2021 Annual Letter
For many, 2021 offered the hope of a new year - one to propel civilization beyond an indescribable 2020. A new vaccine, constructed within just months, seemed like a get-out-of-jail-free card from the entrapment of COVID 19.
Yet, despite the vaccine's undeniable benefits, it failed to put the pandemic in the rear-view mirror. Those more acquainted with the basic study of virology may have seen this coming, and we still wait patiently for the covid upheaval to pass. The year 2021 brought a series of shifts throughout the economy and our everyday lives that resulted from the unprecedented measures taken in 2020. The government’s reaction to the economic crisis by dispersing a stimulus in both 2020 and 2021 will, for many years, be refuted by some and praised by others. Regardless, we undoubtedly dodged a complete economic collapse. While the early months of COVID decimated many companies, the broader economy pushed through without irreversible damage.
Even the most rapid decrease in GDP did not bring as much destruction as the great depression. One only has to read a few passages about the 1930s depression to see what true economic downfall looks like.
In fact, take the graph of the Dow Jones Industrial during the 1929 – 1930 period, flip it over on its head and you have a similar graph to what the market was like in 2020 and 2021. The result of this? Simply put, the government stimulus flowed, in unbelievable amounts, from the treasury department to the brokerage accounts of millions of Americans.
With the additional funds, Americans drove up prices to levels not seen for two decades. The S&P ended 2021 at 24.5 times earnings and the NASDAQ at 29.7 times. 1999 and 2000 were the last reflections of the indexes at these levels.
As with all stock market booms, there are a few stars who get an overwhelming amount of attention, and few stars shined as bright as Tesla, whose share price rose 1,000% over the past 2 years as if its stock rise was as autonomous as its vehicles.
But stock prices aside, the company also starred in a wave of a new concern for climate change and a push for electric vehicles. While Tesla sells a fraction of the vehicles of Ford or General Motors, it leads the industry in sales of electric vehicles with 936,172 sold in 2021. Countless other firms have been all too happy to piggyback on the excitement that Tesla has brought to the market. More electric vehicle companies went public in 2021 than in any other year in history, all of whom hoped (and succeeded) to capitalize on the enthusiasm flooding the market. Almost all these companies have been given valuations so sky-high as to spark flashbacks to 1999 internet companies.
If feeling generous, we could classify all these behaviors as speculation in the stock market. Now, let’s go one step further to gambling.
Down On the Corner
In 2012 a new thread was created within the online program Reddit as a means for individuals interested in stocks to share their opinions and thoughts on certain equity purchases. To ensure the thread wasn’t taken too seriously, a playful, but still driven name was given to it: WallStreetBets; presumably formed by people who had never set foot on Wall Street. However, in 2021 a peculiarity happened within the group.
Its members, armed with stimulus checks deposited into their brokerage accounts, collectively decided to push the stock of GameStop up dramatically; enough to throw a financial wrench into the institutional money management machine, who, with their supposedly superior knowledge, placed short positions on the video game retailer.
A short position, as it related to equities, involves borrowing shares in a company and then selling them to another party, with the promise that one will purchase them back at a later date and then return them to the party from whom they were borrowed. The hope for these “short sellers” as they’re called, is that they purchase back the stock at a lower price than they sold them, and then return them to the lender, pocketing the difference. The lower the price goes the more money is made by the short seller.
However, the price isn’t guaranteed to fall lower. Should the price rise, the short seller has to buy back the shares at a higher price before returning them to the lender, resulting in a loss. The higher the price, the bigger the loss for the short seller.
This brings us back to our Reddit rebels, who pushed the stock of GameStop so high that those who had short positions against the company suffered immense losses. In dramatic cases like this, the activity is known as a ‘corner’, because the short sellers are forced into a corner to buy back shares at a much higher price.
This happens perhaps more frequently than most realize, but seldom does it involve such a large number of retail investors, while achieving such wide media coverage. This is not a first and is certainly not the most dramatic example.
To see the full-scale drama that a corner can cause we must go back more than a century to 1901.
The concentration of the stock market in railroad stocks in the early 1900s is indescribable compared to the vast number of companies and industries that make up today’s market. At that time roughly 60% of the stock markets’ capitalization was made up of railroad companies. All capitalist titans of that generation had in some way interests in the railroads. But because of the poor economics of a railroad company, a strong market position was essential to succeed. The slightest hint of competition could bring the company to an end, and this competition led to a fierce rivalry between 4 of America’s greatest capitalists.
E.H. Harriman was the largest shareholder of Union Pacific and turned his company into an incredibly profitable machine. At the possible threat to his railroad, Harriman, along with his banker Jacob Schiff, began to purchase shares in the Northern Pacific railroad to ease the threat it was posing to the Union Pacific.
But the Northern Pacific already had a large shareholder in James J. Hill and his banker J.P. Morgan. Due to Hill and Morgan’s lack of attention, Jacob Schiff and Herriman were able to purchase large stakes in the Northern Pacific and come close to controlling the company. Upon hearing this news, J.P. Morgan placed an order for a large enough block of stock to assert his control, but this purchase didn’t come cheap, and the stock shot up.
As a result of the battle, the short sellers in the Northern Pacific were getting caught in the crossfire. Once they realized that there was a bidding war between America’s most powerful businessmen, they realized how high the stock may go, and began to close out their short positions. The ‘corner’ that these short sellers found themselves in caused the price of Northern Pacific to rise from 100 to 1,000 in less than a week, and it wreaked havoc across the market.
Because the railroads were such a large part of the market, ripples of this rivalry spread far beyond the Northern Pacific. U.S. Steel, formed after Morgan’s purchase from Andrew Carnegie, went from $54 to $26 in just days. The pain from the Northern Pacific caused devastation and the suicide rate rose drastically among some of these short sellers.
Only after the two sides agreed on a truce did the markets begin to calm, but the financial destruction from this corner echoed through Wall Street for decades. All short positions, even today with heightened regulation, carry the risk of this happening.
Tesla, GameStop, Zoom, and AMC all saw unbelievable price rises during 2021, making large profits for their investors. But the glory of price hikes stops at financial assets. The more applicable price rises to consumers are seen on store shelves rather than on their Robinhood accounts.
The trillions of dollars pushed into the economy were undoubtedly going to result in inflationary troubles. It was not until the latter part of 2021 that the public saw high enough upticks in inflationary measures to spark cause for concern. While the inevitable impact of inflation hit hard asset prices (as explained in my 2020 article), only after figures above 5% annual inflation were released did the government begin discussions on ways to counteract the inflationary trend.
The most common ways to dampen inflation are to increase interest rates, decrease stimulus, and tighten the money supply through lower consumer expectations. All plausible methods, but for those less familiar with an inflationary world, it should be noted that inflation cannot be turned on and off with government policy like a mechanical switch. It takes years to build up and can take years to cool down. The closest the nation has come to an off switch for inflation was in the 1980s when Fed Chairman Paul Volker increased interest rates from 11% to 21% in a matter of 36 months.
The result was a country-wide recession, a president losing re-election, and anger towards the Fed and Treasury department not seen since the days of Andrew Mellon in the depression. An effective, but very painful, “off” button.
The reason inflation can be so dangerous is that once it gets going it’s difficult to stop. If businesses charge more for their products, consumers will demand higher pay from their employer, meaning the employer will have to charge more for their products and so on.
This poses a difficult question for managers. They have a moral obligation to their employees and a financial obligation to their shareholders. Meaning they must balance the decision of paying their employees more or keeping salaries at the same level and distributing excess profits to shareholders. The higher the rate of inflation goes, the bigger this problem becomes. Business articles, annual reports, and investor relations calls are all being centralized around the growing problem of inflation and how each business model will allow it to adapt.
Rate of Interest
In last year’s letter, I described the immense importance of interest rates on the value of financial assets. If the Fed decides to go the route of raising interest rates over time the result could be a shock to the market. It may sound trivial to say the central bank attempts to push rates to 4.5% (still a low figure historically speaking). Yet, that rate would be a 462% increase over 2021 rates...No small change.
A ten-year bond with an interest rate of .8% (2021 rate) may have a present value of $923. But with a discount rate of 4.5%, the value drops to $643. The Fed, as well as investors, should be very cognizant of these rates.
Micro - Organisms
Enough macroeconomics. The more understandable, and in my opinion the more interesting, is the micro. The industries, the companies, and the entrepreneurial and capitalistic mindset serve as the stone on which the country rests.
What we’ve seen during this tumultuous time is the pure essence of capitalistic Darwinism. This unforeseen event causing utter destruction tests the business organisms that make up our $24 trillion dollar economy.
Not all could possibly survive, but of the ones that do, many emerge stronger. The ones that perished should be remembered for their effort and contribution. The mom-and-pop restaurant that, after 5 decades of operation, had to close its doors for good. The tailor on the corner who operated for a lifetime on narrow margins, spending excess cash on upgraded material rather than pandemic and business interruption insurance. That small group of the 31 million small businesses in the country, that did not survive the past two years, are to be remembered for their effort in driving the U.S. economic machine forward.
As stated, many that emerged, emerged stronger. Their models may have changed but they are now equipped with the experience of another hardship. Benefiting from the antifragility of economic nature. The pandemic altered their common way of operation so much that they had to make a change. And the changes seen in these small businesses over the past 2 years prove that desperation truly breeds innovation.
The country’s industrial titans have proved just as innovative. Turning Zoom from a company name into a verb. Microsoft Teams and Facetime sported countless new features. A decade's worth of technological advancement crammed into 18 months.
But the biggest change to the day-to-day operations of companies has been the widespread adoption of working from home. A somewhat debated topic at the moment but something that will assuredly but seen as the norm in two decades.
Corporations in the U.S. spend billions every year on office space, and American office workers spend additional tens of billions on mortgage and rent payments. Essentially, each office worker has two homes. A home for working and a home for living. Some may not think of an office as a home but calculate the number of waking hours spent at the office versus the number of hours spent at your residence and the evidence is clear - the office is very much a home.
And what of the hours spent getting ready and driving to the office? These additional hours all count toward the time spent for work. It always amused me to hear people say they work 8 hours per day when, in reality, they work 8hrs + travel time + getting ready time.
To make things interesting, do the following exercise. Take the number of hours you “work” each day. (let's say 8 hours). Add travel time (1 hour) plus getting ready time (another hour). In our example, 10 hours are spent per day for work. Now multiply by 5 days per week (50 hours). Now take your weekly salary and divide by that total number of hours. That’s your hourly wage. Not that figure printed on your pay stub.
In our example, someone earning $1,000 per week may think their hourly wage is $25 per hour. But add the travel and getting ready time and their hourly wage drops to $20. For those who want to go one step further, calculate the gas expense, travel expense, and car maintenance expense that is attributable to your commute to work in a year and subtract that from your salary, and then do the above experiment again. All time and money you are paying in order to work, for which you aren’t compensated. And all expenses which don’t exist for the remote worker.
Working from home is here to stay.
Now, how could any letter, supposedly targeted toward financial professionals, be complete without mention of one of the largest single-year “asset” price rises in history. Cryptocurrency (namely Bitcoin) is an interesting phenomenon. A limited number of digital tokens, created by the solving of increasingly difficult mathematical equations, and distributed instantly and without record. No one can doubt it is a tribute to human ingenuity. But for the speculator looking to purchase such an instrument, I only offer a recommendation to read an all too forgotten book: Extraordinarily Popular Delusions and the Madness of Crowds. Its origin is in psychology, not finance, and its Scottish-born author comes from the same discipline. A book I would deem a necessity to any aspiring financier, investor, wealth manager, or anyone else planning to engage in any sort of asset purchase. Apart from that, I offer nothing.
Along with this “asset” class upon which I have no comment are SPACS, IPOs, NFTs, and digital real estate. However, I have a few comments regarding the man chosen to oversee these developments.
I read brief articles about Gary Gensler (the SEC chairman appointed in 2021) but nothing came across as peculiarly interesting. After watching a few clips of him on CNBC as well as an interview on the David Rubenstein show, I do, however, have quite a bit more admiration for him.
It is a difficult job to be a regulator such as him, particularly during such a bull market when people seem to be willing to put money into anything. Yet, he has shown he is up to the challenge and willing to be unpopular among the crowd to implement protective legislation. In addition to his policies, what has also shown his character is his authorship of a book encouraging investors to put their money into low-cost index funds and not be enticed by advisers charging a high fee. This is a simple, and important concept, preached from John Bogle to Warren Buffett, and one all investors should be informed of. The index funds remain the best way to participate in the country’s growth, and despite the naysayers, one thing that is sure is that the U.S. will continue to grow.
The coming years will be largely spent on adapting to the changes brought about in 2020 and 2021, and a generation who had never given a second thought to inflation will get to be very familiar with the concept. What this new generation will also have to cope with is lower expectations on the rise of equities as the percentage increases seen over the past few years can’t possibly continue.
Nonetheless, the country will push through any hardship it must face, and as we’ve seen post pandemic, it will emerge stronger.