Altus Insight September, 2018

The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor

Date: September 30, 2018
FR: Forrest Jinks
RE: A Short, Long Time Ago
 
“If someone has a loaded gun pointed at their head long enough, does it lose its urgency? If a baby is born with the same gun point at its head, does it even know that it is there?”
Dan Carlin
 
“How did I go bankrupt? Two ways. Gradually, then suddenly”
Ernest Hemingway, The Sun Always Rises
 
Ten years and three days ago I married my wife. Or maybe I should say she married me. Two thousand eight had been a pretty rough year up to that point (to be fully accurate, the pain started in August 2007). I was living in my parents’ basement and had made less than $12,000 in income the preceding twelve months. Everyone that worked for me had been let go, including me, though I had to keep showing up at work each day, doing everything in my power to salvage whatever equity was left and use it to pay down lenders and investors, hoping that with each dollar the crushing sense of guilt would be reduced. Through effort, a huge amount of luck, and mowing a couple hundred bank-owned lawns twice a month, I made just enough to keep the doors of the business technically open. And despite being well into seven digits of insolvency, I somehow avoided personal bankruptcy as well. The year leading up to the wedding was the most difficult year of my life, and something I will never forget. And yet, I feel incredibly fortunate as well. Being able to avoid bankruptcy allowed the business to be built back much more quickly than it otherwise would have been. Outside of business, I can’t help but thankful for 2008 because it was the year my wife and I got married.

I have yet to figure out what possessed her to say yes at that stage of my life. I literally couldn’t afford to contribute anything to the new family, despite the long and tortuous work days.  Even more confounding to me is that these ten years and four children later she is still here, at my side in support, as a wonderful mother, and as my best friend.

Ten years and 15 days ago Lehman Brothers imploded, nine years and three hundred fifty-seven days ago began the true 2008 stock market crash; and while those of us in real estate had already been in the mess for a while (residential longer than commercial), suddenly the everything changed for the rest of the world as well.

To most of us, ten years doesn’t seem like that long. Yet it can also seem like a lifetime ago. I was a single adult, which I enjoyed, for considerably longer than I have been married, but it is hard to even recall that life. Everything is different. How I spend my time, how I spend my money, who I consider to be my peers, and in some cases, even who I spend time with. Ten years is half a generation ago (at least using the twenty-year cycle commonly used to define generations: Boomers, Gen-X, the Millennials, etc.). Ten years ago, an eleven-year old didn’t have a smart phone. Index and ETFs were not yet in vogue.

Ten years is a long time. But it is also a short amount of time. Something of a psychological paradox. Recent enough that it can seem to be part of our current life, long enough that the emotions and reactions of the time have faded. Many investors who got beat up badly have recovered and then some; me included. Most current Wall Street traders have never traded in a down market. Leaders of most of the current “unicorns” don’t have a business memory of a recession; and let alone going back to 2001, the last time start up valuations had so disengaged from investment analysis reality.  

Researchers have discovered nearly all investors suffer from a myriad of different biases, sometimes to our benefit but usually to our eventual harm. Recency bias is one of the strongest and most prevalent. Stated simply, recency bias is the assumption that because something has been happening in recent history it will continue to happen for the foreseeable future. The S&P gained 21.83% last year. Therefore, recency bias causes the assumption it will gain 21.83% this year. Federal Reserve Chairmen (or in this case women) make statements that we will never have another financial crisis. Investors stop investing based on company, economic, or geopolitical inputs and instead invest based on euphoria or best guesses of how other investors will invest.
 
Minsky’s debt cycle is important to understand in this context. At the beginning of the debt cycle, borrowers can use the cash flow from the investment made to pay both the interest on the debt and to also pay down the debt. Minsky called this “hedge borrowing”. As the debt cycle accelerates, borrowing for cash flow and business expansion turns into “speculative borrowing”. Instead of the cash flow from the debt paying down the debt, it instead can only service the interest. The speculator is hoping for price appreciation and has to continue to refinance the debt as it balloons. Exuberance enters investors’ blood in the third stage, called by Minsky “Ponzi borrowing”. These investments can’t service the interest cost and only can justify the refinance through price appreciation.  Borrowing increases to pay off previously borrowed money and the cost of that debt, further eroding what equity is left in their investment. This is usually accompanied by higher interest rates, as lenders try to offset the increased risks associated with the borrower. And then it all blows up; the creditor becomes the investor. The original investor no longer owns the asset and whatever equity the investor thought was in the asset disappears. The creditor often also loses equity, as the price of the asset falls below the leverage on the asset.

Throughout history, the business cycle has led the credit cycle. The first stage of the credit cycle occurred in the beginning of the business cycle as investments in property, plant and equipment (PPE) was made to meet existing market demand. As investors saw other investors making a return on investment in the expansion of capacity, additional investment would flow into the particular sector, dropping the borrowing cost and incentivizing the entrepreneurs to build additional capacity to win market share. Exuberance would increase, and capacity would be built to handle future growth. This resulted in too much capacity and an ensuing crash in prices as competitors did everything they could to stay in business. This, in turn, impacted their ability to pay the investment returns, and since investment dollars are in effect a store of future consumption, a loss of investment (or even a loss of return) impacts spending habits which then causes contagion outward into the broader economy. A smaller and smaller percentage of investment is being made into productive assets now than in the past (due to financial engineering and artificially low interest rates) so there is reason to believe the business cycle no longer drives the credit cycle.

Peter Boockvar, Chief Investment Officer of Bleakley Advisory Group believes that due to central banks’ intervention into the economy that we no longer have the historically typical business cycle. Instead, we have monetary/credit cycles. The Minsky credit cycle mentioned above definitely was correlated with and had causation into, business cycles, but with monetary policy muting business cycles and acerbating the pros and cons of using debt, historical debt cycles appear to have been elongated. This leads to more profit earlier in the cycle, with a far greater fall out when the cycle implodes. Said another way, so long as the markets trust the central bank everyone keeps partying, but when the central banks lose control, which they have always eventually done in the past, the fact investors partied far later into the evening than they would have been able to in a normal business cycle leaves everyone with far greater hangovers after the party ends. Notice I said “markets”, not “economy”. Despite the roaring success of investments over the past decade, and despite recent strength in the economy, we are still far below the expected trend line economic growth compared to where we would normally be this far after a recession. Especially one of the size and scope we experienced. Economic history is littered with examples of the larger the crash/recession, the more impressive the recovery (the Great Depression not withstanding as an outlier).
Many explanations for the Great Recession have been proposed and since it is a historical thesis on the most complicated and interrelated organism this world has ever seen (the world economy), there is no way to verify the accuracy of any of the explanations. There is one explanation though, that most prognosticators agree was a contributing factor, if not THE contributing factor. Too much debt.

Ten years have passed and with the help of the central banks, world indebtedness is higher now than in 2008. Global consumer debt? Up (2008 = $37 trillion, 2018 = $47 trillion, with China alone increasing from $757 billion to $6.5 trillion). US student debt? WAAAAAY up. Car debt? Way up. Global non-financial corporate debt? Stratospherically higher (2008 = $46 trillion, 2018 = $74 trillion, or 90% of global GDP). Government debt? Don’t get me started. Incomes look like they are finally starting to rise. Maybe that will help with the consumer debt and we will be able to get a handle on it. Extremely low unemployment means everyone that wants a job has one, and opportunities for advancement are far greater than they have ever been for the Millennial Generation, who are the ones with all the student debt, so maybe better compensated positions can result in the economy growing its way out of the student debt overhang. Many corporations, at least until the tariffs start to bite, are seeing increasing profits. Maybe those profits can help reduce the corporate debt load. However, there are a lot of maybes, and with interest rates creeping higher the cost of reducing that debt will also increase.

In 2005, 2006, and 2007 (and even into/through the Bear Stearns collapse in 2008) everything was hunky-dory. Asset prices were increasing, the economy was strong. We know what happened next. No, not that, not the recession and stock market crash. I am talking about what investors did.
Most investors freaked out, withdrew, and stayed on the sidelines for years. Just like the assumption that since markets have increased the last few years they will increase forever, investors assumed that since the markets were/had fallen they would fall forever. Fortunes were being made, but only by those playing the game.

As everything was blowing up around me in 2007 and 2008, I never could have imagined my life would be where it is today. Even into 2009 and 2010, post wedding, when things were rapidly improving, I still couldn’t have imagined my life in 2018. I don’t mean just financially, but with a wonderful family, an amazing work team, inspirational investors and more…life is about as good as it gets. I am greatly blessed.

But I also still carry scars from 2008. They were deep, and despite some healing, are still prevalent. I hope they never heal completely. I don’t want to fall into the complacency or the Recency Bias trap and assume that because we have come so far that we can’t go back there again. I don’t believe, and don’t want to believe that we are smarter now than we used to be, that governments and central banks have figured out to protect us from ourselves, or that we as humans have evolved to the point that even sans protection we can avoid relapses to pride and greed. Forget relapse, I don’t think we ever escape pride and greed in the first place. Sometimes fear keeps us from doing something to injure ourselves. At the same time, I also don’t want fear to play into what should be rational decision making, resulting in lost opportunities.

No one really knows when the next stock market correction or recession will come, and that’s okay. More importantly for each of us is that we maintain our discipline in business and investing. Where are we within our own personal debt cycle? What is our psychological state? Do we have written “Hit the Fan” investment rules we can follow when the fear and/or greed extremes of our human nature take over? One thing we can assume to be true is that when the next recession or correction comes it will follow the path of Hemingway’s bankruptcy: gradually and then suddenly.

Unfortunately, with monetary cycles, and far more so than with most historical business cycles, a monetary cycle correction will affect each of our own private economies. Part of the degree to which we are impacted is out of our hands; our career, where we live, etc. This was certainly so in 2008. But much of the impact, or lack thereof, ultimately lies with us. Both decisions we make now (convexity, debt loads, etc.) and decisions we make during a correction or immediately in its aftermath (buy/sell/run/hide/grow/etc.). That is all up to us, as imperfect and often irrational humans.

Life can be complicated. Investing can be complicated. Usually it is our human natures that make it so.   
 
Happy Investing.

Forrest Jinks
Altus Equity Group, LP
off: 707/932-5887
www.altusequity.com
About the Author: Forrest Jinks is a managing director of Altus Equity Group, LP and 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, industrial, and retail), debt, and small business start-up (online marketing and site retail). Altus Equity Group currently manages about $125 Million in alternative investment assets. He can be reached at fjinks@altusequity.com.