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Gobsmacked!

“The question is how much further capitalism will be deformed by government intervention on this scale. When the government is willing to buy just about anything, it distorts market prices, which normally guide people to buy into profitable, promising companies. Now investors are simply buying what the Fed buys. The process of competitive capital allocation, which is critical to raising productivity, has broken down….Governments need to recognize that constant intervention to prop up the economy and financial markets is not achieving its intended purpose.”

—Richer Sharma, Chief Global Strategist Morgan Stanley

This week’s record-shattering sale of a 1988 BMW E30 on Bring a Trailer has lit the collector car world on fire. This outcome is a historic market moment for the burgeoning Youngtimer collector segment who covet early BMW M cars. Last week, I was a panelist on Keith Martin’s new SCM Live Zoomcast. This new media venue from SCM invites three experts to share their picks from a live Bring a Trailer auction and predict the outcome. For my pick, I presciently chose the record-breaking M3 and predicted it would sell for $185,000. Many viewers on the Zoomcast felt that was a high number. I reasoned that E30 M3’s are iconic cars, and they appeal to a wide demographic. Most were used up, tracked, and driven into the ground. While E30 M3’s are not rare by most definitions, it is slim pickings to find a sub-20,000 mile example. This car had color, condition, and mileage on its side. My estimate turned out to be wrong—entirely wrong. The hammer price was an astonishing $255,000 inclusive of fees.

Most collector car web threads say the same thing: The M3 buyer, @SouthFloridaWings, probably grew up poor and dreamed of owning an E30 back in 1988. This car was their chance to buy a like-new time machine. There are few investment-grade E30 M3’s left, and this example is among the best out there. The E30 is an iconic piece of BMW’s post-war history and is undoubtedly a rising collectible. It is a pure analog car that is fun to drive. As the owner of an E30 M3 myself, these positive comments are all valid; however, could they be missing a more significant point on the real drivers of this outlier outcome?

A picture is worth a thousand words. Each black dot represents an M3 sale. While you can see some big outcomes, this M3 sale is a major outlier. (Scatterplot courtesy of Bring a Trailer)

Our view is that this gobsmacking sale could have less to do with demographics, passion, collectibility, or rarity (17,970 E30 M3’s were manufactured worldwide over five years) and more to do with global monetary policy, interest rates, and other macroeconomic factors. As a panelist at the Sports Car Market Insider’s Seminar at Scottsdale in 2018, I argued similar factors (i.e., quantitative easing) were increasingly the real culprit behind the surprisingly sharp rise in collector car values (as well as Andy Warhol paintings, fancy New York City apartments, and even Facebook stock). Back in 2018, not many in the Scottsdale audience agreed with me. Today, I am still somewhat of a lone wolf in an industry that believes passion, rarity, condition, and mileage are the key determinants of collector car values.

Since the Global Financial Crisis (GFC) in 2008, central bankers worldwide have embarked on a grand monetary experiment. They have been throwing everything but the kitchen sink at elevating the global economy and propping up financial markets. There were many causes behind the GFC—too much debt chief among them. The solution of central bankers and world governments? Add more debt—A lot more debt. With Covid19 dwarfing the GFC, central bankers are “doing whatever it takes” to keep markets elevated and the financial system liquid. Examples of extreme measures by the Federal Reserve now include buying the debt of Disney, Walmart, AT&T, Nike, and Berkshire Hathaway. The result? Massive appreciation in certain paper assets, rare collectibles, and Hamptons or Aspen-like real estate.

It is getting harder to ignore that a possible growing contributor to outcomes like this M3 sale may be directly related to low rates, a decade of quantitative easing, massive stimulus, and a lot of liquidity in the financial system. Sure, passion and collectability play a key role in the final hammer price of any car. However, those traditional and obvious factors are being augmented and enhanced by extreme Federal Reserve policy. Negative real interest rates distort price discovery and make it challenging to value any asset—including collector cars.

As a partner at Hollow Brook Wealth Management, we are confronted by $250,000 E30 M3’s all the time—but they are disguised as stocks and bonds—not Bavarian automobiles. In today’s market, it is a challenge to run screens and find companies trading at a reasonable multiple of anything. Just a few weeks ago, we reported on Turtle Garage that Tesla had reached $1,000 per share. Guess where it is today, a few weeks later? It is at $1,600 per share! Tesla is now worth more than Toyota, and it is trading at over 200 times earnings. We see trillion-dollar deficits, but we also see trillion-dollar companies, often trading at pricey valuations. Apple, Google, and Microsoft are all worth more than $1 trillion each—the last time I checked a trillion is a thousand billion. It is likely that the venerable economist and Wall Street legend Benjamin Graham never could have imagined a trillion dollar company. 

The following second quarter letter from my investment firm sheds further light on how we got to this point and where we might be heading. It is a little longer than usual but makes for some good Sunday reading. 

Hollow Brook Wealth Management 2nd Quarterly 2020 Letter

 

To V or Not to V, that is the question.

We hope that this letter finds you, our clients, your families, and friends as well as possible in these extraordinary times. All of us at Hollow Brook are well. We have been able to operate remotely with full effectiveness, and now that New York State is reopening, the team is slowly returning to spending a limited amount of time in our office. We offer again our profound thanks to all those providers of healthcare and other essential services throughout the country on whom we all depend.

From an investing, personnel, and operations standpoint, it has been a busy quarter. We have worked tirelessly to make the most out of shelter in place and have handily leveraged our robust remote workplace environment. As a result, there is a lot to share and this quarterly letter is longer than normal.

First, we would like to announce the retirement of Lillian Preziosi. Lillian began her career working for Wayne out of college and has been by his side ever since. We are so grateful for her decades of commitment, service, and hard work. Lillian’s dedication to Hollow Brook and excellence in all she did was an inspiration to all of us. We wish Lillian all the best in the years ahead.

It is with great enthusiasm that we announce that Andrew Norris has officially joined Hollow Brook on a full-time basis as Co-CIO. In this role Andrew will work with Wayne and the team to further develop asset allocation, investment policy, risk assessment, and overall portfolio construction. If you have not had the pleasure of speaking with Andrew please do not hesitate to reach out.

With Andrew joining us full time, we are also excited to announce that Thomas J. Girard will now occupy his seat on our Advisory Board. We have known Tom for several years and have a deep respect for his fixed income expertise and general financial experience. Tom served as the Chief Investment Officer of Fixed Income for NYL Investors until June 2018. NYL Investors is a wholly owned subsidiary of New York Life Insurance Company, the largest mutual life insurance company in the United States. Tom oversaw the management of $145 billion in fixed income assets, 65 investment professionals, and was responsible for a $140 million P&L. He was also responsible for setting investment strategy, leading committee meetings, and overseeing risk management of all fixed income portfolios. Tom received his BS from St. John Fisher College in Rochester, NY, earned his MBA from Fordham University, and acquired his CPA in 1986. We are looking forward to working with Tom and benefiting from his counsel.

On the operational side, we continue to heavily invest in improving and upgrading our technology platform. Our goal is to lead our industry in technological adoption and advancement. We have been working over the past year on a major upgrade to our performance reporting system. During the upcoming quarter we will be migrating to Black Diamond. In addition to enhanced reporting we will be providing portal access where clients can view performance reports electronically and via a mobile application. We are extremely excited to share this new robust platform and our enhanced reporting capabilities with you. Stay tuned for details.

As we previously mentioned in our last letter, the CARES act, which was passed back in March, included a provision to waive the Required Minimum Distribution (RMD) requirement for 2020. The IRS announced on June 23rd that individuals who have already taken RMDs in 2020 might be able to “roll back” those distributions. If you have any questions or would like to discuss in more detail please reach out to Andrea O’Neill (aoneill@hbwmllc.com 212-364-1838) or anyone on the Hollow Brook team.

Last quarter our letter addressed the following: the precipitous falls in all financial assets (except precious metals), the connections between all asset classes due to leverage, the need for strong monetary policy support to keep markets functioning, and the need for strong fiscal support to tide unemployed or furloughed workers over while large parts of the economy were shut down. We expressed concerns about the possible extent of the financial market and economic recovery. We believed that the duration of time of the economic slowdown due to the potential of more widespread and lingering effects of COVID-19 would be longer than suggested by political leadership, and that this would constrain financial market returns.

This quarter we must point to the rapid, strong monetary policy action by the Fed (already significantly larger than after the Global Financial Crisis (GFC)), the huge fiscal support from Washington, and the resulting astonishing recovery in financial markets. The Fed’s balance sheet has reached nearly $7.5 trillion, or nearly 35% of GDP, as large as during WWII. Chairman Powell has stated that there are no limits. Fiscal support exceeds $2.8 trillion and further support is under discussion in Washington. It will also be measured in trillions.

The financial market recovery has been immediate. The NASDAQ index is ahead for the year and the S&P500 is within a whisker of its level at the beginning of the year. US Treasury bond yields are at all-time lows and credit spreads have tumbled nearly to pre-crisis levels. Corporate bond issuance has already exceeded 2019 total volume as companies have raised capital to survive a weak economic period. In short, despite some tense moments in March, financial markets have rebounded while measures of volatility have fallen. Yet unemployment exceeds 20 million and furloughed workers add another approximately 15 million people to this metric. The US economy is forecast to contract by approximately 5% in 2020 and the most optimistic forecasts suggest full recovery only by the end of 2021. Many service industries, which account for a significant portion of the US economy, and industries such as travel and leisure, aren’t projected to recover fully for many years. How can these seeming contradictions be explained?

The consensus answer, judging by market action, is that investors have learned not to fight the Fed, especially with the experience of the last 11 years. A widely held view is that interest rates will remain low indefinitely, and that securities are therefore worth more. There is no alternative to equities, and inflation, as has been the case for the last 10 years, will remain subdued, meaning there are no adverse consequences for extreme monetary and fiscal policy.

Hollow Brook is aware of these views for investment policy, but our medium to long-term fundamental approach has different conclusions. We know that monetary and fiscal policy act fast as financial markets attempt to discount them. We also know that they act slowly in the real economy. We think we are at a moment when the fundamental consequences of the virus crisis will slowly be felt in financial markets. We think the economy will be impaired for longer than is anticipated and we think that there are important investment consequences for extreme monetary and fiscal policy, which portfolios must protect against now.

As investors with a medium to long-term time horizon, we think that the two important questions we must ask ourselves are:

  1. How strong or fragile is the global economic recovery likely to be?
  2. Given the monetary and fiscal policy background, is it likely that the next 10 years will resemble the last 10 years in investment terms?

How strong or fragile is the global economic recovery likely to be?

Our central assumption in response to the first question is that a strong partial recovery is possible, but that this will reach a plateau lower than a full recovery if public confidence is not fully restored. This view is based on two assumptions. The first is that the effects on the behavior of people as a result of the virus remain until an effective vaccine and/or treatment is widely available. Huge resources are being thrown at the problem by multiple pharmaceutical companies around the world, and manufacturing bottlenecks are being dealt with by building production capacity in advance of the discovery of a vaccine. However, the best examples in history suggest that this is at least a 12-18-month process, of which safety must be an integral part. It appears to us that COVID-19 is not yet fully understood.

In the meantime, the virus continues to accelerate in the emerging markets, which are important for global economic activity. Furthermore, the virus is accelerating again in the southern and western United States, causing partial reversals of attempted reopening policies. Policies that allow higher incidence of the virus in order to preserve economic activity have not proved successful in Sweden (which has pursued herd immunity), or in the southern US states that reopened soonest. A perverse consequence of allowing higher infection rates is that public confidence will take longer to be restored.

We believe social distancing, wearing a mask, and good hygiene have proved so far to be effective tools in containing the spread of the virus. It is reasonable to assume that, whether mandated by policymakers or not, individuals on their own volition will continue to practice it. We have also asked ourselves if schools will reopen fully in the fall. Without schools, it is possible a parent will be obliged to stay at home. The combination of continued social distancing and related work practices for shift working suggest only a partial effective labor force, regardless of the industry in question.

Certain industries such as restaurants, airlines, travel, and other service activities which are significant employers, and which necessitate close physical proximity with and between customers will only be able to reopen very gradually and may not achieve pre COVID-19 levels for many years.

The second assumption is that consumer behavior may change more permanently. Will consumers return to activities and spending patterns, which the virus has shown to be non-essential? Will high savings due to the lockdown and Paycheck Protection Program (PPP) dollars remain as savings, or will they be spent? Will the young, who have less money, spend, while the older, who have more money, save? Recent data shows that lower income brackets have hardly reduced spending, since almost all spending is on essentials, while the savings rate for higher income brackets has risen and stayed at about 17%.

The IMF has recently revised its economic forecasts to greater economic declines in 2020, and no full recovery until 2022. Given the arguments set out above, this forecast seems reasonable to us.

Will the next 10 years be like the last 10 years in financial markets?

Before 2020, financial markets were characterized by:

– low interest rates

– low credit spreads

– leveraging

– low credit risk

– positive asset spirals

– low capex (excluding the Cloud)

– globalization (Pre-President Trump)

– low economic growth

– tax cuts

– low apparent inflation, but high inflation in education, healthcare, retirement costs etc.

– powerful digital economy, obscuring other weaknesses

Post-2020 we think financial markets will be characterized by:

– low interest rates

– higher credit spreads

– first more leveraging, then deleveraging

– higher credit risk, and bankruptcies

– reverse asset spirals (commercial real estate etc.)

– deglobalization

– higher capex, retooling of supply chains

– low or negative economic growth

– higher taxes

– significant bifurcation between the digital economy and the rest

– inflation, deflation, stagflation, or the status quo ante? All at the appropriate time

Our view is that the next 10 years will be different, because highand rising debt levels, economic stress, subsequent deleveraging and deglobalization all argue against it. In parallel, and closely related, more asset price inflation (a consequence of massive monetary policy efforts), and therefore more wealth inequality will be politically unacceptable as will high levels of unemployment. Many companies in many industries may not survive the COVID-19 crisis, and those that do (self-financing digital economy businesses are an exception) will need to reinforce their capital structure by raising fresh equity. Share buybacks to amplify EPS could be a thing of the past. Eventually, after a wave of emergency debt financing, deleveraging both by companies and individuals to reinforce capital structure, the opposite of the last 10 years, may be the backdrop. Re-engineering supply chains will put margins and profits under pressure both as capex becomes important, and as it is less advantageousto outsource low value-added activities. Finally, the public fiscal position resulting from COVID-19 crisis policy actions will be a significant problem. It may become politically acceptable, and necessary, to raise taxes on corporations and the rich. Arguments about global competitiveness will be diluted because all countries are in the same boat of deglobalization.

Key to this discussion is the rising possibility of political change. By this we don’t necessarily mean the coming US election, though this is a moment when change could begin to manifest itself. Current civil unrest, and its relationship to wealth inequalities highlighted by the virus crisis combined with risk from the virus, is in our opinion a symptom of deeper secular change, of which rising populism and totalitarianism around the world are also part.

History shows that extreme wealth inequalities, inflation or deflation, and the resulting breakdown in important elements of social contracts are always the prelude to significant political change. In the developed countries, and especially in the US and UK, wealth inequality is at all-time highs. At the same time, for the middle and working classes, real incomes have not risen for many years and there is high, but unmeasured inflation. For example, it has never been as expensive to retire. Low interest rates require high capital amounts for a modest income. Healthcare and education have never been as expensive. These are all important social bargains, which are at a breaking point, setting different generational cohorts against each other. The combination of all these pressures at this moment suggests to us that it is prudent to factor into portfolio decisions the possibility of significant political change. Investors haven’t had to do this since 1980 and may not be doing so today.

What if we are wrong? A vaccine might be created quickly, which markets would discount immediately. In this case, our investment policy, which gives exposure to risk assets, will participate in market gains, but not to their full extent. The incumbent President might win reelection. It seems to us that this would heighten existing political and geopolitical tensions, and so delay, but also strengthen the case for secular and structural change.

We are pleased that Hollow Brook investment policy has defended risk capitalwell as markets fell in the first quarter and has participated in market gains during the recovery. The background against which we invest is one of deglobalization and desocialization (because of the virus). This dynamic leads to the observation that equity markets are still led by a more and more predominant group of large US technology companies, a process that has been amplified by the recovery since March. We were conscious of this concentration early in the year and remain so now. Precious metals remain relevant given the risks of inflation or even stagflation that may follow from monetary and fiscal policies. The avoidance of leverage remains important not only to ensure that portfolio companies have the flexibility to negotiate difficult circumstances but also to mitigate the risk of deflation. In summary, our current analysis seeks to find values in which we can deploy capital to achieve long term compounding returns. We will also avoid the complex financial structures that are partly behind the current financial collapse. Our framework suggests that potentially attractive investments could initially be found:

  1. industries that our fundamental analysis suggests are well positioned to survive and prosper in a period of great structural and secular change.
  2. corporations with strong balance sheets giving the autonomy to invest and restructure supply chains while finance is less available, and while obligations to the state hinder competitors.
  3. high quality credits offering the opportunity to lock in attractive yields while credit markets have been dislocated
  4. real assets to mitigate inflation risks
  5. work outs, distressed credit, and select special situations as a complement to the core portfolio.

The lifeblood of our business is our client base and the many referrals and recommendations we have received over the years. If you know someone who might benefit from our careful, thoughtful, and process-oriented approach to integrated wealth management, we would gratefully appreciate any referral.

Please stay safe and have a great 4thof July holiday weekend. Thank you for your trust and confidence and please do not hesitate to reach out if we can be of help.

Sincerely,

Hollow Brook Wealth Management

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