence and confirmation bias.
Since then, we have trimmed our holding in Alibaba, notwithstanding our positive view on the prospects of the business and our assessment still that the company is undervalued. To avoid making the same error again, we have instituted risk controls that set a maximum position size for Chinese companies and certain other technology companies.
The second mistake of the past 12 months was being too cautious prior to the announcements about vaccine trials results that were released in November 2020. Our focus, as always, was on wanting to protect our investors from the risk had the vaccine trials failed. Thus, we did not place enough importance on the opportunity that would arise from successful trial results. Our combined risk ratio cap (which is discussed below) makes it expensive from a risk-budgeting perspective to place a meaningful proportion of the portfolio in cyclical stocks such as banks, industrials and travel-related companies. We knew the trial results were coming and prior to November 2020 we evaluated numerous more pro-cyclical opportunities (that have all done well since). But for various reasons I decided not to invest in these cyclicals and the portfolio entered November last year with limited cyclical exposure. In hindsight, this was a mistake. However, we will not chase the market after that horse has bolted.
We are happy with the underlying operating performance of each company in the portfolio (and, in most cases, their operating performance through the pandemic has been exceptional). We judge that the portfolio is well positioned to prosper over the next three to five years, almost irrespective of how events play out in the short term.
Risks hiding in plain sight
There is considerable debate and uncertainty on whether inflation will re-emerge as a threat and whether central banks will be forced to tighten monetary policy. It is clear that the reopening of economies and pent-up demand fuelled by expansive fiscal and monetary policies are resulting in constraints along supply chains and in labour markets. This has placed upward pressure on various goods and services such as building materials, certain commodities and transportation costs. It is likely these inflationary pressures will persist for some time.
The big question is whether these pressures will prove to be transitory – that is to say, disappear once supply chains normalise – or lead to more permanent inflationary pressures. Most central bankers say they think inflationary pressures will subside next year and they feel comfortable with their loose monetary policies. While we agree that this is the more likely outcome, we don’t think people should be complacent about inflation risks.
There is a meaningful risk that we may enter a period of inflation that troubles markets. Even if you believe that inflationary pressures are more likely to be temporary, the most important question to ask is what happens if inflation pressures are not temporary. If central banks were forced to tighten monetary policy by reducing, or ending, asset purchases and increasing interest rates, we could witness a major correction in equity and other asset markets.
Other risks hiding in plain sight include some worrying asset price bubbles. It would be fair to say that we are witnessing one of the most extreme delusions in modern history, measured by the breadth of participation and size. This delusion has some powerful attributes: cult-like behaviour, rebellion against authorities, gambling, break-out technology, a fear of missing out and the madness of crowds.
You have probably guessed that the prime example of bubbles are cryptocurrencies with Bitcoin being the pin-up. To put Bitcoin into context, if it were a listed company it would be the seventh or eighth most valuable company in the world (depending on the day).
Devoted followers accuse doubters of not understanding blockchain or the role of cryptocurrencies. Calling out a cult is not popular, particularly when people are making ‘easy’ money. But in times of cult-like behaviour, the most important thing is to stay rational and not be afraid of being unpopular with the crowd.
Let's look at crypto gold
Perhaps the best way to show how weird all this is, is to imagine if someone were to create crypto gold.
Imagine this journey starts via a proposal to launch a gold exchange-traded fund backed by one metric tonne of gold (35,274 ounces). At market prices, the assets of the new gold ETF are worth US$65 million. The gold ETF has one million units on issue so the initial price per unit is US$65, which should move in line with the gold price. The new gold ETF is named GOLDCOIN and listed on a reputable stock exchange. There is nothing revolutionary about GOLDCOIN other than it offers an easy way for investors to trade in gold.
A genius colleague, Hideyoshi Son (excellent, virtuous, good and respectable), proposes some enhancements to GOLDCOIN:
- The total amount of gold in the ETF is fixed at one metric tonne
- The total maximum number of units that can be issued is capped at 20 million units (rising from one million to a maximum of 20 million over time)
- New units are issued to people who solve a complex mathematical riddle.
On review, we run into a problem: that the rules of the reputable stock exchange ban the issuing of units to new investors for no consideration. Not to be deterred, Hideyoshi Son says we need to create a mechanism to trade our product outside the system so we won’t be constrained by stock exchange rules or, for that matter, laws or regulations. He suggests that units in GOLDCOIN be recorded on a new fully distributed ledger known as the blockchain.
This form of ledger changes everything, he argues. Most importantly, a blockchain ledger gives reliable proof of ownership but also total privacy – no one can find out who owns units in GOLDCOIN. Our new product is outside the constraints of the current system and doesn’t have to comply with any anti-money-laundering laws, exchange rules, consumer-protection laws, etc. This provides GOLDCOIN with an enormous potential market.
We launch GOLDCOIN on the new blockchain but things don’t go as planned. Each time we issue a unit to a person who solves the riddle, the value of a unit of GOLDCOIN falls. We are so stupid. Obviously when we create units for no consideration the value per unit falls. In fact, once the total number of units reaches the maximum 20 million allowed, the value of GOLDCOIN will fall by 95% on a per-unit basis.
Hideyoshi Son sees the flaw in our product. The problem, he says, is that the asset backing of GOLDCOIN is fixed at one metric tonne of gold. The solution, I suggest, is to increase the asset backing up to a maximum 20 metric tonnes of gold, in line with the maximum number of units we can issue. If we do this, each unit will always be backed by 0.035 ounces of gold. We now have the perfect product, a digital form of gold where each unit is always backed by the same quantity of gold, that can be traded anonymously on the blockchain outside of the reach of authorities.
Hideyoshi Son says so far so good but we need to do something more radical. He says the proposal to fully back the product with gold won’t work under the magic he is proposing where crypto mining and the solving of a complex riddle lead us to create another unit of GOLDCOIN. He says if additional units are backed by gold, and paid for, then no one will be motivated to solve the riddle.
He says the solving of a complex problem and setting a maximum limit on the total number of units that can be issued is essential to the psychology behind the illusion. He says to solve the problem of dilution resulting from issuing new units we need to remove the physical gold underpinning the value of GOLDCOIN. By removing any tangible asset backing from our product there can be no dilution when issuing new units – you cannot dilute something that has no value. He argues that people can be convinced that GOLDCOIN, with a capped number of units to be issued, is a new form of digital gold.
Sceptical me asked: “How can something that is imaginary, with no tangible value, be more valuable than our original product backed by one metric tonne of gold?”
Hideyoshi Son, a master of human psychology, says we have the perfect circumstances to create an illusion, one that defies the laws of economics and logic:
- Post the financial crisis of 2008-09 and the recent pandemic, millions of people are worried that the world’s major currencies are being debased by excessive ‘money printing’ by central banks. He says placing a cap on the maximum number of units of GOLDCOIN that can be issued plays into these fears. He has inverted the law of dilution to a law of scarcity;
- Removing any tangible value from our product removes any anchoring bias around its actual value;
- The fact that ownership is untraceable, and the fact that it can be traded, makes units the ultimate medium of exchange for illicit activity;
- The riddle-solving (or mining as it was to become known) to win a newly created unit and the dazzle of the blockchain give our product mystical properties;
- ·Social media, with the right clickbait, will fuel unconstrained and widespread promotion of our product – no need to worry about legal constraints such as laws that demand a prospectus. He is most excited by a platform called TikTok due to its ability to attract a generation of first-time speculators. He guesses that as the price is driven up, more and more speculators will get on board. The mainstream media will become infatuated, thus giving GOLDCOIN legitimacy; and
- ·As momentum grows, more people will be attracted to this unregulated system of easy money. Entrepreneurial people will offer services such as exchanges and crypto wallets.
Hand it to Hideyoshi Son, a true genius. He has created the illusion of scarcity and hence value from something that has no intrinsic worth. Our product, he argues, will become the world’s greatest Ponzi scheme. Some call his scheme a new digital currency or even crypto gold – highly amusing given that there is no gold backing.
The above illustration clearly is absurd and defies logic
This imaginary product has attributes that are similar to those of Bitcoin. In our opinion, it is virtually certain that, in time, cryptocurrencies that are not backed by assets or by a central bank will become worthless. It is concerning, but not surprising, that regulators have not put in place appropriate regulations and consumer protections. They should.
Cryptocurrencies are operating outside the system, which enables their use for money laundering, terrorism, ransom, cybercrime and other illegal activity. It is inevitable that the regulators will catch up, and the day of reckoning may be approaching sooner than people expect. It is likely that this will end in tears for many people.
That said, while we are sceptical about the value of today’s cryptocurrencies, we believe in blockchain technology and think it will have profound implications and disrupt many industries. We expect that most central banks in time will issue digital currencies and private asset-backed cryptocurrencies (or stable coins) will enter more common use.
With the explosion of government debt following the pandemic amid the money printing of central banks, the case for a gold-backed cryptocurrency grows by the day. Maybe there is some truth in GOLDCOIN after all.
First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.
Analysis as at 4 August 2021. This information has been provided by Firstlinks Pty Ltd (ACN 161 167 451), a Morningstar publication, for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances. This article does not reflect the views of WealthHub Securities Limited.