The Investment Scientist

Today I had a very productive meeting with a long-time client of mine. At the end of the meeting, I mentioned that he appeared to have lost quite a bit of weight and he went on to tell me that through diet, exercise and some medications, he was able to reverse his diabetes. I am so happy for him! He is truly making the best investment in his life!

Did you know that Warren Buffet made 99% of his $90b wealth after he turned 50? To be more exact, he did it after he turned 54. Now he is 91. So how did he do that? After all, he is such a boring investor! He missed the best moment to get into AAPL. To this day, he is still not invested in TSLA and he totally doesn’t understand Bitcoin. In his entire investment career, he has rarely had a blockbuster win. So how on earth did he accumulate so much wealth? One often-overlooked reason is that he has lived a very long life.

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I learned this “Quantity of Money” equation during my Oxford program and it has greatly helped me understand Fed’s actions and their implications.

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It appears to me that in times of great uncertainty, people want me (a financial advisor) to know where the market is heading the most. Certainly, I have my informed opinions, bringing all my education and experiences to bear. But I often find myself having to explain that I can’t see into the future and tell them exactly what the market is going to do, all I can provide is informed guesses, and long-term investment success should not depend on guesses, informed or otherwise.

Today, let’s do a mental exercise: imagine I can actually accurately predict the market. If an ordinary person had $10,000 to invest in the S&P 500 index on 1/1/2000, by the close of the market yesterday his investment would have grown to $45,320. Not too bad!

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About a month ago, I wrote about the silver lining of fallen bond prices. The message I tried to get across was that the lower prices are not a bad thing: 1) You will still get your principal back; 2) You will earn higher interest income. Today I would like to tell you about another money-making opportunity presented by fallen bond prices – tax loss harvest!

This technique is usually used for stocks, but you can use it for bonds as well.

Let’s say that at the end of last year, you had $200k invested in various bond funds. Since then, bond prices have fallen about 10%. Your bond funds will show a $20k loss on paper. Now you can sell these funds to realize the loss and use the proceeds to buy other bond funds so that you have the same exposure. 

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I am writing this article one hour before today’s market close. If there are no surprises, the S&P 500 will end the day in a bear market, meaning the index is giving us a 20% discount  from its peak. As a comparison, the Nasdaq is already giving us a 30% discount. 

As savvy investors, many of my clients and readers want to know: will the discount get deeper? And how long will the discount last? Well, like I always say, nobody can predict the future, but we surely can learn from history. That’s why I have done a study of all twelve bear markets since 1950. The table below illustrates my findings:

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If you bought a bond fund three months ago, you may have seen your fund go down about 10% in value! What the heck is going on? Aren’t bond funds supposed to be safe? In today’s newsletter, I will explain what’s going on, I will explain why you should still consider your bond funds safe, and I will even give you some hidden upsides of bond funds going down in value.

What’s Going On?
Last month we saw interest rates rallying. Bonds are essentially fixed future promised payments.  The current value of a bond is the sum of all fixed payments discounted by interest rates. When interest rates go up, it stands to reason that, applying the mathematical formula, the current value of the bond will  go down. This mathematical logic applies to all bond funds. 

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From the peak, Nasdaq is down about 24% and the S&P 500 is down about 14%. I am sure when you read your investment statement, you will feel queasy and wonder if you should stay invested. I think this is a good time to review my wardrobe theory of investment. Here is what I wrote in December 2018:

Treat your investment portfolio the same way you would treat your wardrobe…

For simplicity’s sake, let’s say you acquire your entire wardrobe from Neiman Marcus. If Neiman Marcus had an across-the-board 50%-off sale, would you throw up your hands in despair and say, “Darn it, my entire wardrobe just lost half of its value. I better sell it all at the flea market or I will lose everything?”

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When something seems too good to be true, it is often not true. But there is one exception in the financial world: I bonds. 

I bonds are federal government bonds sold to individual investors that pay a very high-interest rate that is linked to inflation. For instance, the current rate is 7.12%. On the first business day of May, the Treasury Department will announce a new rate that will be close to 10%. Some expected it to be 9.62%. Nowhere in the world can one get this high of an interest rate, guaranteed by none other than the US government.

So what is the catch?

Well, there is no catch, but there are some limitations.

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The US inflation numbers for March just came out – it’s 8.5%, another 40-year high. I am afraid that, with the Ukraine War still raging, inflation will get worse before it gets better.

Shortly after the Russian Invasion of Ukraine, the West adopted the “Nuclear Option” of economic sanctions – expelling Russia from the SWIFT system. SWIFT is the payment system that undergirds international trades. Now that  Russia is no longer part of this, it can not sell its energy and agricultural products to the world market. 

How Would That Affect Global Commodity Prices?
Russia is one of the top three exporters of the following commodities: oil and gas, wheat, maize, sunflower seeds, sunflower oil, and fertilizers. On average it accounts for about 15% of world supplies. When these supplies are pulled out of the global market, the price of these commodities will skyrocket as they already have. Since these are basic commodities, and many products use them as inputs. The price shock is going to filter through downstream products as well. 

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In the face of rising uncertainties and the prospect of persistent inflation, today I investigated the historical performance of stocks and gold relative to inflation. Here is what I found:

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Over the last few days, I have begun to sense that a number of my clients are worried since the S&P 500 has dropped 13% and Nasdaq, about 20%. 

I would like to argue, if you are going to worry about something, please worry about the inflation rate, which just went up to 7.9% in February even before Russia’s invasion of Ukraine. 

Why is inflation so much more damaging?
You could have kept your money in a safe, and yet you still lost 7.9% to inflation in one year. If this level of inflation keeps going for ten years, you will lose 79% of the value of your money. That’s basically a wipeout.

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Last Thursday when the news reported that Russia had just launched an invasion of Ukraine, the market opened down nearly 800 points. A client called to ask if we should move to safety, but I was able to persuade him to stay put. I did that without knowing that the stock market would end the day slightly positive, followed by the BEST rally since 2020 on Friday. Such is the unpredictable nature of the stock market. Today I am gonna show you, missing the best days of the market can be extremely costly

Below is research from JP Morgan that I found on the internet. You can see that between 1995 and 2014, the annual return of the S&P 500 is 9.85% if invested through the whole duration. But missing just the 10 best days would drop the annual return to only 6.1%. Missing the 20 best days would drop the annual return to 3.62%. Missing the best 30 days would further drop the annual return to only 1.49%. 

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Yesterday in a client progress meeting, the client asked me a question: “What do you think of crypto?” I usually get this question either when cryptos are rallying or crashing. As you may know, over the last three months, most cryptos have lost 50% of their value. In fact, I more or less alluded to this in my earlier newsletter. I wrote that in a Fed tightening cycle, the vanguard market will fall first. Decades ago, the vanguard market used to be the emerging market, now it’s the crypto market.

So what do I think of crypto? I have asked myself the same question, read a lot of books and white papers about it, and even took a full-length MIT class on crypto taught by Gary Gansler, who is now the SEC chairman. I have a good understanding of the technical aspect of cryptos, but I still can’t figure out the economic rationale of their existence and their sky-high valuations.

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Yesterday, when I had a lunch meeting with the chief scientist at Fannie Mae, our conversation quickly turned to inflation.

My view of that is more pessimistic than the Fed and most mainline economists. Somehow, these economists seem to have forgotten a basic economic tenet – the rational expectation theory. This theory, to put it in layman’s terms, basically says that on aggregate, what people expect to happen will happen. That’s why Fed officials have long been extremely careful about what they say that could change people’s expectations. 

Today’s Fed under Jerome Powell has been much less careful. Here are the three acts of the current Fed that have crushed the expectation that inflation will stay low and stable. 

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I had a blessed 2021! Here are the highlights.

1) Finished all my Oxford courses.

2) Produced a Showstopper improvised musical show for my Oxford classmates at Oxford.

3) Visited the Balkans, especially “the Bridge over Drina.” Learned about its fascinating and tortured history.

4) Took my kids to many Western European cities/towns.

5) Continued my hip hop adventure with Doug. Now I can more or less rap freestyle!

6) Started learning German. With help of a fantastic teacher Kat, I can now speak broken German.

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In my last newsletter article, I explained what tapering means and how that would affect the market. At the end of the article, I opined that the Fed’s leisurely pace of turning off the money spigot may not be enough to turn the tide of inflation.

It now appears the Fed agrees with me. The latest announcement from the Fed has dropped the word “transitory”, signaling its recognition that inflation is here to stay. Not only that, but the Fed’s taper timetable has been expedited. The original plan was $15B less money “printed” every month, with July being the month that money printing will come to an end. The new timetable is to end money printing by March. After that, the Fed plans to raise interest rates three times.

The Fed is the banker for banks. When the Fed raises interest rates, banks have less incentive to lend out money since they could easily make a profit by just parking their money with the Fed. This is the traditional way of reducing the amount of money in circulation. 

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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