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Conundrum



Today I want to briefly comment on a newsletter recently published by Jared Dillian. Dillian is a former trader at Lehman Brothers who now runs a variety of investing-related services through Mauldin Economics. On July 11, 2019 he shared "The Curious Case of the ZIRP NIRP Gold Bugs" via his free newsletter, The 10th Man.


Dillian writes about recent nominees to the Federal Reserve Board who seem to believe - simultaneously - in hard money and soft money. That might be someone who believes - for example - in the gold standard while at the same time advocating for keeping interest rates at very low levels (or even zero, as in Zero Interest Rate Policy or ZIRP; or negative, as in Negative Interest Rate Policy). These kinds of developments are of keen interest to us as entrepreneurs and investors.


As entrepreneurs, the effect of Federal Reserve action is direct: Fed policy impacts the cost of money, and cost of money - whether debt capital or equity capital - is a critical part of starting and growing an enterprise.


As investors, the effect of Federal Reserve action is indirect: policies like ZIRP and NIRP have had material impact on financial markets since the Global Financial Crisis. And as I wrote on June 3, historically low long-term interest rates mean (mathematically) that cash flows anticipated by stock investors far into the future are worth more today (in present value terms) than they would be otherwise. That necessarily means that higher-growth companies (with perhaps lower cash flows today but much higher expected cash flows in the future) will be valued at higher levels, all else being equal. It’s not the only reason for growth/tech dominance in the US stock market (and to a lesser extent, globally) over the last decade, but it's part of the story.


But back to Dillian. Here's the quote from his letter that caught my eye:


"We used to worry about dovish Democrats taking over the Fed and cutting interest rates and bringing back the inflation of the 70s. Now the Republicans are doing it! A Democratic administration would behave no differently. Sobering thought - we are in for decades of ultra-loose monetary policy…I know plenty of stock market bears reading this newsletter. Think of what unlimited monetary stimulus is going to do to your short positions. It is going to hurt like an Alvin and the Chipmunks Christmas CD…I'm not optimistic on stocks - it's just the reality of the situation. Unlimited. Monetary. Stimulus. Forever. Those houses in San Francisco are probably not going to get any cheaper."


Currently there is essentially no opposition to further monetary stimulus. Not from Congress. Not from the Administration. And not from the Federal Reserve itself. That seems unlikely to change any time soon, given the way things are evolving culturally and socially. Lax monetary policy for decades to come? Maybe, and there's also the possibility that along the way we get an economic downturn and louder cries for government to "do something!" and at some point the relationship between the Fed and the Treasury is fundamentally altered. That would throw the cat amongst the pigeons! Truly unlimited stimulus might mean interesting times for truly limited and scarce assets…


The conundrum is how to deploy capital, as a disciplined investor who does not like to lose money and who seeks a margin of safety, when valuations for US stocks are high (by any historical measure), and when there's monetary stimulus as far as the eye can see.

Well, for starters, we don't give away our patience and discipline - those attributes are among our greatest advantages! But we can see the world for what it is (not what we wish it to be) and adapt accordingly. We can take advantage of loose money conditions with thoughtful and strategic use of financing at low interest rates; we can reinvest in our businesses, where in many cases long-term IRRs remain compelling versus public markets; and we can look further afield, at markets and assets less affected by continued stimulus.


This conundrum might be with us for a while. Better pack lunch.

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