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On the Shoulders of Giants

March 2018 Insight

This past month I had the good fortune of attending the Strategic Investment Conference in San Diego. It was quite different than I expected and definitely to the upside. Instead of hearing investment experts pontificating about their projects and investment theories, presenters included historians, sociologists, econometricians, demographers, political scientists, geopolitical analysts, a twenty-eight year old multi-billionaire crypto currency miner, and the president and CEO of the Buck Institute for Research on Aging.  Even the economic and investment experts were world renown authors and money managers, including Jeff Gundlach, considered by most to be the most preeminent bond trader in the world, David Rosenburg, Chief Economist – Gluskin Sheff and frequent contributor to CNBC and other media outlets, and John Burbank, CIO – Passport Capital and part owner of the Golden State Warriors.

I could use a lot of ink recounting the various insights and tips learned from the speaker line up, but it would take a considerable amount of time to read and I have a feeling that much of what I would write would only be interesting to me and maybe a few others. Instead, in the following paragraphs I will try to boil down the event into my three most poignant takeaways. Hopefully they will also be of value to you. In full disclosure, even my “boiled down” recount is expansive, so this article is considerably longer than most.

Before I jump in I need to withdraw/modify an opportunity I presented in last month’s Insight. I said that I thought farm land could end up being an opportunity due to rising interest rates and my expectation of a stronger dollar. There could still be opportunities due to the rising interest rate environment, but I have done a complete 180 degrees in my thinking as relates to the strength of the dollar. I now believe it will weaken over the next several years, providing a tailwind to agricultural commodity prices, though the possible trade war could impact certain categories of these commodities. A weakening dollar, especially paired with increased trade restrictions should also increase demand for domestic light industrial real estate. We were already high on light industrial as an asset class but have now moved it near the top of our priority list.

Back to the Conference:

The Hit the Fan Plan:

After the fires many of us realized we should have had a plan. Something, somewhere that could be used as a reference in times of trouble when emotions are high and you are trying to do as much as you can as quickly as you can. Our list would have included what to grab/pack: underwear (check), cell phone (check), laptop (check), kids “lovies” (whoops), as well as what to do: turn off propane (check), leave contact information on front door for fire (nope), etc.. Do you have an investment plan for when things hit the fan? Despite every thought to the contrary during times of stability, we all think we will be able to act rationally regardless how bad things get. We like to think we will buy at the bottom, we won’t panic and liquidate good positions, etc.. But unfortunately that is really only true for a fraction of us, and we won’t know which fraction until things get ugly. Instead of hoping we are among the few, the proud, the rational, we are probably better off putting together a document of how we will handle each of our investment positions when things aren’t going well. This should apply not just to each position individually, but more importantly to when the market, the economy, etc. is under duress. With a plan as a grounding rod, and hopefully with the intestinal fortitude to follow it, we can turn an experience that will scar many people for years into the future, into one that is highly profitable.

Regime Change:

Odd for an investing conference, but it seemed to me the most common phrase used by presenters was regime change regardless of their area of expertise. Taking a few steps back from our day to day lives and looking at things over a longtime horizon this makes sense. After all, we have been in what is commonly called “The Great Moderation” for over three decades now, a long cycle by history’s standards. The following are some of the regime changes mentioned:

1. Labor: The printing press caused the price of books to drop by 90% and destroyed the profession of the scribes. Inventions in the industrial revolution destroyed entire classes of the population and led to revolts in many parts of the industrialized world. Change, difficult change, is not new. Karen Harris, Director of the Macro Trends Group of Bain and Company, presented their Labor 2030 forecast. Their belief, and one they are banking their business activity on, is that we are entering another labor dislocation (regime change) similar to the industrial revolution, this time with automation and robotics eliminating 25% of the current workforce by 2030. Other speakers at the conference thought this estimate was conservative and a much higher percentage of the workforce would be displaced. Even if they are wrong by half it will have major implications to our investment portfolios.

2. Volatility: Over the last few years we have experienced an unprecedented period of extremely low volatility. This is after years of volatility decline as markets learned to trust central banks to “de-risk” investing by having the market’s back. No more. For one, the central banks are losing credibility in the eyes of market participants. Two, the new Fed Chairman, as the Chairman of the most important central bank in the world, has a very different viewpoint on the Fed’s duties than past couple Chairs. His comments since his appointment have been rather vanilla, but if his own history is any guide, Chairman Powell will not be following the same dovish and market protectionist path of his predecessors. Another thought here is that low volatility markets favor buy and hold investors but high volatility markets favor traders because most investors don’t have the willpower to hold positions through high volatility.

3. China: At the 19th Communist Conference earlier this year, Chairman Xi changed the incentive structure of the technocrats that run China. Previously it was all about growth. The Party largely turned its eye to local politicians lining their pockets with kickbacks so long as production and economic growth kept rolling forward. It was necessary for China to do this to deal with the huge amounts of population moving from the country and into the industrialized centers. Population migration and growth rates are changing, and the previously critical economic growth is no longer needed for societal stability. Instead Xi is now focusing on development of domestic markets, a reduction in excess production capacity, and a focus on environmental responsibility. For years the excess capacity in China has been exporting deflation to the rest of the world. If this is being reversed expect inflation to increase. (Note: China is crushing the world in innovation and company creation. As I have discussed many times in the past, new company creation in the US has fallen below the rate of company death rate. Do you know how many companies are in the Wilshire 5000 index? 3,492. Nowhere close to 5000. There aren’t enough companies to fill the index).

4. Federal Reserve/Interest Rates: Starting with “The Maestro” Alan Greenspan, through Ben Bernanke and to Janet Yellen, there was a consistent direction of interest rates, down. Not only has this reduced market volatility (see above) it has made owning nearly all asset classes a winning proposition. While certainly not the only consideration, there is no question this asset price trend has exacerbated the rich/poor gap. Despite the share of the world’s debt trading at negative yields increasing over the past several weeks there are strong indications that interest rates will increase over the next twelve months and likely farther into the future. As the Federal Reserve pulls back from the bond purchases, and with the addition of an exploding deficit, the supply of bonds available for purchase will greatly increase. Where will those buyers come from? The bond market dwarfs the size of the equity markets despite the worldwide stock market increases over the past couple years. Yet the equity markets are still large and liquid. Yields will have to increase, but once they increase enough there will be investors that will move from the equity markets to the bond markets for the interest income that is available. But it will require an increase in market rates to get there. The history of debt markets is far greater than that of equity markets, going back hundreds of years. This history reveals other periods of low interest rates (even as recently as the 1950s and 1960s). The trend has always eventually reversed. It is highly unlikely this time is any different.

5. Demographics: The Baby Boomer generation was the largest US generation ever. They were followed by the Gen X’ers, a much smaller generation. As Baby Boomers move into retirement, and then into the late life cycle, the social contracts that have been in place for the past 80 years will be severely stressed. Following Gen X are the Millennials. Unlike the relatively wallflower-like Gen Xers, Millennials are not so willing to accept the life that has been given to them. There is no question that policies passed by largely Baby Boomer politicians have spent money they didn’t have that will have to be paid back by future generations. Issues with entitlement programs will shine a light on this. After all, even the rather staid Congressional Budget Office predicts Social Security will be insolvent by 2026. Who then pays the Social Security payments for the remaining Boomers (there will be a lot of them) and the front end of the Gen Xers? It will fall on Millennials more than anyone else. Don’t expect them to be happy about it.
Elsewhere in demographics, but unfortunately a tailwind to the abovementioned issues, is that population growth in general is slowing down. The western world social contracts are Ponzi schemes dependent on growing populations to contribute to the system for the benefits of the recipients. Non-immigrant population growth is essentially zero. Our population growth comes from immigration. And we know what is going on with immigration right now.

6. Populism and Politics: While likely most correlated with the demographic cycles as discussed, there are considerable other tailwinds pushing the growth of populism. Not least of these is the widening of the rich/poor gap and middle-class job losses, first through reduced trade barriers and increasingly due to automation. This is not solely a US phenomenon. Presenter Neil Howe wrote about this coming shift in western societies in his book The Fourth Turning (next up in my audible queue) and spoke about it at the conference. The Baby Boomers were a revolutionary lot. Think of the social upheaval during their younger days. They felt they could do better than previous steady, conservative generations at running the country. For a while they were right, but as mentioned in bullet point #5, government spending over the past 16 – 18 years has exploded, most of it funded through debt that will have to be repaid by future generations. Additionally, there are issues like [insert your own pet social issue here] that have people up in arms, thankfully not yet literally. Many, if not most of the old solid blue-collar jobs that have been lost are the younger edge of the Boomers. The Boomers are revolutionary. The Millennials are being “charged” for excesses of the elders. The Millennials are appearing like they could be revolutionary. Add to this massive expected job losses due to automation. Those affected feel like the establishment has failed. Populism is the natural result. To the thinking of the presenters, there isn’t a question about whether populism continues to strengthen, but rather whether the populism of the left or the populism of the right ends up wresting control.

7. Life Span and Living Span: For generations, life span in the US has steadily increased. At least until lately when life span growth has largely plateaued. Part of this is due to a divergence in life expectancies between socio-economic groups with higher income/higher wealth groups continuing to live longer. Groups like The Buck Institute are likely to cause an acceleration in the life spans of high income groups (and probably in the future all groups) over the coming years, but that is only a small part of story. The true growth will be in what is being called “Living Span”. This is easiest understood as measuring the life in your years versus the years in your life. By tackling the disease of ageing, major gains have been made in reducing morbidity with much greater advances being in final testing and/or regulatory approval. There are two massive implications to investors (outside direct investment in the space itself).

a. People that are healthier for longer will need things to do. This will mean many people will stay in the workforce longer. Others will be spending more money living life versus money spent on trying to stay alive. This is opportunity for companies that can provide options for these people to spend their money and for companies that can figure out how to tap into the substantial expertise that will keep at least one foot in the workforce versus where it used to retire and go away.

b. These inventions/advancements will exacerbate the rich/poor gap as the same people that can afford the new technologies are the same people that are making the highest incomes (or have the largest investment portfolios). Longer careers and/or investment horizons paired with higher incomes and/or capital bases will result in greater wealth in the hands of those that are working/investing longer. Separately, these new advances should eventually increase life spans. Without changes to the entitlement programs across the world the longer life spans will accelerate the demise of the Social Security and Medicare programs at the expense of younger generations.

8. Financial Markets and Banking: Bitcoin has gotten a lot of financial press over the last several months due to its meteoric rise in price and its ensuing collapse, though even with the collapse the price (as measured in dollars) is still over three times higher than it was 12 months ago. Most of the media is somewhat mocking of Bitcoin and other cryptocurrencies. Much of their claims aren’t inaccurate in a purely technical sense but most presenters at the conference are taking a dramatically different approach. On multiple occasions it was pointed out that internet stocks, hype, and hysteria followed a similar path, going parabolic in the late 1990s before getting crushed in the early 2000s. Many companies disappeared and their investors lost huge amounts of investment. But the utility of the internet remained and the winners that came out of that correction are now among the largest companies in the world and most American’s can’t imagine their daily lives without instant access to the internet. The idea is cryptocurrencies, and even more so blockchain technology, is following the same path, and once it all shakes out the blockchain is going to completely redefine our daily lives. Including a complete transition of the banking system as we know it, which has been largely unchained for hundreds, or even thousands, of years. Bankers are an extremely wealthy bunch of people so this transition is not going to happen quietly. Expect all kinds of regulation to be used as roadblocks as banking lobby leans on their pocket elected in order to protect their territory. But as more and more millennials move into positions of power those roadblocks will be eroded.

What ideas would get me thrown off the set of CNBC?

Presenter Jared Dillian made the point that being a contrarian when everyone else is being the same contrarian isn’t being a contrarian at all. To be a contrarian you have to come up with ideas that other people have never thought of and would think are preposterous. He takes that line of thinking a step farther and pairs it with the observation that the financial media is almost never right. To his way of thinking contrarian ideas are the ones that will get you thrown off the set of CNBC if you were lucky enough to be invited and brave enough to show conviction in your ideas. That line of thinking resonated with me. Not because all contrarian ideas are good ones, but if I am thinking about what would get me thrown off CNBC I am less likely be caught by surprise when the consensus is wrong. And occasionally, one of these contrarian ideas may turn out to be a money maker. The following are some of my ideas that wouldn’t go over on CNBC but I think need consideration. Some of the below were influenced by ideas presented at the conference.

1. De-urbanization – Consensus is that small towns are going to continue to wither while population centers continue to attract the best and brightest. But what if this isn’t true? What if the gig economy will create opportunities for people and families to not have to live in crowded and expensive cities? What if delivery services like Amazon are bringing city comforts to the country? What if technology leads to a home schooling boom (this is already happening BTW)?

2. Interest rates are going down – Everybody knows interest rates are going up. Everybody. At Altus we have largely pulled back and gotten far more conservative around new investments in apartment repositioning projects, which has been our bread and butter for the last couple years, due to the non-permanent nature of the required financing. With the deficit growing, the Federal Reserve reducing its debt holding positions and corporate debt at historical highs, the economy is awash in debt, which should cause interest rates (the price of money) to increase. It is simple supply and demand. But what if other factors are contributing to keep interest rates low, or even moving lower? Population growth is slowing, investment has been flowing into capacity usage maximization (Uber) and price discovery (Amazon), and geopolitical risks are rising. These are all factors that are deflationary and/or push down interest rates.

3. Retail – Lenders don’t like retail. CNBC doesn’t like retail. No one likes retail. Except that in many places retail leases are setting new highs and tenants are fighting over certain types of spaces. Could it be that consensus has over reacted? After all, nearly all assets are a good buy if the price is low enough.

4. Unions’ usefulness is over and is going away – Maybe. Possibly. And the argument can certainly be made that the very reasons for unions’ existences are no longer present in the economy. But it also may be that unions will be able to step into the non-hierarchical structure of populism movements and provide the structure, discipline, and commonality of voice the movements need to gain traction. Desperate times call for desperate measures. It was desperate times when unions first gained their prominence and power. If 25% of the work force will be unemployed in 12 years due to automation, we might face some very similar desperate times.

5. Trump’s policies are good for the long-term US economy – It is largely the consensus in the press and “sophisticated” circles that Trump’s policies are too much too late (tax cuts), far too much too soon (tariffs) or outright in left field (deficit spending growth in a strong economy).  Outside of the decrease in the speed of new regulations, which I support heartily, I can’t wrap my head around the logic behind these moves. But what if I am wrong? After all, he certainly isn’t the first president under which protectionist trade policies have been instituted. Shoot, it was protectionist trade policies put in place to protect northern industry against the more advanced English industry that led the South to secede in 1861. Even our previous administration used tariffs as a geopolitical weapon, just with a lot less fanfare. I guess the point here is that while I/we have beliefs on the sanity of decisions, the truth is only time can provide a report of those decisions, and even then the outcomes of those decisions have to be judged with so much economic “noise” that we can’t know for sure if the judgement is clean.

6. Construction prices are going to drop precipitously within 10 years – Despite the slowdown in new regulation over the past 15 months on a federal level, regulation on local and state levels continue to accumulate. All those regulations increase costs. Construction hasn’t seen any productivity gains in 30 years, most of which I believe is due to the continual increases in compliance requirements. There doesn’t seem to be an end in sight. But what if new technology changes this? What if housing costs become such a hot button topic that the approval cycle for new means and methods is shortened to the point where incremental improvement materials and methods become profitable because the approval process is less onerous. What if there are enough of these incremental improvements that it adds up to real dramatic change? What if there is one or more technologies that can create real dramatic change on their own (3D printing for instance)? This is scary to think about as a real estate company who uses cost of construction as a key component in investment decisions.

7. Markets and economies can be predicted with a high correlation – everyone says no one can predict the future. But what if this simply isn’t true? What if predicting the future of markets and the economy is really difficult and most people can’t do it but there are some that can? Or what if the financial media can’t do it so they need for the masses to think no one can, or else they will lose their credibility? Or what if the establishment can but because of its incentive structures they are better off keeping the rest of us drinking from the punch bowl as long as possible so they can continue to earn their fees? Sure, this may be a crazy thought, but then again, maybe not. Equity market predictions made by GMO, run by Jeremy Grantham, have been shown in academic studies to have greater than 90% correlation, which is extraordinarily high, though of course it is impossible to know how current forecasts will turn out for another 7 years. If GMO can be that close on equities (they are also calculated to have greater than 80% accuracy on bonds) why can’t another company be able to predict commodities, interest rates, or real estate? My guess is there are those that are and can. The trick is to be able to find them within the asset classes in which we want to invest. We are human, and as humans we are much more likely to either discredit all forecasts because most forecasts we see are wrong, or probably more dangerous, latch on to a forecaster because their outlook agrees with our own (this is called confirmation bias). Buying into a bad forecast is much worse than not following a forecast at all.

Happy Investing.

About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at fjinks@altusequity.com.


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